TAX ACCOUNTING ISSUES

Transcription

1 TAX ACCOUNTING ISSUES 8 Issue 1: Cash and Accrual Methods Issue 2: Choosing a Tax Accounting Method Issue 3: Book-Tax Conformity. 270 Issue 4: Inventories Issue 5: I.R.C. 263A UNICAP Rules Issue 6: Cost of Goods Sold Issue 7: Installment Sale Method Issue 8: Accounting for Soil and Water Conservation Expenses Issue 9: Accounting and Reporting Rules for Tips Issue 10: Changing a Tax Accounting Method Issue 11: Correcting Depreciation Errors Learning Objectives After completing this session, participants will be able to perform the following job-related actions: Determine when income is included and when expenses are deducted under the cash and accrual methods of accounting Identify taxpayers that are prohibited from using the cash method and taxpayers that are required to use the accrual method Explain when the taxpayer has to use the same accounting method for tax reporting and financial reporting Identify which taxpayers are required to keep inventories, and explain how those inventories are kept and valued Learn when the UNICAP rules apply, what costs have to be capitalized, and how the rules are applied to value inventory Calculate cost of goods sold Apply the installment sale regulations to report gain from a deferred payment sale Explain the limit for deducting soil and conservation expenses and the carryover of the deduction in excess of the limit Ascertain the difference between a tip and a service charge, and advise employers and 2015 Land Grant University Tax Education Foundation, Inc. 263

2 employees about their tip reporting and withholding obligations Determine what constitutes a change in an accounting method, and understand what consent is required to change methods and what adjustments have to be made because of the change Learn how to correct depreciation errors Introduction FINAL COPYRIGHT 2015 LGUTEF Tax accounting methods determine when and how income and expenses are reported on a federal income tax return. The two most common accounting methods are the cash receipts and disbursements method (the cash method) and the accrual method. This chapter describes the timing of inclusion of income and expenses under the cash and accrual methods, the requirements for selecting an overall tax accounting method, and whether the method selected for tax reporting has to be the same method that the taxpayer uses for bookkeeping. Inventory accounting and uniform capitalization (UNICAP) are examples of special methods of tax accounting. This chapter explains how inventory accounting and the UNICAP rules operate to identify and value inventory, as well as the calculation of cost of goods sold to determine the cost to produce or acquire inventory that has been sold during the year. Tax accounting methods are overall methods (such as the cash and accrual methods), and they are also methods of accounting that apply to specific items of income and specific expenses. This chapter discusses tax accounting treatment for the deferred recognition of income on installment sales, current deductibility of soil and water conservation expenses, and specialized methods for reporting and withholding on employee tips that are given directly or indirectly to the employee but deemed paid by the employer. Once a taxpayer has adopted a tax accounting method (overall or specific), the taxpayer may need IRS approval to change that method. This chapter discusses the procedures for changing tax accounting methods, including the new procedures under Rev. Proc , I.R.B. 694, that simplify certain accounting method changes for small businesses, and the procedures to correct depreciation errors. ISSUE 1: CASH AND ACCRUAL METHODS The two most commonly used tax accounting methods are the cash method and the accrual method. Taxpayers filing their first tax return can adopt any permissible method of tax accounting. I.R.C. 446(c) establishes the cash and accrual methods for computing taxable income. The cash method and the accrual method determine when income is included in taxable income and when expenses are deductible. Different methods of accounting can be used for each trade or business, and a combination of methods can be used. Once a method has been adopted, changes typically require IRS consent. Cash Method Cash method taxpayers include income when it is actually or constructively received [Treas. Reg ]. Under the constructive receipt doctrine 264 LEARNING OBJECTIVES of I.R.C. 451, income may be included before it is actually received if it is credited to the taxpayer s account, set apart for the taxpayer, or otherwise made available to the taxpayer. Income is not constructively received if there is a substantial limitation or restriction on the taxpayer s receipt of the income [Treas. Reg (a)]. Example 8.1 Constructive Receipt Paige Turner is an independent contractor. In November 2015 Paige provided services for ACME, Inc., a manufacturing company. Paige is a cash method taxpayer and uses the calendar tax year. ACME s standard procedure is to mail payment to contractors by regular US mail. ACME mailed Paige a check on December 27, 2015, by certified mail. On December 31, a postal employee attempted to deliver the check, but

3 Paige was not home. The postal employee left a notice stating that the mail could be picked up at the post office after 4:00 p.m. that day. Paige did not receive the notice until 6:00 p.m., when the post office was closed. The post office was closed January 1, and Paige picked up the check on January 2, Although the check was unqualifiedly committed to Paige when it was mailed on December 27, 2015, and it was made available to Paige on December 31, 2015, the funds were not subject to the will and control of Paige until January 2, Paige did not expect to receive a check by certified mail and did not intentionally delay receipt of the check. The income is included in Paige s 2016 income. Cash method taxpayers typically claim deductions when they pay expenses [Treas. Reg ]. However, cash method taxpayers may not be able to claim a current deduction for expenses paid for a future accounting period (prepaid expenses). An expense paid by a cash method taxpayer in advance is deductible only in the year the service or property that was purchased is used or consumed, and under the general rule of I.R.C. 263(a), prepaid expenses must be capitalized. If the expense qualifies under the 12-month rule, a taxpayer is not required to capitalize prepaid expenses (although the taxpayer can elect to capitalize such expenses). The 12-month rule applies to amounts paid to create rights or benefits for the taxpayer that do not extend beyond the earlier of 12 months after the right or benefit begins, or the end of the tax year after the tax year in which payment is made [Treas. Reg (a)-(4)]. The 12-month rule does not apply to amounts paid to create financial interests or I.R.C. 197 intangibles. Example 8.2 Prepaid Expenses On December 1, 2015, Smith Industries, Inc. paid a $10,000 insurance premium to obtain a property insurance policy. The policy has a 1-year term that begins on February 1, 2016, and ends January 31, The $10,000 is a prepaid expense because the benefit of the policy extends beyond the tax year of the payment. Because the benefit attributable to the $10,000 payment extends beyond the end of the tax year (2016) following the tax year in which the payment is made (2015), the 12-month rule does not apply. Smith Industries has to capitalize the $10,000 payment [Treas. Reg (a)-(4)(f)(8), Example 1]. Example 8.3 Prepaid Expenses On December 31, 2015, Gomez Roofing, Inc. paid a $10,000 insurance premium to obtain a property insurance policy. The policy has a 1-year term that began on December 15, 2015, and ends on December 14, The 12-month rule applies to the $10,000 payment because the benefit attributable to the payment does not extend more than 12 months beyond December 15, 2015 (the first date the benefit was realized by Gomez), and it does not extend beyond the end of the tax year following the tax year in which the payment is made (because the payment was made in 2015 and the policy ends in 2016). Because the 12-month rule applies, Gomez is not required to capitalize the $10,000 payment [Treas. Reg (a)-(4)(f)(8), Example 2]. Application of the 12-Month Rule The 12-month rule is used to determine whether a prepaid expense can be deducted in the year the expense is paid. It does not affect either the determination of when a liability has accrued under the accrual method or the determination of whether the economic performance test has been met. Accrual Method Generally, accrual method taxpayers include income when earned [Treas. Reg ]. Under the all events test of Treas. Reg , an accrual method taxpayer s income is considered earned, and included in gross income, when all the events have occurred that fix the right to receive the income, and the amount of income can be determined with reasonable accuracy. Income is not included if the amount owed can t be estimated accurately, or if there is reasonable certainty that amounts owed won t be collected. Accrual Method 265 8

4 Example 8.4 All Events Test for Income Pete Bogg is an independent contractor who uses the accrual method and has adopted the calendar tax year. Pete performed services for Sandy Beach on December 15, Sandy agreed to pay $200 for services rendered. Pete sent an invoice to Sandy on December 30, 2015, and Sandy paid the invoice on January 10, The all events test was met in 2015, when Pete performed the services and fixed his right to receive payment. Pete must include the $200 in his 2015 income. Under the all events test of Treas. Reg , accrual method taxpayers claim a liability in the tax year in which 1. all the events have occurred that establish the fact of the liability, 2. the amount of the liability can be determined with reasonable accuracy, and 3. economic performance has occurred with respect to the liability. The first two parts of the test are similar to the all events test applicable to the inclusion of income, but the all events test for inclusion of liabilities is not met until there has been economic performance. Economic Performance If the liability arises from the provision of services or property to the taxpayer by another person, economic performance occurs when the services or property is provided. If the liability arises from the use of property by the taxpayer, economic performance occurs ratably over the period of time the taxpayer is entitled to the use of the property. If the liability requires the taxpayer to provide services or property to another person, economic performance occurs as the taxpayer incurs costs to satisfy the liability [Treas. Reg ]. Example 8.5 Services or Property Provided to the Taxpayer Feldstein Ltd., an accrual method limited partnership, owns a parcel of property containing oil and gas. In December 2013 Feldstein entered into a contract with Big Rig Drilling, Inc. pursuant to which Feldstein paid Big Rig $200,000 to provide a completed well by December 31, Big Rig 266 ISSUE 1: CASH AND ACCRUAL METHODS started drilling in May 2015 and completed the well in December Economic performance with respect to Feldstein s liability for drilling and development services provided by Big Rig occurred as the services were provided. Consequently, Feldstein incurred a $200,000 liability for the 2015 tax year [Treas. Reg (d)(7), Example 4]. Example 8.6 Use of Property Provided to the Taxpayer Flying High, Inc., an accrual method corporation, charters aircrafts. On December 20, 2014, Flying High leased a jet aircraft from Ground Zero, Inc. for the 4-year period that began on January 1, The lease obligates Flying High to pay Ground Zero $500,000 of rent per year. Economic performance with respect to Flying High s rent liability occurs ratably over the period of time Flying High is entitled to use the jet aircraft. Consequently, the $500,000 liability for rent was incurred by Flying High for the 2015 tax year and for each of the next 3 tax years [Treas. Reg (d)(7), Example 6]. Example 8.7 Services or Property Provided by the Taxpayer In March 2007 Deep Wells, LLC, an accrual method oil company, entered into an oil and gas lease with Energy, Inc. In November 2007 Deep Wells installed a platform and commenced drilling. The lease obligated Deep Wells to remove its offshore platform and well fixtures upon abandonment of the well or termination of the lease. In 2015 Deep Wells removed the platform and well fixtures at a cost of $200,000. Economic performance with respect to Deep Wells s liability to remove the offshore platform and well fixtures occurred as Deep Wells incurred costs in connection with that liability. Costs for removal services were incurred in 2015, and Deep Wells incurred a $200,000 liability for the 2015 tax year [Treas. Reg (d)(7), Example 1]. Recurring Items Exception Treas. Reg provides an exception to the economic benefit rule for recurring items.

