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.