In the construction industry, supply-chain challenges are nothing new. They've just gotten much more media attention over the last few years. Increased globalization, a pandemic and geopolitical strife have all contributed to some notable slowdowns, though things have generally been better lately.
One way that construction companies can mitigate supply-chain problems is to maintain their own inventories of various building materials, products and supplies. However, an inventory can also complicate tax planning. Here are three big issues to consider.
Inventory valuation is one of the core areas where construction businesses encounter tax complexities. The value of inventory is a contributing factor in the calculation of cost of goods sold (COGS), which is a major expense for construction companies and a key line item on your income statement that helps determine taxable income. COGS is also a good metric for identifying ways to better control costs and improve the bottom line.
For construction companies, COGS generally includes the total cost of materials, labor, equipment and overhead used to complete each project. This amount is then subtracted from total revenue. Unlike a retail business that can quickly identify the cost of each item, calculating COGS can be tricky for contractors because the mix of materials, labor and indirect costs can vary by job.
Breaking down COGS by project and using job-costing methods may help simplify this task. You can assign cost codes — that is, price tags — to individual project tasks based on both the direct and indirect resources they consume. Then, you can use the cost codes as line items for adding up a project's total cost.
Getting back to inventory, the IRS allows several valuation methods for tax purposes. However, First-In-First-Out (FIFO) and Last-In-First-Out (LIFO) are perhaps most often used by construction businesses. Which one you apply can have a substantial impact on taxable income, so it's important to choose carefully.
LIFO assumes that the last items added to inventory are the first sold. This means COGS will be based on the most recent prices, which can help reduce taxable income in times of rising prices or if your construction company is ascending to a higher tax bracket. However, LIFO can result in inventory that's overstated on the balance sheet.
FIFO assumes that the first items added to inventory are the first sold, which is useful when prices are falling or if you expect your construction business to land in a lower tax bracket because COGS will be based on the oldest prices. But FIFO can result in inventory that's understated on the balance sheet.
Inventory shrinkage is the loss of inventory because of damage, fraud, theft or other factors. It can lead to discrepancies between what's in the inventory and what's recorded on a company's books — which may lead to tax issues.
The IRS expects businesses to track inventory shrinkage and adjust their records accordingly. Failing to account for shrinkage could inflate the value of your inventory, resulting in a lower COGS and, subsequently, a higher net income and greater tax liability.
To prevent shrinkage, be sure you're taking adequate security measures to protect your inventory. These may include cameras, motion detectors, and of course properly locked doors and windows. You should also perform periodic physical counts and implement a robust inventory management system.
States and local municipalities may impose their own taxes on inventory. These can include sales and use taxes as well as inventory tax, which typically falls under the umbrella of property taxes.
Inventory tax is levied on the value of a company's inventory held within the state or municipality at a specific time — usually the end of the fiscal year. Because tax rates and regulations differ from state to state and municipality to municipality, construction companies that operate in multiple jurisdictions may find compliance challenging.
Suffice to say, it's important to stay up to speed on the tax rules in each state and city or town where your company operates. Keep precise records of where inventory is held and what items are stored there. If possible, shift inventory to locations with lower or no inventory tax. You might also be able to time inventory purchases and transfers to reduce your tax burden.
Again, an accurate inventory management system is a must for construction businesses that operate in multiple locations and maintain complex inventories.
Although these three issues are common to construction companies with inventories, the specific tax risks, as well as the tax-saving opportunities, will depend on the details of your situation. Contact our firm for help identifying optimal ways to track, account for and manage the tax impact of your inventory.
Get in touch today and find out how we can help you meet your objectives.