5 Recurring items are treated as incurred during the year, even though economic performance has not yet occurred. The exception applies if 1. the all events test is met (all events have occurred to establish the liability, and it can be determined with reasonable accuracy); 2. economic performance occurs on or before the earlier of the fifteenth day of the ninth calendar month after the close of that tax year, or the date of a timely filed return (including extensions); 3. the liability is recurring; and 4. either the amount of the liability is not material, or accruing the liability in the year in which the all events test is met results in a better match against income than accruing the liability in the year of economic performance. Accruals to Related Cash Method Taxpayers See the Business Issues chapter in this book for a discussion of the deduction for accrued expenses owed to related cash method taxpayers. ISSUE 2: CHOOSING A TAX ACCOUNTING METHOD Some taxpayers are prohibited from using the cash method, and some taxpayers are required to use the accrual method. This section reviews the requirements for selecting a permissible tax accounting method. Subject to the restrictions described below, a taxpayer can use any tax accounting method or combination of methods that clearly reflects income. Taxpayers Who Cannot Use the Cash Method I.R.C. 448(a) prohibits C corporations, partnerships with a C corporation as a partner, and tax shelters from using the cash method of tax accounting (or any hybrid method that includes the cash method). Three exceptions in I.R.C. 448(b) allow use of the cash method by certain farming businesses, qualified personal service corporations, and taxpayers with average gross receipts not exceeding $5,000,000. Farming Businesses The prohibition on use of the cash method by C corporations and partnerships with a corporation as a partner does not apply to a farming business. A farming business is defined by I.R.C. 263A(e)(4) to include raising, growing, and harvesting of timber and ornamental trees; operating a nursery or sod farm; or raising or harvesting of trees bearing fruit, nuts, or other crops. A farming business does not include the processing of the trees or crops. Although an exception to I.R.C. 448 allows farming corporations to use the cash method, separate requirements under I.R.C. 447 may require farming corporations to use the accrual method. Under the general rule of I.R.C. 447, a corporation engaged in the trade or business of farming or a partnership engaged in the trade or business of farming (if a corporation is a partner in the partnership) must use the accrual method of tax accounting. I.R.C. 447 does not apply to the operation of a nursery or sod farm, or to the raising or harvesting of trees (other than fruit and nut trees). There are also some broad exceptions for farming businesses operating as S corporations (or farming partnerships with an S corporation partner), farming corporations that meet a gross receipts test, and family farming corporations that meet a gross receipts test. Exception for Subchapter S Farming Corporations I.R.C. 447 does not apply to S corporations, and a farming corporation that has elected subchapter S status can use the cash method of tax accounting. Similarly, a farming partnership with an S corporation partner can use the cash method. 8 Taxpayers Who Cannot Use the Cash Method 267

6 Exception for Farming Corporations with Gross Receipts under $1,000,000 A farming corporation that is a C corporation, or a farming partnership with a C corporation partner, is not subject to I.R.C. 447 and can use the cash method of tax accounting if the corporation meets a gross receipts test. The gross receipts test is met if, for each prior tax year beginning after December 31, 1975, the corporation (and any predecessor corporation) did not have gross receipts exceeding $1,000,000. All corporations that are members of the same controlled group of corporations [as defined by I.R.C. 1563(a)] are treated as one corporation, and their receipts are aggregated. Exception for Family Farming Corporations with Gross Receipts under $25,000,000 A family farming corporation that meets a gross receipts test can use the cash method of tax accounting. The test for a family farming corporation will be met if, for each tax year beginning after December 31, 1985, the corporation did not have gross receipts exceeding $25,000,000. To qualify as a family farming corporation, at least 50% of the total combined voting power of all classes of stock entitled to vote and at least 50% of all other classes of stock of the corporation have to be owned by members of the same family and certain closely held corporations. Family is defined broadly to include brothers and sisters, the brothers and sisters of the shareholder s parents and grandparents, the ancestors and lineal descendants of any of the preceding, a spouse of any of the preceding, and the estate of any of the preceding. Qualified Personal Service Corporations Qualified personal service corporations can use the cash method of tax accounting, even if they are C corporations or partnerships with a C corporation partner. A qualified personal service corporation must meet a function test and an ownership test set forth in Temp. Treas. Reg T(e). Function Test Substantially all of the activities of the personal service corporation must involve the performance of services in a qualifying field. Qualifying fields are the following: 1. Health 2. Law 3. Engineering 4. Architecture 5. Accounting 6. Actuarial science 7. Performing arts 8. Consulting Substantially means that 95% or more of the time spent by employees of the corporation is devoted to the performance of services in a qualifying field. For purposes of determining whether this 95% test is met, the performance of any activity incident to the actual performance of services in a qualifying field is considered the performance of services in that field. Some examples of activities that are incident to the performance of services in a qualifying field include the supervision of employees engaged in directly providing qualifying services, and the performance of administrative and support services in connection with qualifying activities. Example 8.8 Performance of Services in the Field of Consulting Good Investments, Inc. is in the business of executing transactions for customers involving various types of securities or commodities generally traded through organized exchanges or other similar networks. Good Investments provided its clients with economic analyses and forecasts of conditions in various industries and businesses. Based on these analyses Good Investments recommended transactions in securities and commodities. Clients placed orders with Good Investments to trade securities or commodities based on Good Investments s recommendations. Good Investments was typically compensated for its services based on the trade orders. Because the compensation of Good Investments was contingent on the trade orders, Good Investments was not considered to be engaged in the performance of services in the field of 268 ISSUE 2: CHOOSING A TAX ACCOUNTING METHOD

7 consulting. Good Investments was engaged in brokerage services [Temp. Treas. Reg T(e), Example 5]. gross receipts for the short year are calculated as follows: (gross receipts for the short period 12) the number of months in the short period. Ownership Test Substantially all (95% or more) of the stock of the personal service corporation must be owned directly (or indirectly through one or more partnerships, S corporations, or qualified personal service corporations that are not tax shelters or partnerships with a C corporation as a partner) by employees performing services for the corporation in a qualifying field. The ownership test will also be met if the stock is owned by retired employees who had formerly performed services for the corporation in a qualifying field. Ownership after Death of Employee The ownership test will still be met if substantially all of the stock is owned by the estate of an employee or retired employee, or by a person who acquired the stock by reason of the death of the employee or retired employee who performed services for the corporation in a qualifying field. This exception applies only to the 2-year period beginning on the date of the death of the employee. Entities with Gross Receipts of Not More Than $5,000,000 C corporations and partnerships with a C corporation partner can use the cash method of tax accounting if the average annual gross receipts of the entity for the 3 previous tax years does not exceed $5,000,000. Corporations, partnerships, and other trades or businesses treated as being under common control pursuant to I.R.C. 52(a) and (b) are aggregated for the purposes of calculating gross receipts. Similarly, affiliated service groups and certain arrangements designed to avoid employee benefit requirements under I.R.C. 414(m) and (o) are combined for purposes of calculating gross receipts. If an entity has not been in existence for the preceding 3-year period, the gross receipts test is applied for the time that the entity (or trade or business) has been in existence. If a tax year is less than 12 months, Included in Gross Receipts Gross receipts for a tax year are the gross receipts that are recognized under the accounting method the taxpayer uses for federal income tax purposes. Gross receipts include total sales (decreased by returns and allowances) and all amounts received for services. In addition, gross receipts include investment income and income from incidental or outside sources. For example, gross receipts include interest, dividends, rents, royalties, and annuities, regardless of whether these amounts are generated in the ordinary course of the taxpayer s trade of business. Not Included in Gross Receipts Gross receipts are not reduced by cost of goods sold or by the cost of property sold if the property is a noncapital asset, such as stock in trade, inventory, a copyright or musical composition, certain accounts or notes receivable, and government publications. For sales of capital assets or sales of real or personal property used in a trade or business, gross receipts are reduced by the taxpayer s adjusted basis in the property. Gross receipts do not include the repayment of a loan or similar instrument (such as a repayment of the principal amount of a loan held by a commercial lender). Gross receipts do not include sales tax or other similar state and local taxes collected if the tax is legally imposed on the purchaser and the taxpayer is only collecting and remitting the tax to the taxing authority. Other Restrictions on Method of Accounting Taxpayers who satisfy one of the three exceptions to the I.R.C. 448(a) prohibition on using cash accounting may be required to use accrual accounting under other rules. Special Rule for Inventories Taxpayers are required to use the accrual method for sales and purchases of merchandise if it is necessary to use an inventory [Treas. Reg (c) 8 Other Restrictions on Method of Accounting 269

8 (2)(i)]. It is necessary to use an inventory if the production, purchase, or sale of merchandise of any kind is an income-producing factor. Exceptions See Issue 4: Inventories in this chapter for two main exceptions that allow taxpayers to use the cash method even though they are required to use an inventory. Clear Reflection of Income The taxpayer s choice of tax accounting method must be a permissible method, and it also has to clearly reflect income. An accounting method clearly reflects income if it is consistent [Treas. Reg ]. Consistency includes both use of the same method from year to year and use of the same method for income and expenses. In addition to consistency, a tax accounting method clearly reflects income if it follows accepted industry practice, it is reasonable and simple, and it fairly states the taxpayer s income [Sho-Me Power Electric Cooperative v. United States, 93 A.F.T.R. 2d (RIA) (W.D. Mo. 2004)]. Different Accounting Methods The consistency requirement does not always preclude use of different tax accounting methods. A taxpayer can use one method for business matters and another method for personal matters. A taxpayer can also use different methods for different businesses. ISSUE 3: BOOK-TAX CONFORMITY This section explains whether a taxpayer has to use the same methods of accounting for calculating taxes and for managing its business. Pursuant to the general rule of I.R.C. 446, taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books. The statute requires use of the same accounting methods for tax reporting and for bookkeeping (book-tax conformity), but courts and IRS administrative guidance have frequently held that tax reporting methods can differ from financial accounting methods. Courts have considered the objectives of financial and tax accounting, which are very different. A primary goal of financial accounting is to provide useful information to management, shareholders, creditors, and other interested persons. A primary goal of tax accounting is the equitable collection of revenue. Given this diversity, even contrariety, of objectives, any presumptive equivalency between tax and financial accounting would be unacceptable [Thor Power Tool Co. v. Commissioner, 439 U.S. 522 (1979)]. Differences in book and tax accounting methods have been allowed if a taxpayer s books contain records and data that allow reconciliation of the differences between a taxpayer s return and its books. In Rev. Rul , C.B. 190, the IRS held that a corporation that maintained its books on the accrual method could file income tax returns on the cash method. Book-tax conformity was not required because the taxpayer s books and records clearly showed the adjustments made to convert its books to the cash method. Accounting Methods Must Clearly Reflect Income Variations between tax reporting and financial accounting methods have been allowed only if the taxpayer s method of tax accounting clearly reflects income. All items of income and expense have to be treated the same every year. A combination of tax accounting methods is allowed if it is used consistently. 270 ISSUE 2: CHOOSING A TAX ACCOUNTING METHOD

