Change of accounting - Elect out of 263A

Give me a couple of weeks. I'm trying to put together my own comment letter to send the Service, (which I will share here since it will be public anyway). That should clear up some of the issues and outline my thoughts on how it should work out.

Action, I will take a stab at it, and then Brian can let us know if I got close. I think you want to make a change so that you do not have to account for inventory at all. Your choice would be either to conform to your books or to treat the items purchased as non-incidental materials and supplies. But then you might be able to use DMSH to expense all of the ingredients anyway. Whether that works might depend on how you identify the unit of property - if the company spends $50,0000 on sugar, does that mean that DMSH is n/a, or if the company purchases pounds of sugar at a time that cost less than $2,500 per purchase, could you expense by using the DMSH election?

But if you want to change your method so that you don't have to use 263A, why not also change so that you don't have to account for inventory at all, and then you don't have to capitalize labor etc into your inventory. You just expense the materials & supplies as product is sold.

JAD are you suggesting that by maintaining and adjusting inventories, you will need to capitalize labor and administrative costs even if you elect out of 263A? I think it's important for these two companies to track their inventories and know what they are and to make an annual adjustment to them, it will give them better information on what their costs are. It would just be so much simpler if we didn't have to do the 263A adjustment every year.

I think you have choices. You can choose to change your method of accounting so that you aren't subject to 263A. You can also choose to change your method of accounting so that you don't maintaining inventory. But if you do maintain inventory, then I think you need to capitalize the normal costs to inventory (Sec 471, right?). These are the direct costs, such as material and labor, that go into producing or acquiring the inventory.

If your inventory turnover is high and your ending inventory is low, then maybe the income statement impact doesn't make much difference to your client. I have a client with very slow inventory turnover, and this is going to make a big difference to him, not having to capitalize production costs.

Also, consider complexities with state conformity. You are in HI, right? I am in CA. CA has not conformed, which is a bummer, to say the least.

The Service has not made up its mind about how electing out of section 263A will impact L&OH capitalization. Qualifying small taxpayers have two options: 1) use their book inventory method (which may or may not include book L&OH capitalization) OR 2) treat inventory as non-incidental materials and supplies. Under Rev. Procs. 2001-10 and 2002-28, non-incidental material & supply treatment meant that only raw materials and the raw material content of WIP and FG was capitalized on the balance sheet (as supplies). This cost was deducted when the inventory was provided to the ultimate customer, e.g. when it was sold. For normal FIFO or average cost-using taxpayers, non-incidental material and supply treatment would usually be better -- IF the Service follows the old rev procs. The primary exception would be where the taxpayer expenses its inventory for book purposes.

I took a webcast Monday that touched on these issues. I emailed the speaker, who used to specialize in 263 (she now spends more time on multi-state issues). Here was my question:

Also, for changing from having inventory to accounting for purchases as non-incidental materials and supplies, we benefit by not having to capitalize 263A costs AND 471 costs, correct? So the 481 adjustment will include the previously capitalized 263A costs and 471 costs, such as direct labor, correct? Not having to capitalize direct costs is also really valuable simplification. Is my understanding accurate?

Here is her response:

Your last paragraph is NOT correct. Going to non-incidental materials and supplies for accounting for inventory only means that you deduct cost of inventory when you place the item in service (or sell it). This provision and the other accounting method changes do not say anything about not having to capitalize costs in 471. these costs continue to be capitalized.

Here is my current question:

If direct costs must be capitalized to non-incidental materials and supplies, then what is the point of changing the accounting method to not account for inventories? At the end of the day, we have the same value for the asset on the balance sheet, we still have the complexity of having to capitalize the direct costs, and nothing has changed.

What did you mean by this question:
Not having to capitalize direct costs is also really valuable simplification. Is my understanding accurate?

Aren't direct costs treated the same as NIMS? (I had Harry in mind when I created this abbreviation.) Are you referring to direct costs other than materials?

This provision and the other accounting method changes do not say anything about not having to capitalize costs in 471. these costs continue to be capitalized.
I look forward to Brian's comment on this.

I don't know who the presenter was, but she is wrong about labor and overhead. This isn't just my opinion. See, for example, pages 5-7 of Les Schneider's comment letter. You'll get similar results if you look in Rev. Procs. 2001-10 and 2002-28. See, e.g. Example 20 in Rev Proc 2002-28 where only the raw material content of finished goods is deferred until the year the goods are provided to the taxpayer's customers. This follows directly from the definition of inventoriable items in those two rev procs, where the item is limited to goods purchased for resale and raw materials used to produce finished goods.

ok, thanks. I will circle back to her and post back here when I hear from her again.

Here is my email to her and her reply:

Me:

Thank you for the reply. I am writing to follow up on the issue about capitalizing 471 costs to non-incidental materials and supplies. I discussed your response with other CPAs on an online forum (without identifying anyone). Here is our confusion:

1. What is the point of electing out of maintaining inventory if the taxpayer still must treat purchases as non-incidental materials and supplies and must capitalize costs under 471? What is the practical difference between maintaining inventory and electing out?

