Restaurant Inventory

I have a new pizza shop client that just started in November of 2021. They did their own thing until now, I’ve taken over all their bookkeeping, payroll, etc.

Although the impact is not going to be substantial either way, I find it really silly to keep an inventory for restaurants. Under the accrual method of accounting, you can expense any prepaids that are going to be used up in the next 12 months. I have the viewpoint that food inventory is more of prepaid that "inventory" like a retail store, and with food I would certainly bet 100% of their inventory will be used within a month or two. Any thoughts on this? I know that there is the DMSH and NIMS rules but I don't feel comfortable expensing actually inventory so I'm conflicted on the accounting treatment.

Thanks!

I usually conform to what they use for their books. If they expense it, then that's how I treat it on the TR

You might want to get familiar with 1.471-1. There are choices for a taxpayer who is not required to maintain inventory. NIMS is accounted for as used, so you avoid capitalization issues but still have to deal with a balance sheet account. You can conform to books and records, and there are specific rules as to what exactly that means. There is an example about a bakery making cookies, buying the ingredients in year 1 and selling the cookie in year 2.

DMSH is not available for NIMS or inventory.

If you make a change to the taxpayer's accounting method, you need to file a 3115.

If the business started at the end of 2021, is Form 3115 relevant in this case?

Good point. There would have been a return for 2021, right? So I assume warnickcpa is starting as of 2022. But even if the restaurant accounted for inventory in 2021, I believe that an accounting method is not established until it is used 2 years in a row...so perhaps 3115 is n/a in this situation.

For what its worth:

1) They did their own stuff for 2021. They did not deduct the 7K of inventory the purchased as part of the APA to purchase the business, but probably expensed the entire amount of purchases.

2) I'm doing the bookkeeping going forward

3) The client is a small tax payer, we're talking a mom and pop pizza shop. Cash basis

3)1.471-1 (b)(4)(i)- (i) In general. The costs of inventory treated as non-incidental materials and supplies are recovered through cost of goods sold only in the taxable year in which the inventory is used or consumed in the taxpayer's business, or in the taxable year in which the taxpayer pays for or incurs the cost of the inventory, whichever is later. Inventory treated as non-incidental materials and supplies is used or consumed in the taxpayer's business in the taxable year in which the taxpayer provides the inventory to its customer[...]

So from the sounds of it my wish to just expense everything is probably not acceptable... Any input here would be fantastic

Keep reading the regs. There is more. You have the option of conforming to books & records, and there is specific discussion in the regs about what that means. These regs are pretty readable.

You might want to get familiar with 1.471-1.

https://www.ecfr.gov/current/title-26/chapter-I/subchapter-A/part-1/subject-group-ECFRb3578fa14bdb9ea/section-1.471-1

I'm even more confused now to be honest. From the way that this reads is that as long as you meet the definition of a small business with gross receipts under $25mm and don't account for inventory on your books that you don't need to account for inventory on the tax return. I thought inventory was inventory. My whole question in the OP is relating more to situations like restaurants where their inventory is more like supplies and materials vs. a retail store where they buy and sell goods.

Publication 538 states If you are a small business taxpayer (defined below), you can choose not to keep an inventory, but you must still use a method of accounting for inventory that clearly reflects income. A small business taxpayer can account for inventory by (a) treating the inventory as non-incidental materials and supplies, or (b) conforming to its treatment
of inventory in an applicable financial statement (as defined in section 451(b)(3)). If it does not have an applicable financial statement, it can use the method of accounting used in its books and records prepared according to its accounting procedures.

This tax advisor article make it out to be that as long as the don't have AFS and are under the gross receipts threshold they can expense the inventory when paid: https://www.thetaxadviser.com/issues/20 ... tions.html

I'm doing this from memory so take this for what its worth. I thought that what you are calling supplies etc for restaurants was treated as inventory. Supplies and materials are essentially NIMS, right? And the regs say that we have to account for NIMS as used, so maintain a balance sheet account. The example in the regs that forces the baker to account for cookie ingredients, deducting costs when cookies are sold, seems on point. It is very irritating, especially since the JCT said that we could apply DMSH to NIMS to claim the deduction when acquired. The IRS said no.

Yes, if you meet requirements, you can conform to the accounting used in the books and records. What is key is the broad definition of "books and records". For example, you are allowed to count inventory to determine when to re-order, but if you provide information of the balance or value of the inventory to your banker as part of a loan application, then you are maintaining inventory in your books as records, per the IRS.

In practice, I take 3 days of COGS and round it off to the nearest $1,000. Seems every restaurant i have gets a truck 2-3 times a week and gets about 3 days worth of food. Storage space keeps them from keeping more inventory and if the truck is coming in a day or 2.