9 Electronic Records In an examination the IRS may request a copy of the taxpayer s electronic files, including files created by accounting software and the accompanying metadata. If those records are prepared on the accrual basis, and the taxpayer uses the cash method for federal income tax purposes, the taxpayer must be able to reconcile the two methods. The taxpayer may also have to reconcile book income with tax income on Form 1120, U.S. Corporation Income Tax Return, Schedule M-1 Reconciliation of Income (Loss) per Books With Income Per Return. ISSUE 4: INVENTORIES This section describes when taxpayers are required to keep inventories, whether those taxpayers are required to use the accrual method, and how to identify and value inventory. Subject to certain exceptions under Rev. Proc , I.R.B. 272, and Rev. Proc , I.R.B. 815, if a taxpayer produces, purchases, or sells merchandise in its business, the taxpayer must keep an inventory under I.R.C. 471 and must use the accrual method for purchases and sales of merchandise under I.R.C Inventories must be maintained in a manner consistent with generally accepted accounting principles that clearly reflect income. Inventory must be identified and valued to calculate the amount that is deductible when the merchandise is sold. Rev. Proc Under Rev. Proc , I.R.B. 272, a qualifying taxpayer can use the cash method even if the taxpayer produces, purchases, or sells merchandise. Qualifying Taxpayer To qualify for the exception under Rev. Proc , a taxpayer must meet two requirements: 1. Average annual gross receipts for each prior tax year ending on or after December 17, 1998, must be $1,000,000 or less. Average annual gross receipts for a tax year are figured by adding the gross receipts for that tax year and the 2 preceding tax years and dividing by three. 2. The taxpayer cannot be a tax shelter, as defined by I.R.C. 448(d)(3). Treatment of Inventory Qualifying taxpayers that do not want to keep an inventory must treat inventoriable items (merchandise purchased for resale and raw materials purchased for use in producing finished goods) in the same manner as materials and supplies that are not incidental under Treas. Reg The I.R.C. 263A uniform capitalization rules do not apply to inventoriable items that are treated as materials and supplies that are not incidental, and under Treas. Reg such materials and supplies are deductible in the year they are consumed and used in the taxpayer s business. Materials and supplies are considered consumed and used in the year the taxpayer sells the merchandise or finished goods. Rev. Proc Similarly, under Rev. Proc , I.R.B. 815, a qualifying small business taxpayer can use the cash method of accounting even if the taxpayer produces, purchases, or sells merchandise, and is required to keep inventories. Rev. Proc

10 Qualifying Small Business Taxpayer A qualifying small business taxpayer must meet three requirements: 1. Average annual gross receipts for each prior tax year ending on or after December 31, 2000, cannot be more than $10,000,000. Average annual gross receipts for a tax year are calculated by adding the gross receipts for that tax year and the 2 preceding tax years, and dividing the total by three. If a taxpayer has not been in existence for 3 prior tax years, the taxpayer determines its average annual gross receipts for the number of years (including short tax years) that the taxpayer has been in existence. Gross receipts is defined in Temp. Treas. Reg T(f)(2)(iv). 2. The taxpayer cannot be prohibited from using the cash method under I.R.C The taxpayer s principal business activity has to be an eligible business. The ineligible NAICS codes are the following: a. NAICS code 21, mining activities b. NAICS codes 31 33, manufacturing activities c. NAICS code 42, wholesale trade d. NAICS codes 44 and 45, retail trade e. NAICS code 51, information industries If a taxpayer does not meet the principal business activity test, the taxpayer can still qualify to use Rev. Proc if the taxpayer reasonably determines that its principal business activity is the provision of services, including the provision of property incident to those services, or that its principal business activity is the fabrication or modification of certain custom-designed tangible personal property. Use of Cash Method and Treatment of Inventoriable Items Taxpayers that satisfy the qualifying small business taxpayer exception under Rev. Proc can use the cash method. The taxpayer can account for inventoriable items in the same manner as materials and supplies that are not incidental under Treas. Reg ISSUE 4: INVENTORIES Defining Inventoriable Items Under Treas. Reg taxpayers who must keep an inventory must include items such as: 1. Finished goods 2. Raw materials and supplies that have been acquired for sale or will physically become part of merchandise intended for sale 3. Goods under contract for sale that have not yet been segregated and applied to the contract 4. Goods out on consignment 5. Merchandise or stock in trade, including merchandise in transit if title has passed to the taxpayer 6. Partly finished goods (work in process) 7. Goods purchased under contract for sale 8. Goods held for sale in display rooms 9. Real estate held for sale in the ordinary course of business The following items are not accounted for in inventory: 1. Goods sold (if title passed to the purchaser) 2. Goods consigned to the taxpayer 3. Goods ordered for future delivery if the taxpayer doesn t have title yet 4. Materials and supplies that don t become part of the item for sale 5. Fixed assets such as land, buildings, and equipment used by (not sold by) a business 6. Notes and accounts receivable Identifying and Valuing Inventory Certain manufacturers and retailers are required under I.R.C. 471 to value inventory at the beginning and end of every tax year to determine the cost of goods sold during the year. Determining the value of inventory requires both a method for identifying the items in inventory and a method for valuing the items in inventory. Identification of Inventory The cost specific identification method is used if the actual cost of the inventory items can be ascertained. Taxpayers can use the first-in, firstout (FIFO) method or last-in, first-out (LIFO)

11 method if they cannot specifically identify items with their costs (if, for example, the same type of goods are mixed in inventory, and they cannot be identified with specific invoices). Under the FIFO method, the items purchased or produced first are the first items sold, consumed, or otherwise disposed of. The items in inventory at the end of the tax year are matched with the costs of similar items that were most recently purchased or produced. Under the LIFO method, items of inventory purchased or produced last are the first items sold, consumed, or otherwise disposed of. Items included in closing inventory are considered to be from the opening inventory in the order of acquisition and from those acquired during the tax year. of this method, market value is the market price of each of the costs allocable to the goods being valued. Example 8.9 Lower of Cost or Market John Elk, Inc. makes tractors and values its inventory using cost or market, whichever is lower. At the end of 2015, the $10,000 cost of one of John Elk s tractors was determined as shown in Figure 8.1. FIGURE 8.1 Cost of Tractor Direct materials $3,000 Direct labor 4,000 Indirect costs under I.R.C. 263A 3,000 Cost $10,000 Valuation of Inventory Two common methods to value inventory are established by Treas. Reg : the cost method and the lower of cost or market method. Cost Method The cost method under Treas. Reg includes all direct and indirect costs associated with the inventory item. For goods that are purchased during the year, cost means the invoice price minus any trade or other discounts. Transportation or other charges incurred in acquiring possession of the goods have to be added to the invoice price. Cost may also include certain costs that have to be capitalized under the uniform capitalization rules of I.R.C. 263A. The cost of merchandise that is produced during the year includes the following: The cost of raw materials and supplies that become part of the product or that are consumed in connection with the product Expenses for direct labor Indirect production costs that are incident to and necessary for the production of the product, such as management expenses (but not including any cost of sale) Lower of Cost or Market The lower of cost or market method under Treas. Reg compares the market value of each inventory item with its cost and uses the lower of the two as the inventory value. For purposes The aggregate of the current bid prices of the materials, labor, and overhead required to reproduce the tractor at the end of 2015 were $10,300, as shown in Figure 8.2. FIGURE 8.2 Market Value of Tractor Direct materials $3,100 Direct labor 4,100 Indirect costs under I.R.C. 263A 3,100 Market value $10,300 In determining the lower of cost or market value of the tractor, John Elk compared the cost of the tractor ($10,000) with the market value of the tractor ($10,300), and John Elk valued the tractor at $10,000 [Treas. Reg , Example 1]. Inventory and the Uniform Capitalization Rules Treas. Reg A-7 requires a taxpayer using inventories to adopt the uniform capitalization (UNICAP) rules. In the first year of adoption, the UNICAP rules are applied to revalue all inventory costs accumulated in prior years. I.R.C. 481(a) requires an adjustment equal to the difference between the original value of the inventory and the revalued inventory. Defining Inventoriable Items 273 8

