Taxes and tonewood inventory

[Ken Whisler]

Kinda funny how I used to post on this forum when it was under Deb's hand, I was a rank beginner and hobbyist, and now I've actually made a couple of dollars here and there...

Anyhow, in years past our accountant has advised that when I purchase tonewoods, to not deduct the total purchase when the cash is actually going out, but rather assess the material cost of each guitar sold, subtract that from the top of the sale along with any other running expenses for that period of time, and then pay quarterlies on the remaining balance. I've done OK doing it like this, but I'm in a situation where I need to purchase a larger quantity of tonewoods than I have usually done in times past. Since we are thinking of changing accountants this year, I was also thinking that I really don't want to deal with quarterlies AND the hampered cash flow resulting from a larger than usual purchase. So I'm thinking that this time, I will report the expenditure for the whole purchase, and then when I actually start working from that inventory in the future, I will simply subtract running expenses before calculating quarterlies.

Did what I just say make sense? If yes, how do you guys handle this?

[Peter Wilcox]

Back when I used to have a business and business expenses (for only a few years, and not from lutherie, for sure), I tried as much as possible to match higher expenses to years of higher income, to level out my yearly taxes and possibly decrease my total tax burden over time. So if you think this year's income will be higher than in subsequent years, then deduct it all this year. If you think your income will be increasing, then deduct it for each instrument when it is sold.

Take this advice with a grain of salt - I've always done my own taxes without any expert help, so I could be way off base. But it worked for me, and I was never audited.

[Jason Rodgers]

Clarification: so, say you buy a stack of wood right now, enough to build 6 guitars. Then you build and sell 3. From the sale price, you deduct the value of the wood and any other expendibles that were used to build them, and pay taxes on the remaining income. When you build and sell the next 3, you do that again. But you're paying your taxes every three months, however those sales might fall, rather than folks who get a paycheck every 2 weeks.

Does that sound right? (I know nothing about taxes... my wife does them, and ours are simple enough to plug into TurboTax in less than an hour.)

What all do you include in expenditures for an instrument, aside from sandpaper and bits? Wood, as you say, but how about finish? Frets and truss rods and tuning machines? Everything?

[Randy Roberts]

Ken,

I would ask your old (or new) accountant to explain the differences between cash, and accrual accounting. There are pro's and con's to either, but I don't think you will get away with just jumping around from one to the other through the course of the year.

I also am not an accountant, but have had a business for a long time...

[David King]

Stick with cash accounting whenever possible. I met with a very nice IRS agent about 15 years ago and explained my predicament with having a huge wood inventory and then occasionally cutting off the end of a board to build a guitar and having to calculate what of my inventory remained etc and she said that as far as she was concerned it would be fine to to expense every stick of wood as it came in and not try to worry about doing an inventory. Much more important to inventory unsold instruments as far as they were concerned and not every little screw in a drawer somewhere. I think if you were exclusively dealing with Brazilian rosewood sets that were costing you $1000 each then inventorying those sets makes some sense. For lumber that you may not even use in your lifetime that's only a tiny fraction of what an instrument is worth, you would be happier all around expensing it. A different IRS agent may feel very differently about this issue so be flexible.

[Bill Raymond]

Go to www.irs.gov and download Pub. 334 and read it through. It has answers to most questions you will have as a small business owner reporting on Sched. C. If you don't completely understand everything in it, at least you will be able to ask informed questions of your accountant or tax preparer. I am a retired Enrolled
Agent, but won't give anyone tax advice nowadays, except to refer them to the IRS publications or a practicing E.A. or registered tax preparer.

[Ken Whisler]

All very useful info, THANKS!

So....basically, if I switch to cash accounting, -everything- becomes a running expense as it is bought, correct? If so, can the same be said for capital expenditures like, say, a new table saw? I understand why my account advises to do it the way he has; he's thinking long term advantage. My recent experience says thinking long term hampers cash flow in the short term.

[Barry Daniels]

You can certainly expense a table saw if you have enough annual income to offset it. If not, then something big like a table saw can be spread out over multiple years by depreciating it. This is easy to do if you use Turbo Tax.

