Clients writing off inventory in full because of TCJA

Pros,

I hope everyone is well. I wanted to ask if you are starting to advise clients to write off inventory in full these days because of the new laws allowing businesses to do this if they make less than 25MM a year. These are most businesses in this country. Is it as simple as informing a business to just not report inventory on their balance sheet? I understand IRS says the taxpayer has to conform to their method of accounting reflected in an applicable financial statement. Well, does this mean if a business reports all inventory types of expenses as COGS, then they can just write it all off even though they still have possession of it? And do you see an issue if the business reports the inventory as an asset on the balance sheet and just does an accrual to cash adjustment on the M1 like a prepaid expense for a cash basis taxpayer? What are your thoughts here? I am asking most of this because we have a client who has around 300k in profit and could have 0 in profit if he wrote off 300k inventory (which was inventory as of 12/31/19) to COGS. Thank you for any insight.

Books and records need to be consistent. Inventory can be written off as materials & supplies when the co also makes the DMSH election. Unless this is a new business, taxpayer has already established a method of accounting, so a 3115 is required. Hire Brian Coddington to streamline this process.

So anyway I just picked this thread because it was aptly titled to start a new discussion about the proposed regulations in which the treasury is saying the DMSH does not apply to inventory TREATED materials and supplies because it's still inventory, and the DMSH does not apply to inventory.

Wish they could have brought this up sooner, as I've already advised to a few clients to change their method cash method, elect out of 471 (and applied DMSH), and 263A. I'm not too worried yet, as I believe we're still using a reasonable method. The proposed regs can be relied upon, if wanted, otherwise it's not the rule. As long as we have a reasonable interpretation of the laws at this point we should be ok. This was the preamble to the regulations say:

Two commenters asked for clarification on whether a taxpayer using the nonincidental materials and supplies method under section 471(c)(1)(B)(i) may use the deminimis safe harbor election of §1.263(a)-1(f). As discussed in part 4.B of this Explanation of Provisions, the Treasury Department and the IRS continue to interpret inventory treated as non-incidental materials and supplies as remaining characterized as inventory property. Consequently, proposed §1.471-1(b)(4)(i) provides that inventory treated as section 471(c) non-incidental materials and supplies is not eligible for the deminimis safe harbor election under §1.263(a)-1(f).https://www.irs.gov/pub/irs-drop/reg_132766_18.pdf

Just wondering if we've interpreted that TREATED as materials and supplies meant no longer treated as inventory (and applied DMSH) where does that leave us if this reg goes final? Change in method needed?

<sigh>

The example under the AFS section 471(c) method appears to permit inventory expensing, though it isn't entirely clear. If these regs are finalized and they do permit inventory expensing under the AFS and non-AFS methods and a taxpayer previously filed a Form 3115 to adopt expensing via NIMS plus DMSH, the Service could adjust the year of the change and any other subsequent, open years to use just the NIMS method. If they do allow expensing via the non-AFS and AFS methods, we'd have to wait and see if they allow a Form 3115 to adopt those methods and receive prior year audit protection. The bigger issue is that the broad definition of books and records could eliminate inventory expensing even if it is technically permitted.

Terry, I am posting an email that I sent to clients (after Brian's review) in case it is helpful. If any part is useful, feel free to use.

Dear

I am sending this email to inform you of proposed regulations recently issued by the IRS that may impact the accounting method change that your company recently made to not account for inventories. This email is a bit dense, so I have provided the main points first:

1. The proposed regulations are not taxpayer-friendly regarding the inventory simplification provisions.

2. The proposed regulations are not mandatory. There is a comment period, and at some future date, final regulations will be issued. At that time, we will have to determine what, if any, work is required.

3. Ultimately, we may have to make additional changes in how the company accounts for items that that it purchases or produces for sale to customers.

In your company’s 2018 tax year, we applied for changes in certain accounting methods. The Tax Cuts and Jobs Act made simplifying provisions available to “small business taxpayers”. As a reminder, the company changed from the accrual to the cash method, elected to not apply IRC Section 263A (capitalization of indirect costs to inventory), and elected to treat inventory as non-incidental materials and supplies.

This latter change of treating inventory as non-incidental materials and supplies, combined with the use of the de minimis safe harbor election, results in the company deducting the cost of goods when purchased. This treatment was specifically allowed per the Joint Committee on Taxation’s analysis of the Tax Cuts and Jobs Act.