12 ISSUE 5: I.R.C. 263A UNICAP RULES This section reviews the activities that are subject to the UNICAP rules, the costs that have to be capitalized under the UNICAP rules, and how those costs are allocated. The I.R.C. 263A UNICAP rules require capitalization of the direct costs and a portion of indirect costs to produce certain real property or tangible personal property, and the direct and indirect costs to acquire certain property for resale. For property that is inventory, capitalize means that the costs are included in inventory costs. For selfconstructed assets capitalize means that the cost is added to basis. A self-constructed asset is an asset produced by the taxpayer for use in the taxpayer s trade or business [Treas. Reg A-1]. The capitalized costs are added to basis or inventory (not deducted) and are recovered through depreciation, amortization, cost of goods sold, or an adjustment to basis. Activities Subject to the UNICAP Rules The UNICAP rules under I.R.C. 263A apply to real property and tangible personal property produced by a taxpayer for use in its trade or business or for sale to its customers; and to the acquisition of real or tangible personal property that is inventory or other property held primarily for sale to customers in the ordinary course of business. I.R.C. 263A applies to the cost to produce tangible property, and it does not apply to the cost to produce intangible property. But under Treas. Reg A-2, the UNICAP rules apply to certain personal property even if such property is treated as intangible property under other sections of the Internal Revenue Code. For purposes of I.R.C. 263A, tangible personal property includes any of the following: 1. Films 2. Sound recordings 3. Videotapes 4. Books 5. Artwork 6. Photographs 7. Similar property containing words, ideas, concepts, images, or sounds Tangible personal property does not include property that is representative or evidence of value, such as the following: 1. Stock and securities 2. Debt instruments 3. Mortgages or loans The UNICAP rules apply only to the direct and indirect costs to produce or acquire real or tangible property. Property is produced if it is constructed, built, installed, manufactured, developed, improved, created, raised, or grown. Property produced for the taxpayer under a contract is treated as produced by the taxpayer to the extent the taxpayer makes payments or otherwise incurs costs in connection with the property [Treas. Reg A-2]. Activities Not Subject to the UNICAP Rules There are a number of activities that are excluded from the application of the UNICAP rules. Pursuant to Treas. Reg A-1, the UNICAP rules do not apply to the following: 1. Resellers of personal property with average annual gross receipts of $10,000,000 or less for the 3 prior tax years 2. Property produced under a long-term contract, except for certain home construction contracts described in I.R.C. 460(e)(1) 3. Costs incurred in certain farming businesses (see UNICAP Rules for Farming later in this issue) 4. Costs incurred in raising, harvesting, or growing timber 5. Property used or acquired for personal purposes not connected with a trade or business or an activity conducted for profit 274 ISSUE 5: I.R.C. 263A UNICAP RULES

13 6. Intangible drilling and development costs of oil and gas or geothermal wells, or any amortization deduction allowable under I.R.C. 59(e) for intangible drilling, development, or mining exploration expenditures 7. Research and experimental expenditures deductible under I.R.C Qualified creative expenses incurred as a freelance (self-employed) writer, photographer, or artist that are otherwise deductible on a tax return (but not including expenses for printing, photographic plates, motion picture films, videotapes, or similar items) 9. Costs allocable to natural gas acquired for resale, to the extent these costs would otherwise be allocable to cushion gas stored underground 10. Property produced if substantial construction occurred before March 1, Small amounts of property provided to customers in connection with providing services 12. The costs of certain producers who use a simplified production method and whose total indirect costs are $200, Small resellers with minor production activities 14. The origination of loans (but I.R.C. 263A does include the acquisition by a taxpayer of preexisting loans from other persons for resale) Capitalize Direct Costs If the UNICAP rules apply, the taxpayer is required to capitalize all direct costs incurred to produce or acquire real or tangible personal property. For a taxpayer that produces real or tangible personal property, direct costs are the direct costs of materials and labor. Direct material costs include the cost of materials that become an integral part of specific property produced, as well as those materials that are consumed in the ordinary course of production and that can be identified or associated with particular units or groups of units of property produced. Direct labor costs include the costs of labor that can be identified or associated with particular units or groups of units of specific property produced. Direct labor costs can be incurred by full-time and part-time employees, and also by contract employees and independent contractors. Direct labor costs include basic compensation, overtime pay, vacation pay, holiday pay, sick leave pay, and payroll taxes. For a taxpayer who acquires property for resale, the direct costs are the acquisition costs of the property. In the case of inventory, the acquisition cost is the cost described in Treas. Reg (b). Capitalize Indirect Costs In general, indirect costs are all costs other than direct material costs and direct labor costs (in the case of property produced) or acquisition costs (in the case of property acquired for resale). Taxpayers subject to I.R.C. 263A must capitalize all indirect costs that are allocable to property produced or property acquired for resale. Indirect costs are allocable to property produced or property acquired for resale when the costs directly benefit or are incurred by reason of the performance of production or resale activities. Indirect costs may directly benefit or be incurred by reason of the performance of production or resale activities even if the costs are calculated as a percentage of revenue or gross profit from the sale of inventory, are determined by reference to the number of units of property sold, or are incurred only upon the sale of inventory. Indirect costs may be allocable to both production and resale activities, as well as to other activities that are not subject to I.R.C. 263A. Taxpayers must make a reasonable allocation of indirect costs between production, resale, and other activities. Figure 8.3 reports the treatment of several common indirect expenses. Indirect Service Costs Capitalizable indirect service costs are those that directly benefit or are incurred by reason of the performance of the production or resale activities of the taxpayer. A portion of these costs has to be capitalized under I.R.C. 263A. Deductible indirect service costs do not directly benefit or are not incurred by reason of the performance of the production or resale activities of the taxpayer. 8 Indirect Service Costs 275

14 FIGURE 8.3 Capitalization of Indirect Costs Description of Indirect Cost Bidding expenses for contracts awarded to the taxpayer Bidding expenses for contracts not awarded Capitalizable indirect service costs (defined earlier) Deductible indirect service costs (defined earlier) Engineering and design; and preproduction costs such as costs attributable to research, experimental, engineering, and design activities (to the extent that such amounts are not research and experimental expenditures described in I.R.C. 174) Research and experimental expenditures under I.R.C. 174 Depreciation, amortization, and cost recovery allowances on equipment and facilities Cost recovery allowances on temporarily idle equipment and facilities Depletion (only allocable to property that has been sold for purposes of determining gain or loss on the sale) I.R.C. 179 costs Employee benefit expenses such as a stock bonus, pension, profit-sharing or annuity plan, or other plan deferring receipt of compensation or providing deferred benefits; premiums on life and health insurance; safety benefits; medical treatment; recreational and dining benefits; and membership dues Pensions and other related costs, or contributions under any stock bonus, pension, profitsharing, or annuity plan, or other plan deferring the receipt of compensation, whether or not the plan qualifies under I.R.C. 401(a) Handling costs, including costs for processing, assembling, repackaging, and transporting goods Indirect labor costs that cannot be directly identified or associated with particular units or groups of units of specific property produced or property acquired for resale (for example, factory labor that is not direct labor) Indirect material costs that are not an integral part of specific property produced; the cost of materials that are consumed in the ordinary course of performing production or resale activities that cannot be identified or associated with particular units of property Cost of insurance on a plant or facility, machinery, equipment, materials, property produced, or property acquired for resale Selling and distribution costs, including marketing, selling, advertising, and distribution Licensing and franchise costs such as the fees incurred in securing the contractual right to use a trademark, corporate plan, manufacturing procedure, special recipe, or other similar right associated with property produced or property acquired for resale Interest [special rules under I.R.C. 263A(f) apply] Taxes attributable to labor, materials, supplies, equipment, land, or facilities used in production or resale activities Taxes assessed on the basis of income, such as state, local, and foreign income taxes, and franchise taxes that are assessed on the taxpayer based on income Officers compensation Purchasing costs, such as selection of merchandise, maintenance of stock, placement of purchase orders, establishment and maintenance of vendor contracts, and comparison and testing of merchandise Quality control and inspection Rent I.R.C. 165 losses Rework labor, scrap, and spoilage Costs of carrying, storing, or warehousing property off-site Capitalize? No No No No No No No No 276 ISSUE 5: I.R.C. 263A UNICAP RULES

15 FIGURE 8.3 FIGURE 8.3 Capitalization of Indirect Costs (Continued) Description of Indirect Cost Storage and warehousing costs incurred by a taxpayer at an on-site storage facility Tools and equipment not otherwise capitalized Repair and maintenance of equipment or facilities Utilities, such as electricity, gas, and water Strike expenses, including costs associated with hiring employees to replace striking personnel (but not wages of replacement personnel), costs of security, and legal fees associated with settling strikes Warranty and product liability costs Capitalize? No No No Deductible service costs do not have to be capitalized under I.R.C. 263A. Capitalizable indirect service costs under Treas. Reg A-1(e)(4) include the following: 1. The administration and coordination of production or resale activities 2. Personnel operations, including the costs of recruiting, hiring, relocating, assigning, and maintaining personnel records or employees 3. Purchasing operations, including purchasing materials and equipment, scheduling and coordinating delivery of materials and equipment to or from factories or job sites, and expediting and follow-up 4. Materials handling and warehousing and storage operation 5. Accounting services such as cost accounting and payroll (but not accounts receivable and customer billing) 6. Data processing 7. Security services 8. Legal services Deductible indirect service costs under Treas. Reg A-1(e)(4) include the following: 1. Overall management or policy setting expenses, such as the board of directors and the chief executive 2. Strategic business planning 3. General financial accounting 4. General financial planning (including general budgeting) and financial management 5. Establishing personnel policy 6. Quality control 7. Safety engineering policy 8. Insurance or risk management policies 9. General economic analysis and forecasting, and internal audits 10. Shareholder, public, and industrial relations 11. Tax services 12. Marketing, selling, or advertising Indirect service costs that are partially allocable to production or resale activities (capitalizable indirect service costs) and partially allocable to nonproduction or nonresale activities (deductible indirect service costs) are mixed service costs. Mixed service costs are allocated separately from other costs. Exception If 90% or more of a mixed service department s costs are deductible indirect service costs, a taxpayer may elect to not allocate any portion of the service department s costs to property produced or property acquired for resale. UNICAP Rules for Farming Generally, the UNICAP rules apply to property produced in a farming business, and the taxpayer is required to capitalize direct costs and a portion of indirect costs incurred in the raising or growing of plants and animals [Treas. Reg A-4]. UNICAP does not apply to a farming business if UNICAP Rules for Farming 277 8

