Don't Let Dead Inventory Kill Your Profits

It’s a fact of business life. Eventually, some of your inventory will die.

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Items may be overstocked, products may become obsolete or demand may dry up. Whatever the cause of death, excess inventory is a dangerous condition that can threaten your financial health if it’s not kept in check. Swelling inventory can lead to a variety of problems, including:

· Higher personal property taxes

· Higher storage, transportation, handling and insurance costs

· Higher financing charges

· Increased risk of obsolescence, damage and theft

· Reduced earnings as a result of write-offs and markdowns.

Prevention, of course, is the best medicine. Improving the accuracy of your forecasts and implementing just-in-time inventory management techniques, for example, are two ways to keep inventory under control. But if you find yourself with excess inventory, there are several things you can do to stop the bleeding.

The first thing is, get it off the books. Most businesses report inventory at historical cost for property tax purposes. But if an item’s market value has dropped below its original cost, writing it down or writing it off your books can reduce your property tax costs. Be sure that your inventory valuations are well-supported and documented. Depending on your industry, it may be appropriate to establish a policy for writing down certain items gradually as they age.

Follow up that item by getting it off the shelves. Write-offs may make inventory disappear from your financial statements and the property tax rolls, but unless you physically dispose of it, the costs remain very real. Plus, you can’t take a tax deduction for inventory that’s still sitting on your shelves, worthless or not.

To qualify for a tax deduction for excess or obsolete inventory, you must do one of three things: (1) sell it in a bona fide sale—to a liquidator or scrap dealer, for example, (2) destroy it, or (3) donate it to charity.

If you sell inventory, the deduction is generally equal to the excess of your tax basis in the property (usually your cost) over the price you receive for it. A sale is not considered bona fide, however, if you retain any special rights in the property, such as the right to buy it back for a below-market price. If you destroy inventory, presumably it has no salable value, even for scrap. In that case, you should be entitled to deduct your full tax basis.

The deduction for charitable donations is generally equal to the property’s market value, but no more than your tax basis in the property. Certain inventory donations, however, are eligible for an enhanced deduction. A C corporation that gives inventory to a charity for the care of the ill, the needy or minors, can deduct 50 percent of the amount by which the property’s value exceeds its tax basis (but no more than 200 percent of basis).

Two similar deductions are available through the end of 2007. C corporations can claim an enhanced deduction for book inventories donated to public schools, and any type of business can claim an enhanced deduction for food inventory donated for the care of the ill, the needy or minors.

Several other requirements apply, so be sure to consult your tax advisor before you give inventory away. Also, keep in mind that inventory donations are subject to annual limits on charitable deductions (that is, 10 percent of taxable income for a C corporation).

To keep inventory levels within healthy limits, you should monitor them continually. Techniques such as cycle counting allow you to track inventory in “real time” and take corrective action before it gets out of control.


Toby Toler, tdtoler@weaverandtidwell.com, is the Director of Property Tax at Weaver and Tidwell LLP, with offices in Fort Worth, Dallas and Houston. You may learn more about Weaver
and Tidwell by visiting www.weaverandtidwell.com

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