Page 66 - DCOM301_INCOME_TAX_LAWS_I

Unit 3: Tax Planning: An Introduction

3. Inventory Valuation Methods: The method a small business chooses for inventory Notes
valuation can also lead to substantial tax savings. Inventory valuation is important because
businesses are required to reduce the amount they deduct for inventory purchases over
the course of a year by the amount remaining in inventory at the end of the year.

Example: Mr. X that purchased `10,000 in furniture during the year but had `6,000
remaining in furniture at the end of the year could only count `4,000 as an expense for furniture
purchases, even though the actual cash outlay was much larger. Valuing the remaining furniture
differently could increase the amount deducted from income and thus reduce the amount of tax
owed by the business.
The tax law provides two possible methods for inventory valuation: the first-in, first-out
method (FIFO); and the last-in, first-out method (LIFO). As the names suggest, these
inventory methods differ in the assumption they make about the way items are sold from
inventory. FIFO assumes that the items purchased the earliest are the first to be removed
from inventory, while LIFO assumes that the items purchased most recently are the first to
be removed from inventory. In this way, FIFO values the remaining inventory at the most
current cost, while LIFO values the remaining inventory at the earliest cost paid that year.

Did u know? LIFO is generally the preferred inventory valuation method during times of
rising costs. It places a lower value on the remaining inventory and a higher value on the
cost of goods sold, thus reducing income and taxes. On the other hand, FIFO is generally
preferred during periods of deflation or in industries where inventory can tend to lose its
value rapidly, such as high technology. Companies are allowed to file Form 970 and
switch from FIFO to LIFO at any time to take advantage of tax savings. However, they
must then either wait ten years or get permission from the IRS to switch back to FIFO.
4. Equipment Purchases: It is often advantageous for small businesses to use this tax incentive
to increase their deductions for business expenses, thus reducing their taxable income and
their tax liability. Necessary equipment purchases up to the limit can be timed at year end
and still be fully deductible for the year.

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Caution This tax incentive is also applicable to the personal property put into service for
business use, but with the exception of automobiles and real estate.
5. Benefits Plans and Investments: Tax planning also applies to various types of employee
benefits that can provide a business with tax deductions, such as contributions to life
insurance, health insurance, or retirement plans. As an added bonus, many such benefit
programs are not considered taxable income for employees. Finally, tax planning applies
to various types of investments that can shift tax liability to future periods, such as treasury
bills, bank certificates, savings bonds, and deferred annuities. Companies can avoid paying
taxes during the current period for income that is reinvested in such tax-deferred
instruments.

3.1.2 Tax Planning for Different Business Forms

“The first step in tax planning–for small business owners and professionals, at least–is to select
the right form of organization for your enterprise,” is according to Albert B. Ellentuck in the

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