16 1. the taxpayer is not a corporation or partnership required to use the accrual method under I.R.C. 447; 2. the taxpayer is not a tax shelter prohibited from using the cash method under I.R.C. 448; and 3. the taxpayer produces plants with a preproductive period of 2 years or less, or the taxpayer produces animals in a farming business. A farming business is defined as a trade or business involving the cultivation of land or the raising or harvesting of any agricultural or horticultural commodity. Examples include nurseries; raising or harvesting trees that bear fruit or other crops; and raising, caring for, training, and management of animals. A farming business includes processing activities that are incidental to the business, but it does not include processing. Capitalization of Animal Expenses Note that most taxpayers producing animals in a farming business qualify for this exception, and the animal production expenses do not have to be capitalized. However, a taxpayer that is a corporation or partnership required to use the accrual method must capitalize animal production expenses. Example 8.10 Processing Activities Blueberry Farms is in the business of growing fruit. Blueberry Farms harvested, washed, inspected, and packaged the fruit for sale. Blueberry Farms also processed the fruit into jam and sold the jam to customers in the course of its business. The harvesting, washing, inspecting, and packaging were incidental to the growing of the fruit, and Blueberry Farms was in the farming business with regard to these activities. Blueberry Farms was not in the farming business with regard to the processing of the fruit to produce jam. For purposes of applying the exclusion for the production of plants with a preproductive period of 2 years or less, the IRS publishes lists with the nationwide weighted average preproductive periods [IRS Notice , I.R.B. 742]. Costs That Must Be Capitalized If the UNICAP rules apply, a farming business has to capitalize the direct costs and an allocable portion of the indirect costs of production. The capitalizable costs of producing a plant are the acquisition costs of the seed or plant, and the costs of planting, cultivating, and maintaining the plant during the preproductive period. These costs include the following: 1. Management 2. Irrigation 3. Pruning 4. Fertilizing 5. Spraying and harvesting 6. Storage and handling 7. Electricity 8. Repairs on buildings and equipment used in raising the plants The capitalizable costs of producing an animal are the acquisition costs of the animal, and the costs of raising or caring for the animal during the preproductive period. Such costs include the following: 1. Management 2. Feed 3. Maintaining pasture or pen areas 4. Veterinary services 5. Hired labor 6. Tax depreciation 7. Farm overhead Preproductive Period of a Plant The actual preproductive period of a plant (for purposes of determining the period during which costs have to be capitalized) begins when the taxpayer first incurs costs that directly benefit or are incurred by reason of the plant. Generally, this occurs when the taxpayer plants the seed or plant. Depending on the plant, the actual preproductive period ends when the plant first becomes productive in marketable quantities, or when the plant is sold or otherwise disposed of [Treas. Reg A-4(b)(2)(i)(C)(2)(i)]. 278 ISSUE 5: I.R.C. 263A UNICAP RULES

17 Preproductive Period of an Animal The actual preproductive period of an animal (for purposes of determining the period during which costs must be capitalized) begins at the time of acquisition, breeding, or embryo implantation. For an animal that will be used in the trade or business of farming (for example, a dairy cow), the preproductive period generally ends when the animal is (or would be considered) placed in service for purposes of I.R.C. 168, which is the date the animal is mature and ready to be bred [C.C.A (March 2, 2007)]. However, for an animal that will have more than one yield (for example, a breeding cow), the preproductive period ends when the animal produces (for example, gives birth to) its first yield. In the case of any other animal, the preproductive period ends when the animal is sold or otherwise disposed of [Treas. Reg A-4(b)(2)(ii)]. Allocation of Preproductive Costs Because the preproductive period of a heifer s first calf begins when the heifer is bred, and the preproductive period of the heifer ends when the first calf is born, the costs incurred for the heifer during the gestation period of the first calf generally must be allocated between the first calf and the heifer. However, the taxpayer can elect to allocate all of those costs to the first calf [Treas. Reg A-4(b)(2)(ii)(C)]. Actual or Published Preproductive Period The actual preproductive period is used to determine the period for which costs of production must be capitalized. The 2-year preproductive period for determining whether the UNICAP rules apply is based on published guidance, not the actual preproductive period of the plant or animal. Electing Out FINAL COPYRIGHT 2015 LGUTEF A taxpayer that produces plants in a farming business [if the taxpayer is not a corporation, partnership, or tax shelter required to use an accrual method under I.R.C. 447, and is not prohibited from using the cash method by I.R.C. 448(a)(3)] can elect out of the application of I.R.C. 263A. The election does not apply to certain citrus or almond grove businesses. An election to not apply the rules of I.R.C. 263A must be made on the original return for the first tax year in which the taxpayer is required to capitalize I.R.C. 263A costs, or the taxpayer can file a Form 3115, Application for Change in Method of Accounting, in accordance with Treas. Reg (e)(3). Allocation of Costs After I.R.C. 263A costs have been identified, they have to be allocated. Direct costs and those portions of indirect costs and mixed service costs that are attributable to property being produced or acquired have to be allocated to the production or resale property. Allocation of cost may be simple for direct costs, which are fully attributable to specific property. But indirect costs and mixed service costs that are attributable to activities subject to I.R.C. 263A and activities not subject to I.R.C. 263A have to be allocated between those activities. Once the cost attributable to production and resale activities has been determined, that cost must be allocated between cost of goods sold (the cost of inventory sold during the year) and ending inventory. Outsourcing the Calculations Allocation of costs can require complicated calculations. Certain companies specialize in providing those calculations, and it may be more efficient to outsource the allocation calculations to one of those companies. Allocate Costs to Property The allocation methods depend on the type of cost. The taxpayer can use any reasonable method, but generally the following rules apply: 1. Direct material costs are allocated to the property produced or property acquired for resale by the taxpayer using the taxpayer s method of accounting for materials, such as 8 Allocation of Costs 279

18 the specific identification method, FIFO, or LIFO. 2. Direct labor costs are allocated to property produced or property acquired for resale using a specific identification method or standard cost method. 3. Indirect costs (which may be attributable to production and resale activities and nonproduction or nonresale activities) are allocated using either a specific identification method, a standard cost method, or a burden rate method. 4. Service costs are a type of indirect costs and can be allocated using the same allocation methods available for allocating other indirect costs. Mixed service costs can be allocated using the simplified service cost method [Treas. Reg A-1(h)], or the portion of mixed service costs that are allocable to the taxpayer s production or resale activities can be allocated pursuant to methods specified in Treas. Reg A-1. The following are examples of some of those methods: 1. The costs of security or protection services must be allocated to each physical area that receives the services, using any reasonable method applied consistently (such as the size of the physical area, the number of employees in the area, or the relative fair market value of assets located in the area). 2. The costs of legal services are generally allocable to a particular production or resale activity on the basis of the approximate number of hours of legal service performed in connection with the activity. Legal costs may also be allocated to a particular production or resale activity based on the ratio of the total direct costs incurred for the activity to the total direct costs incurred with respect to all production or resale activities. 3. The costs of a centralized payroll department or activity are generally allocated to the departments or activities benefited on the basis of the gross dollar amount of payroll processed. 4. The costs of a centralized data processing department are generally allocated to all departments or activities benefited using any reasonable basis, such as total direct data processing costs or the number of data processing hours supplied. 5. The costs of an engineering or a design department are generally directly allocable to the departments or activities benefitted based on the ratio of the approximate number of hours of work performed with respect to the particular activity to the total number of hours of engineering or design work performed for all activities. 6. The costs of a safety engineering department or activities generally benefit all of the taxpayer s activities and are allocated using a reasonable basis, such as the approximate number of safety inspections made in connection with a particular activity as a fraction of total inspections, the number of employees assigned to an activity as a fraction of total employees, or the total labor hours worked in connection with an activity as a fraction of total hours. Change in Allocation Method A change in the method or base used to allocate service costs (such as changing from an allocation base using direct labor costs to a base using direct labor hours), or a change in the taxpayer s determination of what functions or departments of the taxpayer are to be allocated, is a change in method of accounting. The taxpayer has to obtain IRS consent to the change. Allocate to Ending Inventory If the taxpayer keeps an inventory, the I.R.C. 263A costs (those direct and indirect costs of property produced or property acquired for resale) have to be further allocated between cost of goods sold and ending inventory. The simplified allocation method for production costs and the simplified resale method for resale costs compute the I.R.C. 263A amount that has to be allocated to ending inventory, and the balance is included in cost of goods sold. 280 ISSUE 5: I.R.C. 263A UNICAP RULES

19 ISSUE 6: COST OF GOODS SOLD Cost of goods sold represents the cost to produce or acquire inventory that has been sold to customers, and manufacturers and merchants calculate cost of goods sold to offset receipts from the sale of those goods. Under Treas. Reg , gross income from a manufacturing, merchandising, or mining activity is the excess of receipts over cost of goods sold. Cost of goods sold is calculated as beginning inventory, plus production and acquisition costs incurred during the year (expenses included in the cost of inventory under I.R.C. 471 and 263A), minus the closing inventory. Figure 8.4 shows Part III of Schedule C (Form 1040), Cost of Goods Sold. FIGURE 8.4 Part III of Schedule C (Form 1040), Cost of Goods Sold 8 Calculate Beginning Inventory For a merchant, beginning inventory is the cost of merchandise on hand at the beginning of the year. For a manufacturer or producer, beginning inventory is the cost of raw materials and supplies, work in process, and finished goods on hand at the beginning of the year. Add Purchases Merchants add the cost of all merchandise they bought for sale during the year. Manufacturers or producers add the cost of all raw materials or parts purchased for manufacture into a finished product. In calculating the cost of purchases, merchants and manufacturers must use the prices they actually pay, and they have to deduct all returns. They also have to deduct merchandise that is withdrawn for personal or family use. If merchants or manufacturers receive a trade discount on their purchases, the discounted price should be included in cost of goods sold. Cash discounts, such as a reduction in the purchase price for early payment of an invoice, can be deducted from total purchases, or they can be included as a separately stated income item. Add Cost of Labor For manufacturers, labor costs included in the cost of goods sold are both the direct and indirect labor used in fabricating raw materials into a Issue 6: Cost of Goods Sold 281

