Crafts Inventory and Taxes

Dear Rich: I have been making crafts for gifts for many years. Over the years I have accumulated much inventory, including several sewing machines, yards of various fabrics and ribbons, etc. I have recently decided to start a business selling on etsy.com. When doing my taxes, how do I claim the existing inventory accumulated over the last 20 years, much of what I will use in my new business? WARNING! Entry may cause drowsiness. Do not read while driving.
Right, you had a question. Short answer: You probably can't count your 20 years of supplies as inventory unless you have incorporated those materials in finished (and unsold) works or works in progress.
The Basic Inventory Rules.  Inventory includes completed but unsold crafts work, raw materials used to create the crafts work, crafts works in process and certain supplies that become part of your crafts work. In other words it's all the stuff you've created that's unsold as well as all of the direct costs to make that stuff. The IRS wants you to calculate your inventory value (or "cost of goods") at the beginning and ending of each tax year. These costs include:

• the money spent on materials that become an integral part of the finished product, or materials consumed in the manufacturing process and are identified with the crafts goods
• the money spent on labor associated with each crafts items -- payments for employees, contractors, payroll taxes, etc.
• indirect costs necessary for production of each item other than direct production costs. (You may not have any of these unless you can calculate things like variable and fixed overhead expenses).

If you don't know how to calculate the direct costs of materials and labor for your goods, there's an explanation in our book for crafts artists as well as the explanation in this IRS circular.
Can you deduct 20-year old ribbon and fabrics? Although we talked about raw materials as part of the inventory, the IRS position seems to be that only finished (or partly finished) merchandise should be included in inventory. According to Code of Federal Reg. 1.471.1, raw materials and supplies should only be included in inventory to the extent that the goods have been acquired for sale or will physically be part of the merchandise intended for sale. So, unless your past purchases are incorporated in finished works or works in progress, they should not be counted as inventory. 

What about sewing machines and other equipment? Sewing machines and other equipment used in production are considered to be long-term assets (assets with a useful life of more than one year). They can be deducted in one year under Section 179, or they can be depreciated.

When tax time arrives ... you may want to consult a tax expert, at least for the first year you calculate inventory. Your beginning inventory for subsequent years will be your ending inventory for the previous year.