The IRS issued proposed regulations on these issues on July 29, 2020. The proposed regulations are not taxpayer friendly. The IRS has abandoned the Joint Committee on Taxation’s approach to the use of the de minimis safe harbor on non-incidental materials and supplies. Without the application of the de minimis safe harbor, non-incidental materials and supplies are deducted in the year that the goods are provided to the customer. Further, the IRS has taken the position that non-incidental materials and supplies are essentially inventory, requiring the capitalization of direct costs.

The regulations include this example: A baker purchased $50 of peanut butter in November 2019. He made cookies in December 2019. He sold the cookies in January 2020. The cost of the peanut butter is deductible in 2020.

There is another potential accounting method available to taxpayers that may allow them to deduct the cost of goods when incurred. The taxpayer may treat costs for tax purposes consistent with the treatment in its books and records. This would seem to provide an easy solution: simply keep inventory and cost of goods sold off of the financial statements. Unfortunately, the IRS’s position is that the totality of the taxpayer’s documents and electronically-stored data are included in “books and records.” There is some discussion in the preamble to the regulations that could indicate that the taking of a physical inventory is fatal to the use of this tax position. There is an example in the regulations where the taking of a physical inventory AND the representation to a creditor of the amount of the inventory on hand causes the cost of the inventory to not be immediately deductible. The regulations conclude that the taxpayer “…may not expense all of its costs paid in the ….taxable year because its books and records to not accurately reflect the inventory records used for non-tax purposes in its regular business activity.”

[Discussion of client’s specific situation, mostly explaining that even if this goes sideways, not having to deal with 263A still will save them money in tax prep fees and remains a huge benefit]

In total, the IRS’s position seems extreme. The intent of the Tax Cuts and Jobs Act was to provide simplification in this area, and the IRS seems intent on thwarting that goal, as it relates to inventory issues. How can a business price the goods it sells if it cannot track costs and count physical goods on hand? It is hard to imagine that Congress intended a business to not track the information that it needs to price the goods that it sells.

There are a great many CPAs who assisted a great many taxpayers in filing accounting method changes to not account for inventory by applying the de minimis safe harbor to non-incidental materials and supplies, based upon the analysis by the Joint Committee on Taxation. Hopefully the final regulations will embrace simplification concepts.

At this time, my recommendation is that we take no action until final regulations are issued. The proposed regulations may be relied upon, but they are not mandatory. There is a comment period, and the IRS will issue final regulations at some unknown, future date. We cannot predict the extent to which the final regulations will follow these proposed regulations.

Although the bait-and-switch between the Joint Committee on Taxation and the IRS is unfortunate, these proposed regulations are not the final word. I will stay alert to these issues and let you know when there are developments. Please let me know if you have any questions.

Wow JAD that's great! I think it's a really good idea to notify affected clients. I'm definitely going to use this. Thank you!

3. Ultimately, we may have to make additional changes in how the company accounts for items that that it purchases or produces for sale to customers.


There is another potential accounting method available to taxpayers that may allow them to deduct the cost of goods when incurred. The taxpayer may treat costs for tax purposes consistent with the treatment in its books and records. This would seem to provide an easy solution: simply keep inventory and cost of goods sold off of the financial statements. Unfortunately, the IRS’s position is that the totality of the taxpayer’s documents and electronically-stored data are included in “books and records.” There is some discussion in the preamble to the regulations that could indicate that the taking of a physical inventory is fatal to the use of this tax position. There is an example in the regulations where the taking of a physical inventory AND the representation to a creditor of the amount of the inventory on hand causes the cost of the inventory to not be immediately deductible. The regulations conclude that the taxpayer “…may not expense all of its costs paid in the ….taxable year because its books and records to not accurately reflect the inventory records used for non-tax purposes in its regular business activity.”

found these.

i would shorten it up. I don't know if any clients will read it because it's so long. Really like the forewarning and that we'll follow up with you on updates, etc. That way we set the expectation for possible later bad news.

thansk again!

Thanks Terry. Outlook caught the typo before sending. Yes, it is long. I don't send this sort of thing often; they will read it. The clients involved are very engaged on this issue because it is such a material change in how they maintain information and record transactions.