20 finished product. Direct labor costs are amounts paid to full- and part-time employees and independent contractors who work on the product being manufactured. Indirect labor costs are amounts paid to employees who perform a general factory function that does not have any direct connection with making the final product but that is a necessary part of the manufacturing process. Direct and indirect labor costs can include wages, overtime pay, vacation pay, holiday pay, and payroll taxes. Add Materials and Supplies Materials and supplies that are directly and indirectly used in manufacturing goods are included in cost of goods sold. Direct material costs include the cost of materials that become an integral part of specific property produced, as well as materials that are consumed in the ordinary course of production and that can be identified or associated with particular units or groups of units of property produced [Treas. Reg ]. Indirect material costs include the cost of materials that are not an integral part of specific property produced and the cost of materials that are consumed in the ordinary course of performing production or resale activities that cannot be identified or associated with particular units of property. Add Other Costs Other costs incurred in a resale, manufacturing, or mining process may be included if they are direct and necessary expenses of the resale, manufacturing, or mining operation. Such other costs that may be included in cost of goods sold are as follows: Shipping and handling Overhead expenses such as repairs, utilities, rent, insurance, depreciation, and taxes Maintenance, quality control, and inspections Other costs that are not included in cost of goods sold are marketing expenses, advertising expenses, and selling expenses. Subtract Inventory at End of Year Subtract the value of inventory on hand at the end of the year (including the portion of the cost of raw materials and supplies, labor, and overhead expenses that have been allocated to ending inventory). No Limit on Cost of Goods Sold Cost of goods sold is an adjustment, not a deduction, and therefore it is not subject to the limitations on deductions found in I.R.C ISSUE 7: INSTALLMENT SALE METHOD This section explains when the installment method can be used, how income is calculated under the installment sale method, and special rules for dispositions to related parties and dispositions of depreciable property. I.R.C. 453 provides a special reporting method for installment sales. An installment sale is a disposition of property in which at least one payment is to be received after the close of the tax year in which the disposition occurs. The installment sale method defers recognition of gain to the tax year when payment is received. The term installment sale does not include a disposition of personal property that is required to be included in the inventory of the taxpayer if it is on hand at the close of the tax year. The installment sale method also cannot be used for the sale of marketable securities. Dealer Dispositions The installment sale method cannot be used for dealer dispositions. The term dealer disposition means any of the following dispositions: 282 ISSUE 6: COST OF GOODS SOLD

21 Any disposition of personal property by a person who regularly sells or otherwise disposes of personal property of the same type on the installment plan Any disposition of real property that is held by the taxpayer for sale to customers in the ordinary course of the taxpayer s trade or business The term dealer disposition does not include a disposition on the installment plan of any property used or produced in the trade or business of farming. Special Rule for Time-Shares and Residential Lots A dealer disposition does not include the sale of a time-share in residential real property if the timeshare is not more than 6 weeks per year. Also, a dealer disposition does not include the sale of a residential lot, but only if the taxpayer (or any related person) will not make any improvements to the lot. Sales of Inventory The installment sale method cannot be used for sales of inventory. So, when selling a business, the taxpayer should make sure that the sale agreement separately allocates a value to inventory. If the taxpayer does not allocate a value to inventory, the IRS can allocate a portion of the sale price to inventory and disallow the installment sale method for that portion of the sale price allocated to inventory. Use IRS Form 8594, Asset Acquisition Statement, to allocate a portion of the sale price to inventory. Example 8.11 Calculation of Installment Sale Income In 2015 Linda Hand, a calendar-year taxpayer, sold real property for $100,000. The buyer made a $10,000 payment at the time of the sale, and the balance of the purchase price is payable in equal annual installments over the next 9 years, together with adequate interest. Linda s basis in the property, exclusive of selling expenses, was $38,000. Linda s selling expenses were $2,000. Therefore, the gross profit is $60,000 ($100,000 sales price $38,000 basis $2,000 selling expenses). The gross profit ratio is 0.60 (gross profit of $60,000 $100,000 contract price). Accordingly, $6,000 (0.60 $10,000) of each $10,000 payment received is gain attributable to the sale, and $4,000 ($10,000 $6,000) is a recovery of basis. The interest that Linda receives is ordinary income [Temp. Treas. Reg. 15a.453-1, Example 1]. Electing Out The installment sale method automatically applies unless the taxpayer elects out of the installment method. If the taxpayer elects out of the installment method, all gain on the disposition is taxed in the year of sale, even for cash method taxpayers. The election is made by reporting the entire amount of gain in the year of sale. The election must be made on or before the due date (including extensions) for filing the taxpayer s tax return for the tax year in which the disposition occurs. Disposition to Related Persons 8 Calculation of Income under the Installment Method Under the installment method, income is recognized as amounts are paid. Income recognized in a tax year is a proportionate share of income realized or to be realized on the total contract price. Special rules apply to a disposition on the installment method if the disposition is made to a related person. Second Disposition If a person disposes of property to a related person (the first disposition), and before the person making the first disposition receives all payments owed on the first disposition, the related person disposes of the property (the second disposition), then the amount realized on the second disposition is treated as received at the time of the Disposition to Related Persons 283

22 second disposition by the person making the first disposition. The rule doesn t apply if the second disposition is more than 2 years after the date of the first disposition. Exceptions apply to transfers of stock to the issuing corporation, compulsory or involuntary conversions, and transfers on death. Related persons are defined as persons who have constructive ownership of stock under I.R.C. 318(a) [except I.R.C. 318(a)(4)], including a spouse, children, grandchildren, parents, and certain partnerships, estates, trusts, and corporations. A related person is also a person who meets any of the family or entity relationships defined in I.R.C. 267(b). Related Person Dispositions See pages in the 2014 National Income Tax Workbook for a more detailed discussion of installment dispositions to related parties. Sale of Depreciable Property If a taxpayer sells depreciable property to related persons, the installment method does not apply. Instead, all payments to be received are considered received in the year of sale. Depreciable property is any property that the purchaser can depreciate. There is an exception for a sale of depreciable property to a related person if no significant tax deferral benefit is derived from the sale. To qualify for the exception, the taxpayer must show that avoidance of federal income tax was not one of the principal purposes of the sale. For purposes of this rule, a related person is defined by I.R.C. 1239(b), except that it also includes two or more partnerships having a relationship to each other described in I.R.C. 707(b) (1)(B). Related persons include the following: 1. A person and all controlled entities [as defined by I.R.C. 1239(c)] with respect to that person 2. A taxpayer and any trust in which such taxpayer (or his or her spouse) is a beneficiary, unless that beneficiary s interest in the trust is a remote contingent interest 3. Except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of that estate 284 ISSUE 7: INSTALLMENT SALE METHOD 4. Two or more partnerships in which the same person owns, directly or indirectly, more than 50% of the capital interests or the profits interests Individuals Are Not Related Parties The I.R.C. 1239(c) definition of related parties does not include individuals. Therefore, family members are not related parties for purposes of the rule that prohibits installment reporting for the sale of depreciable assets. For example, parents can use the installment method to report gain from the sale of depreciable livestock to their children. Recapture Income Recapture income has to be fully recognized in the year of the disposition, and gain in excess of the recapture income can be taken into account under the installment method. For purposes of the installment sale rules, recapture income means the total amount that would be treated as ordinary income under I.R.C. 1245, 1250, or 751. Recapture income must be recognized in the tax year of the disposition, as if all payments to be received were received in the tax year of disposition. Other Recapture Income Not Included Recapture income for purposes of the installment sale rules does not include the recapture of income under I.R.C (soil and water conservation expenses), 1254 (oil, gas, geothermal, or other mineral properties), or 1255 (cost-sharing payments).

23 ISSUE 8: ACCOUNTING FOR SOIL AND WATER CONSERVATION EXPENSES I.R.C. 175 allows a deduction for soil and water conservation expenses. I.R.C. 175 provides farmers a deduction for soil or water conservation expenditures that do not give rise to a deduction for depreciation, and that are not otherwise deductible. The amount of the deduction is limited to 25% of the taxpayer s gross annual income from farming. Gross income from farming under Treas. Reg means the gross income of the taxpayer, derived in the business of farming. The business of farming, as defined in Treas. Reg , includes the following: The production of crops, fruits, or other agricultural products, including fish The production of livestock, including livestock held for draft, breeding, or dairy purposes Income from land used in farming other than the land on which expenditures are made for soil or water conservation or for the prevention of erosion Farming does not include gains from sales of assets such as farm machinery, or gains from the disposition of land. The taxpayer has to compute gross income from farming using the same method of accounting that the taxpayer uses to determine gross income. Expenditures that exceed 25% of gross income from farming can be carried over into the next tax year. There is no time limit on carryovers. To calculate the deductible amount of conservation expenditures for any tax year, the actual expenditures of the year are added to any conservation expenditures carried over from prior years, before applying the 25% limitation. Example 8.12 Carryover of Deductible Soil and Water Conservation Expenses Red Durham paid $90,000 of soil and water conservation expenses in 2013, $110,000 in 2014, and none in He had $320,000 of gross income from farming in 2013, $360,000 in 2014, and $400,000 in Figure 8.5 shows his deductible soil and water conservation expenses and the carryover expenses for 2013, 2014, and FIGURE 8.5 Red Durham s Soil and Water Conservation Expenses Tax Year Conservation Expenses Paid during the Year Carryover from Prior Year Total Current and Carryover Expenses Deductible Amount (25% of Gross Income from Farming) Carryover to Future Years 2013 $ 90,000 None $ 90,000 $ 80,000 1 $10, $110,000 $ 10,000 $120,000 $ 90, , None $ 30,000 $ 30,000 $100,000 3 None 1. $320,000 25% 2. $360,000 25% 3. $400,000 25% 8 The deduction for 2013 was limited to $80,000, which was 25% of the gross income from farming. The remaining $10,000 ($90,000 $80,000) was not deductible for 2013 and was carried over to For 2014 the total of the expenditures to be taken into account was $120,000 (the $10,000 carryover and the $110,000 conservation expenses paid in 2014). The deduction for 2014 was limited to $90,000, and the remainder of the $120,000 total ($30,000) was a carryover to There were no conservation expenses in 2015, so the deduction for 2015 came solely from the carryover of $30,000 from Because the actual and carried-over expenses for 2015 were less than 25% of gross income from farming, there was no carryover into 2016 [Treas. Reg ]. Issue 8: Accounting for Soil and Water Conservation Expenses 285