[David King]

Major tooling investments are called "179" capital investments and there is an annual limit of well over $100,000. All the tax software will let you experiment with the relative benefits of one-time vs depreciation.
Read the aforementioned Pub. 334, it's very concise, easy to read and explains all the basics. https://www.irs.gov/pub/irs-pdf/p334.pdf
I learned a lot about the differences between accrual and cash accounting. "Accrual method" might be what I'm recommending.

[Michael Lazar]

If you're depending on your business for a living and you do not keep your books in accordance with GAAP (Generally Accepted Accounting Practises) and review them at least quarterly you are a recipe for potential financial failure. Proper accounting is truthful, logical and most importantly, informative. Inventory should be accounted for on an accrual basis. If your inventory includes finished guitars they should be valued at cost, not the selling price. Major tool expenses should be capitalized and depreciated in accordance with the schedules for your jurisdiction. Unpaid expenses and inventory sold but not collected should be accounted for under Accounts Payable and Accounts Recievable. When your books are done properly they can then be adjusted in accordance with tax regulations in order to minimize your tax. If your jurisdiction permits cash accounting or other advantageous "shortcuts" (often limited to smaller businesses) then of course you will use them.

Learning basic accounting principles and doing your own books is a lot easier than the practise of lutherie. Any one who says they don't have time given the software available is talking nonsense. But the magic is not in the accounting. The magic is in what goes through you mind while you are doing your books after the end of every month. Each accounting entry has potential for raising questions in your mind and you will almost certainly discover new and better ways of doing things. You will discover expenses that you can cut and other expenses that you've resisted that can be increased to improve productivity and profitability. It will not take long before you know very clearly what you can do to improve any aspect of your business.

That's my rant after 42 years as a Commercial Banker, 5 years as a business turnaround consultant, 10 years as a consultant to communities in the US, Canada and the UK addressing local economic development through small business and (largely concurrently) 35 years as a luthier.

[Jason Rodgers]

Boom! Drop the mic. Thanks, Michael!

[Randy Roberts]

I would hope everyone reading this thread stops and reads Michael's second paragraph several times and takes it to heart. ( At least those contemplating making this a part or full time income source, as apposed to a hobby.)

I married a wonderful accounting mind, who's worked with everything from a solo Jiffy Lube type franchise to several hundred site restaurant operations, to a 6B/yr international commodity trading company.

I had just started my practice, and after trying for the tenth time to explain to her how she obviously had it all backwards as to what was a debit and what was a credit, she picked up the ledger book, dropped it on the desk in front of me, and said "fine, do your own books then". (this was back in the days of 10 lb., 20 collumn ledger books, a pencil and an adding machine.)

It was the biggest favor she could have done for me, and she knew it at the time.

I have done my own books (though not the taxes) for almost 40 years now, and it has been the equivalent of having an ECG machine hooked up monitoring the business aspects of the practice continuously. Any changes in the heartbeat of the practice are noticed right away and any changes needed can happen when they are easiest and most effective.

I would equate having someone else do your monthly book keeping, and getting a report quarterly or end of the year, as being the same as driving down the road facing backwards. Your going to see where you've been, but not where you are or where you're going.

Yes, it takes a little time to do, but it's easily the most valuable thing I could have done with that time.

If coin is involved, then you are an accountant whether you know it or not. You might as well know what the numbers are and mean.

[Bill Raymond]

If you need to change your accounting method, you may be required to file Form 3119 with the IRS. I don't remember all the specifics, but if you look at the instructions to Form 3119, it will provide further information.

[Ken Whisler]

One thing that I should have mentioned: I'm coming off of a 5 year layoff. I let my fictitious name lapse and my EIN has been inactive the whole time. So....

I basically view this as starting from scratch, financially speaking.

I understand the whole short term vs. long term thing. I'm thinking cash flow, even if it means a few $$$ less in the big picture. It does not make much sense to me to report and pay taxes on a profit when my expenditure this year IS going to exceed my income.

All good advice,guys. Thank you all very much for investing the time.

[Barry Daniels]

You won't have to pay taxes if you are not making a profit, but you still should submit a 1040 with a schedule B.