2. I hesitate to mention RP 2002-28 and RP 2001-10 since they are now obsolete, but both might illustrate concepts applicable to non-incidental material and supplies. Neither says anything about capitalizing costs to the raw materials treated as non-incidental material and supplies.

3. Please see pages 5 – 7 of Les Schneider’s comment letter: https://www.ipbtax.com/media/news/428_0 ... mments.pdf

He is an expert in tax accounting and inventories.

The first sentence of page 6 says, “Turning first to the determination of the cost of inventories that are produced by a small business taxpayer, if these inventories are treated as non-incidental materials and supplies pursuant to the provisions of the TCJA, we submit that all of the direct labor and overhead costs incurred in producing the goods are deductible as incurred.”

Another professional, Brian Coddington, called this letter to my attention. My response was that the issue must not be settled if the letter writer is suggesting that this is the appropriate treatment. Brian believes that the issue is settled and that Les is just suggesting that the regs confirm this treatment.

Thank you for any understanding that you can provide. I will share the information with the others.

Her:

Non-incidental materials and supplies deals with the timing of the deduction of inventory costs, not with what costs go into inventory. 'definition is in 1.162-3 which is partially reproduced here:

(a)In general

(1)Non-incidental materials and supplies.—
Except as provided in paragraphs (d), (e), and (f) of this section, amounts paid to acquire or produce materials and supplies (as defined in paragraph (c) of this section) are deductible in the taxable year in which the materials and supplies are first used in the taxpayer's operations or are consumed in the taxpayer's operations.
(2)Incidental materials and supplies.—
Amounts paid to acquire or produce incidental materials and supplies (as defined in paragraph (c) of this section) that are carried on hand and for which no record of consumption is kept or of which physical inventories at the beginning and end of the taxable year are not taken, are deductible in the taxable year in which these amounts are paid, provided taxable income is clearly reflected.


If you use a cash method that requires non-incidental materials and supplies treatment for inventory - what you get out of it is relief from having to record accounts receivable and accounts payable.

If you have citations that you want me to review that support your position, please advise and I will look at them. I don't generally review secondary sources.

****
I hope the regs clearly address this issue.

Very good thread.

On first reading earlier this year, I was obviously mistakenly excited for a few of my clients that we no longer needed to capitalize inventory.

From me reading and understanding, what actually happened is that we can get to a place where we only have to track direct purchases of inventory, and not capitalize other costs, such as L&OH.

E.G. I have a rock yard, mostly landscape supply, they would only have to include the cost of rock/mulch in the cost of their inventory?

There was made mention of the DMSH being relevant here. I am a little confused on this point. I have never understood this to extend to the deductibility of inventory items, is that something that is being proposed as an option (pending guidance from the IRS)? I've historically only applied this to equipment and repairs.

If I have another construction supply company that is selling bricks, it seems a bit ambitious to think that because each brick is below $2,500 (most of my clients do not have an AFS), we could simply write it off, when they have $200,000 of bricks and stones sitting in their yard at any given time.

The point of the posts directly above yours is that not everyone agrees that there is no capitalization of 471 costs to non-incidental M&S

Not everyone agrees on all aspects. What JAD has posted above is an outlier position, the AICPA Tax Section comments and Inventory expert/tax attorney Les Schneider's comments on the TCJA follow what I have discussed above. There are several options for what the ultimate guidance could be.

1. Under not reinventing the wheel, the first option is that Treasury follows Rev. Procs. 2001-10 and 2002-28. If the taxpayer elects out of 263A and elects non-incidental material and supply treatment under section 471, a manufacturer capitalizes into "inventory" only raw materials, i.e. raw materials plus the raw material content of WIP and FG. (L&OH would be deducted as period expenses under this approach.) If the taxpayer also changes to the cash method, the deduction for inventoriable items is the later of providing the inventory to the customer or paying the raw material vendor. This approach is largely supported by reviewing the legislative history. When discussing the present law, the committee report describes the rules of the two rev procs as treating inventoriable items as non-incidental materials & supplies. The report then says that, under the TCJA, taxpayers can treat inventory as non-incidental materials & supplies. This suggests that the old rev proc methods and the TCJA method are the same.

2. The second option is to ignore the specific timing rules in the old revenue procedures and just apply the text of section 1.162-3(a)(1). In this case, manufacturers would deduct the cost of raw materials when they are placed into WIP. Retailers, OTOH, would only deduct inventoriable items when they are sold to customers. In both situations, L&OH are deducted. Even if this option does not prevail, there may be opportunities for a more rigorous differentiation between raw materials and other materials and supplies. The latter would be deducted when placed into WIP, even if the former has to remain on the balance sheet. Though I like the second option since it provides generally better results and relieves small manufacturers of the burden of tracking the raw materials content of WIP and FG, I do not think it is likely since it would mean that the legislative history would then use NM&S treatment to mean two different things in two different places. It is within the range of possibilities, but I consider it less likely.