Had this "method" get by during an audit. Apparently agent had seen this done a bunch of times before and was uninterested after the explanation.

Depends on the type of restaurant, too, IMO. The most recent type of restaurant I worked with was a quick serve place, but they sold some goods at retail. Almost everything else was for wholesale purposes and sold and shipped out as it was produced. I had them account for the retail inventory and an approximate value of wholesale based on weight that may have existed at that time, but almost everything was expensed since it was not sitting around and seemed very de minimis given gross sales.

If they sell alcohol, I would be more concerned about that than food simply because it adds up to so quickly in value. I have seen some of the liquor storage rooms even small restaurants have and they can easily have tens of thousands in liquor inventory. Not to mention if they sell wine or specialize in high end varieties of alcohol...

In practice, I take 3 days of COGS and round it off to the nearest $1,000. Seems every restaurant i have gets a truck 2-3 times a week and gets about 3 days worth of food. Storage space keeps them from keeping more inventory and if the truck is coming in a day or 2.

Had this "method" get by during an audit. Apparently agent had seen this done a bunch of times before and was uninterested after the explanation.

I like this the most. Confirmed with client today that they are turning and burning through inventory on about a weekly basis so this is the approach I'll take. I think the "books and records" issue comes from if their insurance or a loan application in the future needs inventory than they're in trouble. Plus, they didn't record any movement to the $7K in inventory they purchased as part of the APA so the current year inventory adjustment won't be an issue.

The restaurants I work with keep an inventory on their books. However, we only adjust inventory at year-end, which is the only time they do a physical count. If the inventory is not that large, it really should not take that long to do a physical inventory annually.

In my experience, doing a physical count of restaurant inventory is a huge PITA. Figuring out the initial cost after the count is an even bigger PITA.

In addition, restaurants are often on 15+ day payment terms. Chances are the inventory in stock isn't even paid for on cash basis accounting. So there's no actual inventory basis.

There may be specific items you want to track for financial purposes, such as retail goods. For any other items, incidental M&S is definitely the way to go. If that treatment is disallowed for some reason, check into whether you can value it at $0 based on the restaurant's typical payment timeline.

For what it's worth I part-own a bar/restaurant that sells alcohol and food. We do have a little liquor room and a beer walk-in with quite a bit of booze. We get trucks multiple times a week, and a lot of our vendors are net-10 ACH for payment. I don't waste my time counting inventory on Dec 31/Jan 1 and calculating it all up. I actually farm out our tax return (S-corp) and our preparer was totally fine with my estimate of around $6000 of on-hand inventory. Didn't even question it at all. My estimate was pretty close to actual value, and our COGS was around $271k.

Now I'm wondering when and if we're getting a letter from the IRS!

It's my understanding that if a client is a small business taxpayer not prohibited from using the cash receipts method, does not have AFS and expenses "inventory" for books we can conform to that treatment on the tax return as a non-AFS section 471(c) inventory method under Treasury Reg Sec 1.471-1. i.e. We expense inventory on the returns and do not maintain a balance sheet account.

That is assuming inventory counts are not done for insurance, credit, investor reports, etc, as they fall into the "books" catch all under the treasury reg.

I'm just wondering...it's very taxpayer friendly and the hoops are not hard to jump through for most small restaurants/cafes...why use a rule of thumb or estimate when you're given broad latitude to deduct and not maintain a capital account?

Circling back to this.

Does anyone disagree with my understanding in post #17 or feel it's missing something?

I guess you folks haven't ever been hit with a state sales & use tax audit before.
Inventory on hand becomes a material factor in determination of markup percentages that sales tax auditors use in arriving at sales tax audit assessments.
While you continually live to the letter of the law by playing symantics of the law, by continually reciting it here, recognize that not factoring inventory for financial purposes in being consistent with tax return purposes can cost your client should an unfortunate event such as inventory damage occur especially if perishable or should an audit occur where various tax agencies have reciprocal agreements with each other for exchange of information for tax noncompliance.

Circling back to this.

Does anyone disagree with my understanding in post #17 or feel it's missing something?

I generally agree. I believe you can insure your inventory, though. Did you see something in the regs that you said that you cannot do that?

I guess you folks haven't ever been hit with a state sales & use tax audit before.

No one said that sales tax wasn't being paid. My clients are paying their sales tax. It is an income tax rule that allows for an immediate deduction of costs formerly treated as inventory if requirements are met. It is pretty straight-forward. There is no issue about tax agencies exchanging information because the law is followed for income tax purposes and taxes are paid for sales tax purposes.