When to Treat Resale as Capital Gains



inventory
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The way you are responding sounds like you think I am calculating net income independently, and then just arbitrarily raising it by inventory. I'm not doing that. I'm deriving net income backwards from the net cash flow from operations. If net cash flow from operations includes $3.4M of inventory cost and net income should not include that cost, then you have to add the $3.4M back to get back to net income.
I'm not having a hard time understanding it. I'm trying to show by example how the law as written makes it almost impossible for vendors with substantial inventory to do more than break even on a *cash flow from operations* basis, unless they can establish enormous scale and turnover. It's not about understanding how it works. It's about expressing amazement that it is allowed to work that way. If the example I gave with the $40M company doesn't convince you of that nothing will I guess. If you only look at net income it all looks reasonable. When you study the effect on cash flow from operations, it looks devastating.
You say to the car dealer "don't buy $3.4M of inventory" but the way they got the $2M of cash flow from operations was by buying $3.4M of inventory every month. One doesn't exist without the other.

two.
rate
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I'm clear on this.
--
Will



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What you are doing is taking arbritary numbers and trying to make something out of it.
You are trying to make an example inside a bubble. In your example, where did the money come from to buy the inventory? It didn't come from sales. Initial inventory purchases really can't come from sales.
What gets added or subtracted from net income - or the way you want to do it is by subtracting or adding from cash flow - the ~~~changes~~~ in inventory.
Let's say that beginning inventory was the same as ending inventory. In your example that was $3.4 mil. No change in inventory means no adjustment to or from net income (or from or to cash flow).
Cash flow in your example is $2 mil - which is the same for net income - ending inventory isn't added back.
Are we clear here?
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I completely messed up math in that last post. Sorry about posting that without proof reading. So try #2....
wrote

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?

the
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 sheet assets.
And take your example to its conclusion. Let's assume that the car dealer sells $40M of cars per year, and nets 5% after all expenses on a cash-flow basis, so $2M / year of positive cash flow. For simplicity, assume net earnings on income statement + undepreciated inventory costs are about the same amount.
The 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 as expense on income statement.
Now instead of net $2M positive cash flow they have "profit" of over $4.3M?
You do enough experiments around this and you start to generalize some conclusions about resellers that they either:
1) Have to turn inventory faster than 10 times per year. That would be a challenge for anyone but WalMart and maybe 10 other resellers with huge infrastructure investments in logistics.
OR
2) Have to have costs for the inventory that are about 1/10th the actual selling price
OR
3) They have to carry no inventory
If they cannot do one of those then tax law around inventory destroys them.
--
Will



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Paul said:

Absolutely.
There are many retailers with inventory sitting on the shelves for that long. It doesn't magically turn into a capital asset over time.

Congress likes to tinker with people's actions. Many tax laws (tax rates, deductions, credits, etc) were created to tinker with the actions of society.
What reason should the taxpayers of America fund, in the form of deductions and credits, the children of other Americans? The tax code encourages the birthing of children by giving very generous reductions in taxes to those with kids. There's no real reason for that.
What reason should those who enjoy a fine beer or other alcoholic beverage be punished through the tax code? Yet there it is, excise taxes on all forms of alcohol, beer, wine, liquer. There's no reason for that either.

Absolutely. That's what Congress does best. Create very unfair laws.
--
Paul A. Thomas, CPA
Watkinsville, Georgia
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Paul Thomas, CPA wrote:

They're the ones complaining about Walmart driving them out of business when they shouldn't have been in business in the first place.
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Not always. Probably not even often. The business just made a bad decision on what inventory would sell and ended up ordering some items that just flat out didn't move, or, it just didn't move as fast as they thought it might.
In other cases, they bought a large quantity of items to get some discount, and they still have unsold inventory left. It's generally not an item that deteriorates over time, goes out of fashion, or otherwise would be unsellable next year. There's just an extra box of them on the shelf in the store room.
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Will wrote:

http://www.toolkit.com/small_business_guide/sbg.aspx?nid=P11_2452
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