Inventory, cost of goods sold, and how long to keep the paperwork

Buying a watch to resell is not an expense in the year you buy it. It is inventory, and you are taxed on the margin when it sells — which is why the paperwork on a purchase matters long after the money has gone out.

Cost of goods sold is the whole game

Part III of Schedule C computes cost of goods sold, and that is what turns a sale price into a taxable number. A watch bought in March and sold in November puts its cost against its sale. A watch bought in March and still in the safe in December has not produced a deduction yet.

The consequence is that a good year on paper and a good year in the bank can diverge sharply in this trade, because buying deeply into stock consumes cash without reducing taxable income. That is a cash-flow fact rather than a tax problem, but dealers meet it every year and it surprises people.

The default is accrual — and most dealers escape it

The Schedule C instructions put it directly: unless you are a small business taxpayer, you must use an accrual method for sales and purchases of inventory items.

The exception is wide. You qualify as a small business taxpayer if you:

• have average annual gross receipts of $31 million or less for the three prior tax years — indexed for inflation — and
• are not a tax shelter as defined in section 448(d)(3).

For an independent watch dealer that threshold is not a constraint in any realistic year. The mechanics for a newer business: if you have not existed for the whole three-year period, base the average on the period you have existed; include a predecessor entity's gross receipts if there was one; and annualise any short tax years inside the window.

What the exception actually lets you do

If you are a small business taxpayer you can choose not to keep an inventory — but you must still use a method of accounting for inventory that clearly reflects income.

The instructions then give you two safe routes. Your method will not be treated as failing to clearly reflect income if it either:

• treats inventory as non-incidental materials and supplies, or
• conforms to your financial accounting treatment of inventories.

The first is the one most dealers hear about, and it is worth understanding precisely, because the name suggests a deduction that arrives earlier than it does. If you account for inventory as non-incidental materials and supplies, you deduct the amounts paid to acquire or produce those items in the year in which they are first used or consumed in your operations.

Not the year you paid. The year they are used or consumed. For a reseller, the practical timing ends up looking much like cost of goods sold — which is the point people miss when they assume the exception lets them expense a safe full of stock on purchase.

The second route, conforming to your financial accounting treatment, is determined by the method used in your applicable financial statement under section 451(b)(3), or, if you do not have one, the method in books and records prepared in accordance with your accounting procedures.

If you do keep an inventory

You must generally value it each year to work out cost of goods sold. Line 33 gives the permitted bases: at cost, the lower of cost or market, or any other method approved by the IRS.

Watches sit awkwardly here, and it is worth raising with your accountant rather than defaulting. A watch is individually identifiable by serial number, bought at a known price, and sold as a specific item — the conditions in which specific identification is the natural fit. Whether that is available to you as "cost" or needs to be treated as another method is a question the instructions do not answer on their face.

Note also that certain direct and indirect expenses may have to be capitalised or included in inventory. For a dealer, servicing, polishing, parts and authentication before resale are exactly the costs that question is about.

Changing method is a filing, not a decision

If you want to change your method of accounting for inventory you generally file Form 3115, and you may have to make a section 481(a) adjustment to stop income or expense being duplicated or omitted.

The instructions' own worked example is instructive: change to the cash method and account for inventoriable items as non-incidental materials and supplies, and sales accrued in the earlier year but paid in the later one get reported in both years as a result of the change, with the 481(a) adjustment correcting the duplication. Drifting into a new method without filing is how dealers accumulate a problem quietly.

How long to keep it

The retention period runs off the period of limitations — the window in which you can amend to claim a credit or refund, or the IRS can assess more tax.

• 3 years — the general rule, where none of the longer situations applies.
• 3 years from filing the original return, or 2 years from paying the tax, whichever is later — if you file a claim for credit or refund after filing.
• 7 years — for a claim from worthless securities or a bad debt deduction.
• 6 years — where income that should have been reported was not, and it is more than 25 percent of the gross income shown on the return.
• Indefinitely — if no return was filed, or a fraudulent one was.
• 4 years — employment tax records, from when the tax becomes due or is paid, whichever is later.

And the one that governs stock: records relating to property are generally kept until the period of limitations expires for the year you dispose of the property. A watch held for years carries its purchase file the entire time, and then for the limitation period after it sells. Purge by calendar year and you will destroy the basis for something still in the safe.

What a purchase file should contain

The IRS's supporting-document categories are sales slips, paid bills, invoices, receipts, deposit slips and canceled checks. Purchase and expense documents should identify:

• the payee
• the amount paid
• proof of payment
• the date incurred
• a description of the item

For a watch that means the seller, the price, how it was paid, when, and enough description to identify the specific piece — reference and serial number, not "gold watch". You already capture most of this for the secondhand-dealer record your city requires; the difference is that the tax file has to survive for years after the local retention period expires.

Electronic records count. All requirements that apply to hard copy books and records apply equally to electronic ones — which is permission, not a lowered standard.

Where this connects

The gross figure a marketplace reports to the IRS will not match your receipts, and reconciling it is a records exercise: see Form 1099-K. Cash purchases above the reporting line carry their own five-year retention rule under Form 8300.