24 The election to deduct soil and water conservation expenses is made by claiming a deduction in the first year that the conservation expenses are paid or incurred. If the taxpayer does not claim the expenses as a deduction in the first year, changing from capitalization of the expenses to deduction of the expenses is a change in the taxpayer s method of accounting, and the taxpayer has to obtain IRS consent to the change. Similarly, a taxpayer who has elected to deduct conservation expenses will have to obtain IRS consent to change to the capitalization method. ISSUE 9: ACCOUNTING AND REPORTING RULES FOR TIPS This section explains how to distinguish between tips and service charges, and it discusses the withholding and reporting rules for tips and service charges. Direct and indirect cash tips totaling less than $20 in a calendar month are excluded from the definition of wages for FICA purposes under I.R.C. 3121(a)(12)(b). Noncash tips (tips received by an employee in a medium other than cash, such as passes, tickets, or other goods or commodities) from customers are also not wages for FICA tax purposes. Tips under $20 and noncash tips are not reported to the employer. But all direct and indirect cash tips (regardless of the amount), and all noncash tips, are included in an employee s gross income and subject to federal income taxes. Employees who receive $20 or more direct and indirect cash tips in a calendar month must report all direct and indirect cash tips for the month to their employer, and they are subject to FICA and federal income tax withholding. Direct tips that must be reported include cash tips received from customers and tips paid electronically (e.g., via credit card, debit card, gift card, or any other electronic payment method). Examples of directly tipped employees are waiters, waitresses, bartenders, and hairstylists. Indirect tips that must be reported are cash tips received from other employees through a tip-pool, tip-splitting, or other tip-sharing arrangement. Examples of indirectly tipped employees are bussers, bartenders, cooks, and salon shampooers. Tip or Service Charge Service charges paid to an employee are nontip wages. These nontip wages are subject to social security tax, Medicare tax, and federal income tax withholding. Rev. Rul , I.R.B. 1032, provides guidance on the difference between tips and service charges. Factors that indicate that the payment is a tip are the following: The payment must be made free from compulsion The customer must have the unrestricted right to determine the amount The payment should not be the subject of negotiation or dictated by employer policy The customer has the right to determine who receives the payment. Tips are discretionary (optional or extra) payments, and the amount of a tip is determined by the customer. Automatic gratuities are service charges. IRS Fact Sheet gives the following examples of service charges commonly added to a customer s check: Large dining party automatic gratuity Banquet event fee Cruise trip package fee Hotel room service charge Bottle service charge (nightclubs, restaurants) Example 8.13 Service Charge The menu at Blue Jay Restaurant specifies that an 18% charge will be added to all bills for parties of six or more customers. The Brady family s bill for food and beverages for a party of eight included an amount on the tip line equal to 18% of the price for food and beverages, and the total included this amount. Blue Jay distributed this amount to the waitresses and bussers. Under these circumstances the Bradys did not have the unrestricted right to determine the amount of the payment because it was dictated by Blue Jay 286 ISSUE 8: ACCOUNTING FOR SOIL AND WATER CONSERVATION EXPENSES

25 policy. The Bradys did not make the payment free from compulsion, so the 18% charge was not a tip; it was a service charge dictated by Blue Jay [Rev. Rul , Q1, Example A]. Example 8.14 Tip Blue Jay restaurant includes sample calculations of tip amounts beneath the signature line on its charge receipts for food and beverages provided to customers. The actual tip line is left blank. The Brady family s bill showed sample tip calculations of 15%, 18%, and 20% of the price of food and beverages. The Bradys inserted the amount calculated at 15% on the tip line and added this amount to the price of food and beverages to compute the total. Under these circumstances the Bradys were free to enter any amount on the tip line or leave it blank, and the Bradys entered the 15% amount free from compulsion. The Bradys and Blue Jay did not negotiate the amount, and Blue Jay did not dictate the amount. The Bradys determined who would get the amount. The amount the Bradys entered on the tip line is a tip [Rev. Rul , Q1, Example B]. Employer Accounting and Reporting Obligations for Tips Tips received by an employee in the course of the employee s employment are considered remuneration for that employment and are deemed to have been paid by the employer for purposes of calculating the employer s share of social security and Medicare tax owed under I.R.C. 3111(a) and (b) [I.R.C. 3121(q)]. I.R.C requires the employer to pay social security tax on the cash tips received by the employee, up to and including the contribution and benefit base, and to pay Medicare tax on all cash tips received by the employee. Employers must withhold income taxes [Treas. Reg (k)(1)] and the employee s share of FICA taxes [Treas. Reg ] on the tips that the employee reports to the employer. Employers withhold the taxes from the employees wages (other than tips), or from other funds made available by the employee for withholding purposes [I.R.C. 3102(c)]. Employer Liability on Unreported Tips Employers are not liable to withhold and pay the employee s share of FICA taxes on unreported tips. The employer is not required to pay the employer s share of FICA taxes on the unreported amount until the employer receives notice and demand from the IRS [Rev. Rul , Q7]. If the employee s nontip wages and other funds made available to the employer for purposes of withholding are insufficient to pay the income tax attributable to the reported tips and the employee s share of FICA taxes on the reported tips, the employer is required to withhold taxes in the following order: 1. Social security and Medicare taxes on the employee s wages 2. Federal income taxes on the employee s wages 3. State and local taxes imposed on the employee s wages 4. Social security and Medicare taxes on the employee s reported tips 5. Federal income taxes on the employee s reported tips The employer reports tips on Form 941, Employer s QUARTERLY Federal Tax Return, for the calendar quarter in which the tips are received. Tips are deemed received at the time when the written report of tips is furnished to the employer. If tips are not reported to the employer, or the report of tips is inaccurate or incomplete, tips are deemed paid by the employer on the date that notice and demand for taxes is made to the employer by the IRS [I.R.C. 3121(q)]. There is no specific form or procedure prescribed for a section 3121(q) notice and demand. The IRS makes notice and demand when it advises the employer, in writing, of the amount of tips received by an employee who failed to report tips or underreported tips to the employer. Although no specific form is required, a document constitutes a section 3121(q) notice and demand if it 1. includes the words notice and demand and section 3121(q), 8 Employer Accounting and Reporting Obligations for Tips 287

26 2. states the amount of tips received by the employee, 3. states the period to which the tips relate, and 4. does not state that it is not a notice and demand. [Rev. Rul , Q9] Reported tips are included in box 5 (Medicare wages and tips). Reported tips are included in box 7 (social security tips). Uncollected social security tax and Medicare tax is included in box 12. Prenotice The IRS must send the employer a prenotice Letter 3264 at least 30 days prior to issuing the section 3121(q) notice and demand. The prenotice is intended to notify the employer of the I.R.C. 3121(q) FICA tax liability, and to allow the employer adequate time to gather the necessary funds and make a timely tax deposit [I.R.M (December 18, 2012)]. The employer has to report the I.R.C. 3121(q) FICA tax liability as a current period liability for FICA taxes on line 5f of the employer s Form 941 for the calendar quarter in which the IRS makes the notice and demand. The employer must also include the amount of the I.R.C. 3121(q) FICA tax liability on Part 2 of Form 941 for a monthly depositor, or Schedule B of Form 941 for a semiweekly depositor [Rev. Rul , Q10]. The employer s share of FICA taxes on the unreported tips has to be deposited within the time period required by the employer s regular deposit schedule. Example 8.15 Deposit of Taxes on Unreported Tips On January 10, Speedy Staffing, LLC received a section 3121(q) notice and demand stating that a Speedy employee failed to report $100 of tips. Speedy was subject to a monthly deposit schedule. Speedy had to deposit the employer s share of FICA taxes attributable to the $100 on or before February 15 and had to include the liability on its first-quarter Form 941. Tips reported to the employer must be included in the employee s Form W-2 as follows: Tips reported to the employer by the employee are included in box 1 (wages, tips, other compensation). Employee Accounting and Reporting Obligations for Tips The employee must report tips in a written statement furnished to the employer on or before the tenth day of the month following the month in which the tips were received [I.R.C. 6053(a)]. The statement must contain the employee s name, address, social security number, the employer s name and address, the date the statement is given, the period covered by the statement, and the amount of tips received [Treas. Reg (b)]. If the employer does not have a specified form, the employee can use Form 4070, Employee s Report of Tips to Employer. Under I.R.C. 3121(q), for purposes of the employee s share of FICA taxes imposed by I.R.C (a) and (b), tips that are properly reported to the employer pursuant to I.R.C. 6053(a) are deemed to be paid at the time the written statement is furnished to the employer. Unreported tips received by the employee are deemed to be paid to the employee when actually received by the employee. If an employee fails to report tips to his or her employer, the employee is liable for the employee s share of FICA taxes on the unreported tips. The employee pays the employee s share of FICA taxes by completing Form 4137, Social Security and Medicare Tax on Unreported Tip Income, and filing it with Form 1040 reporting tips as wages for the year in which the tips are actually received by the employee [Rev. Rul , Q6]. I.R.C. 6652(b) imposes a penalty for failure to report tips to the employer. The penalty is up to 50% of the employee s share of FICA taxes on the unreported tips. Independent Contractors Independent contractors, such as hair salon booth renters, report their tips as gross income. 288 ISSUE 9: ACCOUNTING AND REPORTING RULES FOR TIPS

27 Reporting Service Charges Generally, employers report service charges as nontip wages paid to the employee. Some employers keep a portion of the service charges. Only the amounts distributed to employees are nontip wages. The employer must withhold taxes on the service charges that are distributed to employees and treat the service charge the same as regular wages for tax-filing requirements. Large Food and Beverage Establishments Special withholding and reporting rules apply to employers who operate large food and beverage establishments (more than 10 employees). These employers must allocate tips among their tipped employees who report tips that are less than a specified percentage of sales. ISSUE 10: CHANGING A TAX ACCOUNTING METHOD This section examines what changes constitute a change in accounting method, what approval is necessary to change a method of accounting, and what adjustments that may be required by a change in method of accounting. Taxpayers choose a method of tax accounting when they first file a return. Subsequent changes in method of accounting typically require IRS approval [I.R.C. 446(e)]. Although a taxpayer generally cannot retroactively adopt a new method of accounting by filing an amended return, if the taxpayer s first return used an improper method, Rev. Rul , C.B. 104, allows the taxpayer to change to a proper method prior to filing the next year s return. What Constitutes a Change in Tax Accounting Method? Under Treas. Reg , a change in a tax accounting method is a change in the overall plan of accounting. Examples of the overall plan of accounting are the cash method and the accrual method. A change in a tax accounting method is also a change in treatment of a material item, such as the change in treatment of a soil and water conservation expense. An item is material if it affects the time to include income or the time to take a deduction. Changes in methods of tax accounting include the following: 1. A change from the cash method to the accrual method, or vice versa 2. A change involving the method or basis used to value or identify inventories 3. A change from the cash or accrual method to a long-term contract method, or vice versa 4. Certain changes in computing depreciation or amortization 5. A change involving the adoption, use, or discontinuance of any other specialized method of computing taxable income Example 8.16 Change in Treatment of a Material Item In 2013 Ace Dry Goods, Inc. reported income and expenses using the accrual method of accounting but reported real estate taxes using the cash method. In 2014 Ace changed the treatment of real estate taxes from the cash method to the accrual method. The change was a change in method of accounting because it was a change in the treatment of a material item in Ace s overall accounting practice [Treas. Reg (e)(5)(iii), Example 2]. The following are not changes in methods of tax accounting: 1. Correcting mathematical or posting errors 2. Correcting errors in the computation of tax liability 3. Adjusting any item of income or deduction that does not involve the proper time for the inclusion of the item of income or the taking of a deduction 8 What Constitutes a Change in Tax Accounting Method? 289

