A company buys a large lot of end use components and sells them slowly over
time. Precise records are kept of the purchase date, cost basis in
individual items, and sales date and sales amount. For those items that
are held for at least one year before sale, under what conditions can they
be counted as capital gains instead of ordinary income?
Is this a company that normally keeps an inventory for sale? Inventory is
not a capital asset. Capital assets are stocks, bonds, precious metals, and
real estate (the financial definition). The sale prices of capital assets
are driven by the market. In your case, I am assuming that the company sets
the sale price, so any gains would be ordinary income. It does not matter
how long the inventory is held before sale.
Nothing's impossible for those who don't have to do it.
Holding a rare piece of technical equipment is absolutely no different than
holding a painting or a house. The price is determined by the market,
based on supply and demand. So they are not different types of items in
the practical sense.
From the accounting point of view, I guess the question is does the law
classify something as a capital asset based on just a fixed checklist (i.e.,
only paintings, houses, stocks, and metails, nothing else), or does the law
classify something as a capital asset based on the process you use to do
accounting for it, or based on other facts, etc.
They'll look at the intent as well as the actual use of that item. If you
used it in the business (like machinery or a building) it's a capital asset.
If it's strictly held for investment purposes - and it's NOT part of your
ordinary business operations - it's a capital asset.
Items that you purchase and hold for ordinary resale to your customers - as
"Rocinante" pointed out, regardless of how long you hold it - is treated as
ordinary income from operations.
So for example if you collect art as an investment, then it is a capital
asset and eligible for capital gains if you hold for a year. But if you
are an art dealer, and you buy art to resell, it is never eligible for
capital gains, even if you hold it for five years?
I guess the government just hates businesses that resell things and likes to
give advantages to ones that buy and hold investments? Pretty hard to see
the fairness in it.
How does the ability to deduct business expenses make it okay that a
business has to declare a sale on inventory held for five years as ordinary
income? I don't see the relationship?
Most resellers barely stay alive. They just barely etch out an existence
and after expenses they might net 5%. It looks like the law is against
them at every step: they have to depreciate slow-selling inventory over
several years, which means in the first few years of business - or any time
they grow rapidly - their positive cash flow is far less than the net income
on the income statement, which overstates net income because of the
inability to take their inventory costs fully in the year they are paid for.
So the 35% tax on net income ends up being more like a 60% to 70% tax on
real positive cash flow.
And if the reseller buys 20 items and sells three in year one, and has to
hold the others for many years, they don't even get the consideration of a
lower tax rate for buying and holding, further pinching cash flow.
To contrast, someone who is holding capital assets for investment is usually
not doing it for a business purpose. That person usually does not need the
cash for survival. Yet that person gets very advantageous tax treatment on
that kind of income.
It reminds me of the fact that Microsoft and Cisco paid almost no income tax
in their boom years during the 1990s because they were able to claim as an
expense the "losses" they were taking on employee stock options, due to
their rapidly rising stock prices. So the businesses with absolutely
every advantage who don't need tax advantages to survive get away paying no
tax at all, whereas typical struggling reseller businesses have every law
written against them, at least for the important sources of income and
The simple answer is that the reseller businesses should learn how to take
advantage of investments if they want to compete and operate as going
concerns. They can cherry pick investments to sell in order to boost
non-operating income. They can also use investment classification (e.g.,
available for sale securities) to move unrealized losses off the income
statement and reduce its volatility. If you can't change the system, then
work with it.
The probability of someone watching you is proportional to the stupidity of
Can you explain this in more detail? I hope you are not saying that the
solution to inventory laws overtaxing reseller businesses is to invest
successfully in the stock market?!
And if you are making so much money on stock market investments that their
profit can materially affect the cash flow of a business, maybe the better
advise would be to quit the tax-disadvantaged business and focus on the
Can you explain this one with an example? The problem in the example I
gave wasn't how to take an unrealized loss. The problem was that reseller
businesses barely manages any positive cash flow at all, but tax laws forbid
taking large parts of real business costs the same year they are paid for.