3. The third option is either of the above, but plus the DMSH, which renders moot any L&OH questions. I don't think this one is likely because the DMSH does not apply to inventory and it also doesn't apply to items that are not treated as an expense on the taxpayer's financial statement/books & records. Though the Service hasn't addressed the latter point directly, this would seem to apply to any amounts hung up on the balance sheet at year-end. Moreover, under the Obama administration, the attorney who drafted the DMSH informally commented that it would not apply to inventoriable items treated as non-incidental materials and supplies under the old rev procs, because they are treated as NM&S, they are not transformed into NM&S. Under the current administration, informal comments (by other Chief Counsel attorneys) have not been so severe.

4. The fourth option is that the some or all L&OH (and other indirect costs) must be capitalized. The theory JAD reproduced above is one of the weaker examples I have seen, since it relies on the undefined term "cost" in section 1.162-3(a)(1). As Example 12 in that regulation section makes clear, (especially when read in conjunction with Notice 88-86), section 263A is the primary driver of L&OH cost capitalization for M&S. Other alternatives I have seen or considered are that section 1.263(a)-2 requires additional cost capitalization or an attenuated theory based on cases like Idaho Power requiring L&OH cost capitalization for self-constructed supplies. The latter has no basis in any previous guidance and the former should be ruled out due to its explicit provisions that M&S are exempted from that rule. Even though the latter has never appeared in any guidance, it is a plausible interpretation, especially if framed in terms of the ordinary meaning of "cost" in section 1.162-3(a)(1) plus an expansive view of Idaho Power and progeny. This could be bolstered by the 7805(b) approach that was taken with this section, (i.e. the regulation was not applied retroactively).

Ultimately, I think the Service already went through this thought process in 2000 through 2002 and is unlikely to change its conclusions, so option 1 seems most likely to me. It is a middle-of-the-road position that doesn't require much explaining away.

Coddington, thank you very much for the synopsis. Very well thought out and easy to follow.

Is Coddington's #33 still the state of things? Has there been any authoritative clarification of whether there are circumstances when inventory can be fully expensed rather than capitalized as NIMS? And what exactly are

... the books and records of the taxpayer prepared in accordance with the taxpayer’s accounting procedures.

?

Let's say we have a small-volume taxpayer who deals in backhoes. He sells them at retail. He has no service department or other source of income from that business, but he has lots of totally unrelated personal income. The average sale price is $25,000 per backhoe. He only sells about 50 or 75 backhoes annually, for a typical sales volume of about $1,250,000 to $1,875,000. He keeps 2 of each model on his sales floor, there are 5 models, and his total direct costs of those 10 models is about 150,000. He has no 263A costs.

He was never eligible for RP 2001-10 because annual. volume exceeded $1,000,000, nor RP 2002-28, because that one excluded retailers. He sells directly from the floor models, and replaces each one as soon as it is sold. He has no applicable financial statement. He'd love to expense the $150,000 inventory and realizes he'd need an accounting method change.

But I'm unclear on the books and records question. Right now he uses QB and records inventory. But his operation is so small and simple that he says he'd be willing to expense the inventory on his books, because he pretty much knows in his head the cost of each hoe, and he really does not have to look at the books in order to manage his business. And if ever needed, he does keep a paper file of each purchase invoice that he gets from the manufacturer, and the sales contract for each hoe he sells. In fact, I think he matches them in a manila file kept for each sale. I hope those are not books and records.

So, with these facts, can he change to expensing inventory?

In that situation, switching to expensing inventory in QB at the beginning of the year would probably allow DMSH expensing if he switches to non-incidental M&S treatment.

But his cost per backhoe is way over $5,000. Can he use DMSH?

Sorry, should’ve read it closer.

The only option would be to change to expensing for book and then adopt the book-conformity method. There’s no guarantee the Service will respect it, but someone has to do it. (I don’t think it will work because the expensing isn’t exactly an inventory method as that term is commonly used.)

The only option would be to change to expensing for book .... The operative term in the law is

... the books and records of the taxpayer prepared in accordance with the taxpayer’s accounting procedures.

. Backhoe dealer has no problem expensing inventory if general ledger is all they mean. But I'm asking whether that decription is construed to include, for example, a folder for each backhoe that contains its paid purchase documents, its paid sale documents, and a simple sheet that contains model name, item number, purchase date and price, sale date and price, none of which makes it to the "books" but all of which is part of his "records".

That is one of the areas where the Service requested comments in Rev Proc 2018-40. I believe it means their general ledger, their permanent books of account. I don't believe it means books AND what can be created from the records, because books are what is prepared in accordance with their accounting procedures from their records. I also believe that they must have books to do this.