Change of accounting - Elect out of 263A

I have a new client (S-Corp) in the vineyard/winery industry. Their sales are below $1 million. They have been using the cash basis method all along. Their prior accountant capitalized all of the vineyard labor and maintenance costs into inventory. I would have elected out of 263A and only capitalized any non-incidental materials and supplies, such as purchased grape or bulk wine.

I am having trouble figuring out what DCN# for this change of accounting. At first, I thought #50, but they are already on the cash basis. Then I thought #186, but that doesn't seem right either.

Now I am concerned this is not an automatic change.

Any help out there?

Can I change to #50 and just say that we are changing to correctly apply the cash method under Rev Proc 2001-10?

Unless I made a mistake in my logic, it appears I do have a nonautomatic change here. Reg 1.263A-4(d)(3).

DCN 234. See Rev. Proc. 2018-40.

Wow! You are the man, Brian! Thank you very much.

That came out 8/6/18. I am glad I did not ask this question a month ago.

I was hoping to do this for a 2017 tax return on extension. It looks like we will need to wait and do this for 2018.

So even though this taxpayer was a small business taxpayer before 2018 (under the old rules) and could have elected out, they can still make this change now in 2018 as an automatic change?

I don't see anything that makes this new Section 12.16 inapplicable to such a taxpayer.

(1) Description of change. This change applies to a small business taxpayer, as defined in section 15.18(5)(a) of this revenue procedure, that capitalizes costs under § 263A and wants to change to a method of accounting that no longer capitalizes costs under § 263A, including to self-constructed assets, pursuant to § 263A(i).
(2) Applicability. This change is effective for taxable years beginning after December 31, 2017.
(3) Inapplicability. This change does not apply to a small business taxpayer, as defined in section 15.18(5)(a) of this revenue procedure, that chooses to no longer capitalize costs under § 263A for home construction contracts, as defined in §460(e)(1)(A). See, however, section 19.01 of this revenue procedure.

Okay, I see. 2017. It is DCN 50. There’s a line in there about including changing from the method of capitalizing 263A costs.

Hmm... It seems strange to make this change since already on the cash basis.

263A is still required for grape producers. Even those on the cash basis. However, those that use cash basis can elect out. The election must be made in the first year subject to 263A. Once that election is missed, the taxpayer needs permission to change.

Rev Proc 2002-28 does not include farming businesses within its scope. Rev Proc 2001-10 does not have a similar exclusion. The implication is that really small farms can use its provisions to make that election under DCN 50.

Would I not mention 263A at all in this change? Is the change from an incorrect application of the cash basis to the correct application of the cash basis?

I think I am getting it. This has nothing to do with failing to elect out of 263A. Rev Proc 2001-10 allows a small business to avoid 263A altogether.

So while my client was on the cash basis and could have avoided this capitalization, they have not yet chosen to apply Rev Proc 2001-10 to their method of accounting for inventory.

That's it. Another way of looking at it would be that DCN 50 includes the election out of UNICAP for very small farmers described in 1.263A-4. I'm not 100% sure on that, but it doesn't change what you can do under that method change, so it is sort of moot.

Thank you, Brian

Brian, if you are still out there, can this particular change be done on the cut-off method? Or is a 481(a) adjustment required?

481(a).

I am just now orienting to what I need to do for my clients after reading RP 2018-40. Is this accurate?

1. Client wants to remain accrual. Therefore, I believe I would prepare a 3115 for designated automatic accounting method change #s 234 (263A) and 235 (not accounting for inventory).

2. I believe that I would have a negative 481(a) adjustment spread for 4 years that is the amount on the balance sheet as of 12/31/17 that was capitalized under 263 and 263A.

3. What if the client continues to maintain his financial statement under the old method? This is not an applicable financial statement. Is this a problem? It looks ok to me because the choice is to (a) maintain non-incidental M&S OR (b) account consistently with the financial statement.

4. Client is on LIFO. I don't think I need to do anything special for this since not accounting for inventory simply makes that go away. Or does this mean that client is supposed to apply LIFO to non-incidental m&s?

5. I understand that there is no cost to filing the 3115 in this situation. I believe that the same applies if I put off filing for one more year to see if CA conforms to the accounting method changes in 2019. Is there anything about this process that becomes more complicated if I put this off for one year?

1. Yes.

2. No, the negative 481(a) adjustment would be taken into account under the normal procedures. The DCN 234 change would have a negative adjustment based on the existing section 263A balance on the tax balance sheet. The DCN 235 change's 481(a) adjustment would depend on the facts.

3/4. The choice is between the book method (for non-AFS taxpayers) and treatment as non-incidental materials and supplies. If the taxpayer elects to use its book method, there is no section 481(a) adjustment. If the taxpayer elects to use the non-incidental M&S treatment, it is not clear what the section 481(a) adjustment would be. As it so happens, the Service hasn't made a decision on how this provision works, but they rushed out the method changes regardless. So there are several possibilities that exist.

On the one hand, they probably would not be allowed to use LIFO for non-incidental M&S, since this was prohibited in the old rev procs. They may be allowed to eliminate the book labor and overhead, which would conform to the treatment under the old rev procs. They might be allowed to treat the raw materials and raw material content as expenses under the DMSH, but this might not effect the 481(a) because of the "treatment as an expense on the books" requirement for that safe harbor.

For a LIFO taxpayer, the choice seems to be between staying on their book LIFO (taking into account any book-tax LIFO submethod differences) OR going to non-incidental material & supply treatment, paying back the LIFO reserve, but possibly expensing book labor & overhead.

5. I do not anticipate them taking away the automatic method change in the near future. They usually leave automatic method changes up for at least a couple of years. If anything, the process will only become more certain in the future.

I am a little confused. Let's say taxpayer elects to use non-incidental M&S treatment.

Let's say inventory at 12/31/17 is $100,000, of which $50,000 is normal costs capitalized (labor, materials) and $10,000 is costs capitalized under 263A.

Isn't the 481 adjustment $60,000, and I start 1/1/2018 with a revised inventory balance of $40,000?

You said,

If the taxpayer elects to use the non-incidental M&S treatment, it is not clear what the section 481(a) adjustment would be. As it so happens, the Service hasn't made a decision on how this provision works, but they rushed out the method changes regardless.

But I cannot be the only person with this type of situation. Is everyone on hold pending further guidance?

Under Rev Procs 2001-10 and 2002-28, non-incidental treatment meant the deduction occurred when the item was provided to the customer, e.g. upon its sale. Inventory was never fully expensed. The only reason people are talking about expensing now is that they think it could be achieved under the DMSH.

Sorry, didn’t answer your question fully. Most people appear to be waiting because the change is available for 2018 and they’re still working on 2017. Also, the Big 4 and the usual commentators do not have much experience with this type of change, so there hasn’t been a rush of comments. Les Schneider and the AICPA (Annette Nellen) are the only commenters of which I am aware.

Aloha Brian, I have read RP 2018-40, but need to read it again along with this discussion to better understand the 263A change. I have two small manufacturing clients, well under 25million in revenue - one makes potatoe chips, the other chocolate. If they are not required to capitalize their costs at the end of the year, it would make things a lot easier. I have two immediate questions though, first, if we discontinue the 263-A adjustments, I still think they need to take inventory annually and adjust for that, so our only change will be to that adjustment, right? Second, can you still tolerate some more questions on this topic? Your help is greatly appreciated