So tax law simply distorts the truth and creates a profit where none
It's a sideline activity - unrelated to the business operations.
Say I operate as a CPA providing tax and accounting services. I can buy
investments - buildings and artwork maybe - that might appreciate in value
over any number of years. When sold these generate profits (gains if you
will) that is taxed differently than profits (gain if you will) from by
But if I'm IN the real estate business of buying and selling real estate -
or I'm in the art business of buying and selling artwork - then the gains
and losses of any sales are treated as ordniary income.
Sorry. That doesn't float. The tax laws, at best, allocate expenses to the
corresponding revenues. So if I were to start up a car dealership in the
last week of December, and my only expense so far was buying up $3,400,600
worth of cars before year end. Yet only one car sold as of the end of
December with a unit cost to me of $19,300. My only expense to date would
be the $19,300. The remaining $3 million is inventory. It's always
inventory till it's sold. Then I get to take a deduction for it's cost.
There are no tax laws that create profit where none truly exist. The laws
shuffle the expenditures for a more realistic result.
What is the "litmus test" for whether a given source of income is a sideline
activity or primary? Is there any hard rule, such as when the income
accounts for more than say - 20% - of the total gross sales or net income?
I understand how tax laws treat that situation. But the practical reality
is that for everyone except extraordinarily rich individuals, cash flow *is*
the profit of the business. Because until a business reaches a really
mature stage and has $10M stuffed on its balance sheets, its the cash from
operations that is the lifeblood of the business. If a tax law creates a
profit to tax where there was very little positive cash flow, that is a
tax-disadvantaged business, particularly where there are not deep balance
And take your example to its conclusion. Let's assume that the car dealer
sells $4M of cars per year, and nets 5% after all expenses on a cash-flow
basis, so $200K / year of positive cash flow. Business keeps $3.4M of
inventory on hand at all times (for simplicity in calculation here), so they
essentially turn over their inventory about once every month. Now at end
of year one operations they have to exclude 2/3 of the $3.4M inventory as
undepreciated inventory and carry that forward? This assumes 3 year
depreciation, and let's not get tied up in a precise calculation of
depreciation (which I am sure I am doing incorrectly) and just talk about
the general concept that some large amount of the inventory cost is not
showing up on income statement. That leaves $2.27M of undepreciated
inventory that they cannot claim on income statement. Now instead of
$200K positive cash flow they have "profit" of over $2M? Goodbye to that
I'm sure I must not be understanding something here, because in the above
example the dealership has to sustain a $4+M tax bill over two years for the
right in year three to show a meager $200K net income.
I know you're looking for a door in to the candy store, but it's based on
the facts and circumstances of ~~each~~ transaction.
Take Coca Cola. They probably have a bottle of Coke from the 1800's (or
whatever) that they have on display in their museum of Coke. That bottle
has never really been "for sale" in the normal course of their business. If
sold, it would most likely be considered a capital asset and a capital gain
on such asset. If not for the corporate tax laws, the sale of that one
bottle would not be taxed the same as a sale of a bottle of Coke that was
And business profits - or more appropriately - profits from a business
activity - are taxede differently than the casual and infrequent sale of
capital assets, investments, etc.
$10 mil? Please.
And recent tax laws have addressed any disadvantage - mainly in accrual
accounting from booking a sale before the cash is recceived - so there's no
Then he has profit. His tax is only on the profit.
I'm unclear as to where you get your ideas from.
Inventory isn't "depreciated". Inventory only gets expensed once it gets
This assumes 3 year
So that even worsens the situation. The company has to exclude $3.4M of
inventory which increases the income statement profit by this much each
year. In the example I gave from the reposting of the original message
with the math error, $40M in annual sales, $2M in net positive cash flow
becomes now now becomes $5.4M of "income". 35% tax rate on that is $1.9M
thus nearly wipiing clean all of the positive cash flow in taxes.
