Obsolete Inventory: Book vs. Tax Write-Off

One of the largest assets for a manufacturer is its inventory. Regardless of how lean you’re able to keep your warehouse, you will likely have to deal with obsolete inventory at some point. So how do you account for obsolete inventory? There are different rules that need to be considered for Generally Accepted Accounting Principles (GAAP) vs. tax methods.

In regards to GAAP, once you have identified inventory that you cannot sell, you must write this inventory off as an expense. Assuming no receipt of payment for the inventory, you will debit a cost of goods sold account and credit either inventory directly or your inventory reserve account. GAAP requires that all obsolete inventory be written off at the time it’s determined obsolete. Therefore, if a company is not regularly reviewing their inventory for obsolescence they could have a large hit to their bottom line. While the process of writing off inventory for GAAP purposes is rather straightforward, being able to get the tax deduction is not quite as direct. Let’s take a look at the tax rules.

For tax purposes, a company is able to take a deduction on their tax return for obsolete inventory if they are no longer able to use the inventory in a “normal” manner or if the inventory can longer be sold at its “normal” price. The ability to take a tax deduction for obsolete inventory can only occur if the inventory is disposed of in 1 of 3 ways:

1. Selling it – This does not mean selling the inventory at a reduced price to your existing customer base. Rather, this is the sale of inventory to a place such as a liquidator or junkyard. The deduction received in this case is equal to the amount of the fair market value, less what you are able to recover for the item.

2. Donating it – A tax deduction may be taken if the obsolete inventory is donated to a charitable cause at no cost to the charity. If the inventory is used directly to care for the needy, ill, or infants additional deductions may be available.

3. Destroying it – This is typically the last approach you would take. The deductions associated are more minimal than if the previous 2 approaches are taken. In addition, the IRS requires you to document the before and after of the inventory that is destroyed.

If you find your company in this position, consider both aspects. Regular review of your inventory will not only help to avoid large write-offs at year end, but will also help with tax planning.

If you would like further support managing your inventory, please do not hesitate to contact us. We will be able to assist you in finding the best solution for your operation matter.

Article submitted by: Jennifer Barrett, MKS&H Audit Senior

About MKS&H: McLean, Koehler, Sparks & Hammond (MKS&H) is a professional service firm with offices in Hunt Valley and Frederick. MKS&H helps owners and organizational leaders become more successful by putting complex financial data into truly meaningful context. But deeper than dollars and data, our focus is on developing an understanding of you, your culture and your business goals. This approach enables our clients to achieve their greatest potential.

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