Effectively there is a 95% corporate tax rate on that business' net positive
You are confusing accrual accounting with tax accounting. Also, inventory
is an asset on the balance sheet. Only the change in inventory is recorded
as an expense on the income statement. Think about it. Why would inventory
on hand be taxed before it is sold? Once you understand the "two-sided"
nature of accounting, this will be clear to you.
"He who doesn't risk never gets to drink champagne."
But the company's net *cash flow* does include money they spend on
inventory, doesn't it?
My example was:
- Company grosses $40M per year.
- Company has net positive *cash flow* of $2M
- Year end inventory of $3.4M
- For simplicity in calculating, I was making assumption that
( net income - inventory cost ) = net cash flow.
So income statement will *not* show that $3.4M of inventory as an expense.
Without that $3.4M expense, the "net income" of the company now is $3.4M
higher than the net cash flow. $2M + $3.4M = $5.4M At 35% corporate
rate, that's around $1.9M tax. Effectively the tax wipes out the entire
net positive *cash flow* of the company.
I understand as an accountant that might seem fine since tax is on income
statement not cash flow. The point I am trying to get across is that for
the company the inability to count inventory as an expense is a catastrophe
until they reach a very substantial scale (e.g., Target, Home Depot) where
they can turn inventory rapidly, or unless the business model avoids most
inventory altogether such as with Dell's build to order model. Because for
any company without a deep balance sheet, the net positive cash flow after
tax of the business *is* the business.
That's why a good set of investment financials breaks out four sections in
the cash flow:
cash from operations
cash from investments
cash from financing
free cash flow (usually defined as cash flow from operations subtracting
out capital expenditures)
Most professional investors look at public stock companies based on the cash
flow *from operations* and free cash flow and *NOT* the income statement.
Because the income statement is easily manipulated by management and subject
to all kinds of tax issues that have little to do with financial earning
power. As the well-respected Morningstar, Inc says:
"Many investors focus on cash flow from operations instead of net income
because there's less room for management to manipulate, or accounting rules
to distort, cash flow...."
I'm referring to cash flow from operations. And I think most operating
managers intuitively understand it is the positive cash flow from operations
that really represents the core value of a company.
So again my example is the company makes $40M in sales, $2M in net positive
cash flow *from operations*, and has $3.4M in inventory. The inventory
does not show as an expense on the income statement, so the net income is
raised by $3.4M. I'm ignoring depreciation and assuming $0 capital
assets. The 35% corporate tax rate on that $5.4M effectively wipes clean
the company's entire net positive cash flow from operations.
He has cash flow from financing, which as you rightly point out is not a
sign that a company made money from operations. It's not the kind of cash
flow I am referring to.
Absolutely. The better investors also look at the income statement as well
as the balance sheet.
Because it's not an expense till it gets sold. Why are you having a hard
time with that.
Sorry, but it's NOT raised because net income is (or should be) the correct
amount of net income from operations - which is always going to be different
than net cash flow in any company with inventory, loans, asset purchases,
liabilities, receivables, etc.
There is NO income based solely on the remaining inventory.
Try this. New car dealer goes out and buys $1,000,000,000 in new cars.
Cash deal - no floor plan financing.
The year ends and he hasn't sold a thing, so no deduction for his
$1,000,000,000 of inventory still on the lot.
No sales means no income, means no profit, means no tax.
Are you with me so far, or have I lost you somewhere.
Dealer sells $10,000,000 of cars for $12,000,000 cash to buyers in year two.
With no other expenses he has $2,000,000 of income or profit from those
He will be taxed on that $2,000,000 of profit at whatever the going tax rate
is for the type of entity he operates the business as. FYI: at 35% that's
Are you with me so far, or have I lost you somewhere.
There is no tax - at least no income tax - on the remaining $990,000,000 of
unsold cars on his lot.
That the car dealer decided to tie up his cash in that much inventory is a
matter to take up with the dealer, not the tax guy.
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