28 4. Adjusting the addition to a reserve for bad debts 5. Changing a treatment resulting from a change in underlying facts 6. Making certain changes involving depreciable or amortizable assets Example 8.17 Change in Underlying Facts In 2013 Ace Dry Goods, Inc. reported income and expenses using the accrual method. Ace deducted vacation pay in the year it was paid because Ace did not have a completely vested vacation pay plan, and the liability for payment did not accrue until the year that amounts were paid. Subsequently, Ace adopted a completely vested vacation pay plan that changed its year for accruing the deduction from the year in which payment is made to the year in which the liability to make the payment arises. The change in the year of deduction of the vacation pay was not a change in method of accounting because it resulted from a change in the underlying facts (the type of vacation pay plan changed) [Treas. Reg (e)(5)(iii), Example 3]. Automatic Consent or Advance Consent There are two procedures to obtain IRS approval of a change in method of accounting. There is an automatic consent procedure under Rev. Proc , C.B. 327, and an advance consent procedure under Rev. Proc , C.B These two procedures have been consolidated and updated in Rev. Proc , I.R.B Both procedures require filing IRS Form 3115, Application for Change in Accounting Method. With automatic consent there is no filing fee and no IRS review of the Form 3115 before consent is granted. With advance (nonautomatic) consent there is a filing fee. The IRS reviews Form 3115 and issues a consent letter. The advance consent procedure applies to all changes except those changes that have to be made under the automatic consent procedures. The Appendix of Rev. Proc , which has been updated in Rev. Proc , lists the changes that can be made using the automatic consent procedure. Some of the changes that 290 ISSUE 10: CHANGING A TAX ACCOUNTING METHOD have to be made using the automatic consent procedure include the following: 1. Electing to use the small taxpayer exception from the requirement to account for inventories under I.R.C Changing from the cash method to an accrual method 3. Changing the timing of incurring liabilities for employee compensation 4. Changing from one permissible method of identifying and valuing inventories to another permissible method of identifying and valuing inventories, such as a change from the cost method to the lower of cost or market method Rev. Proc The IRS issued Rev. Proc , I.R.B. 694, to simplify accounting method changes that arise from final regulations under I.R.C. 162, 168, and 263(a). In an effort to help small businesses to start applying these final tangible property regulations, Rev. Proc permits small business taxpayers to make certain changes in methods of accounting using the cutoff method, and without filing Form Unless it is extended, the waiver of the requirement to file Form 3115 applies only to the first tax year beginning on or after January 1, Repair Regulations See the Repair Regulations chapter in this book for more information on the repair regulations. Small Business Taxpayer Rev. Proc applies only to a small business taxpayer. A small business taxpayer is defined as a business with either 1. total assets of less than $10,000,000 as of the first day of the tax year in which a change in method of accounting under the final tangible property regulations is effective; or 2. average annual gross receipts of $10,000,000 or less for the prior 3 tax years, as determined under Treas. Reg (a)-3(h)(3) (substituting separate and distinct trade or business for taxpayer ).

29 Permitted Changes Rev. Proc allows the following changes in method of tax accounting: 1. Changes in methods of identifying which assets in multiple asset accounts, or which portion of assets, have been disposed of by the taxpayer, from the FIFO method of accounting to the specific identification method, to the modified FIFO method, or to a mortality dispersion table 2. Changes in the method of accounting for disposing of a building or a structural component to which the partial disposition rule in Treas. Reg (i)-8(d)(1) applies 3. Dispositions of tangible depreciable assets (other than a building or its structural components) 4. Changes in the method of accounting for disposing of I.R.C property or a depreciable land improvement 5. Changes under the final tangible property regulations: a. Change to deducting amounts paid or incurred to acquire or produce nonincidental materials and supplies in the tax year in which they are first used in the taxpayer s operations or consumed in the taxpayer s operations in accordance with Treas. Reg (a)(1) and (c)(1) b. Change to deducting amounts to acquire or produce incidental materials and supplies in the tax year in which paid or incurred in accordance with Treas. Reg (a)(2) and (c)(1) c. Change to deducting amounts paid or incurred for repairs and maintenance in accordance with Treas. Reg , including a change in identifying the unit of property under Treas. Reg (a)- 3(e) or, in the case of a building, identifying the building structure or building systems under Treas. Reg (a)- 3(e)(2) for purposes of making the change to deducting the amounts paid d. Change to capitalizing amounts paid or incurred for improvements to tangible property in accordance with Treas. Reg (a)-3, and to depreciating such property under I.R.C. 167 or 168, including a change in identifying the unit of property under Treas. Reg (a)- 3(e) or, in the case of a building, identifying the building structure or building systems under Treas. Reg (a)- 3(e)(2) for purposes of making the change to capitalizing the amounts paid e. Change to capitalizing amounts paid or incurred to acquire or produce property in accordance with Treas. Reg (a)- 2, and if depreciable, to depreciating such property under I.R.C. 167 or 168 Other Changes Require Consent Rev. Proc applies only to these specified changes. Concurrent automatic changes, other than those specifically addressed in the revenue procedure, are not allowed without completing a Form Filing and Adjustments Small business taxpayers that make changes in their methods of accounting pursuant to Rev. Proc do not have to file Form A small business taxpayer that previously filed its federal tax return for its first tax year beginning on or after January 1, 2014, is allowed to withdraw the filed Form 3115 by filing an amended return. The amended return must be filed on or before the due date of the taxpayer s timely filed (including any extension) original federal income tax return for the requested year of the change. Under Rev. Proc , small business taxpayers that change their method of accounting can use the cutoff method. The cutoff method allows a business to make an adjustment under I.R.C. 481(a) that takes into account only amounts paid or incurred, and dispositions, in tax years beginning on or after January 1, Automatic Consent or Advance Consent 291

30 Audit Protection Most changes in methods of accounting made by filing Form 3115 are granted with audit protection. The taxpayer is not required to change an improper method of accounting for the same item in a prior year. Audit protection for prior years is not provided for changes in accounting methods using the cutoff method under Rev. Proc Therefore, some taxpayers may still want to file Form 3115 to make a change in a method of accounting, and receive audit protection for prior years. Section 481(a) Adjustments A change in accounting method may result in the omission or duplication of income or deductions. I.R.C. 481 requires adjustments to prevent such errors. These adjustments must be made when taxpayers change their overall tax accounting method or change their treatment of a material item. Under I.R.C. 481, omitted deductions and duplicated income require a negative adjustment, and omitted income and duplicated deductions require a positive adjustment. If specifically allowed by statute, regulation, or IRS guidance, a taxpayer can use the cutoff method instead of making adjustments under I.R.C Any items arising before the year of change are accounted for under the taxpayer s former method of accounting. Example 8.18 Cutoff Method Royal Flush Plumbing, LLC, a cash method taxpayer, changed its method of accounting from the cash to the accrual method. At the time of the change, Royal Flush had an outstanding $500 account receivable. After the change the $500 would be omitted from income because it hadn t been realized under the old method at the time of change, and it would not be realized in the future under the new method. Royal Flush had to make a section 481(a) positive adjustment and add $500 to prevent the omission of income. If the change in accounting method was done on a cutoff basis, Royal Flush would have accounted for the receivable under the former method (the cash method), and Royal Flush would have included the receivable in income when it was actually or constructively received. The $500 would have been included when it was paid, even though Royal Flush had changed to the accrual method. No income was omitted, and no adjustment was necessary. ISSUE 11: CORRECTING DEPRECIATION ERRORS This section describes the two methods to correct depreciation errors and when they can be used. Taxpayers must depreciate assets using the depreciation rules in effect at the time they place the assets in service. Failure to claim the depreciation deduction is considered an impermissible method of determining depreciation. The basis of the asset is reduced by the amount that should have been deducted, which results in more gain or less loss upon disposition of the asset and potentially more depreciation recapture. Generally, a taxpayer adopts a method of accounting for depreciation by using a permissible method of determining depreciation on the first tax return, or by using the same impermissible method of determining depreciation on two or more consecutively filed tax returns. There are two ways to correct unclaimed depreciation: amend the return or file Form 3115, Application for Change in Accounting Method. Amended Return A taxpayer who incorrectly calculated depreciation for only 1 tax year, or failed to claim depreciation for only 1 tax year, must complete an amended return to correct the error. The correction accounts for the unclaimed depreciation and adopts a permissible accounting method. To 292 ISSUE 10: CHANGING A TAX ACCOUNTING METHOD

31 receive a credit or refund, amended returns must be filed by the later of 3 years from the date that the original return was filed or 2 years from the time the tax was paid. Filing Date A return filed before the unextended due date is considered filed on the due date for the return. Example 8.19 Amending Depreciation Error Jim Brown owns a landscaping business. When getting ready to prepare his 2015 tax return, Jim realized that he had made two mistakes on his 2014 return. Jim purchased a computer on June 1, 2014, for $2,000. He inadvertently listed it as office furniture, resulting in a $114 missed depreciation deduction. He also forgot to list a mower he purchased for $25,000 on June 1, 2014, resulting in a $5,000 missed depreciation deduction. Because this error occurred for only 1 year, and it is still an open year, Jim s accountant can file an amended return for 2014 to take the additional $5,114 in depreciation deductions. Closed Tax Year If depreciation deductions were missed in a closed tax year, the return cannot be amended, but the taxpayer can file Form 3115 and claim the section 481(a) adjustment to get the benefit of the missed depreciation deductions. 2. Changing the treatment of an asset from nondepreciable to depreciable, or vice versa 3. Changing the depreciation method, period of recovery, or convention 4. Claiming special depreciation in the first year if it was not claimed originally, and vice versa 5. Changing the special depreciation allowance from 50% to 30%, and vice versa Other changes do not constitute a change in accounting method, and can be made by filing an amended return: 1. Changing the useful life of a depreciable asset for which depreciation is determined under I.R.C. 167 (prior to ACRS) 2. Changing the use of an asset in the hands of the same taxpayer 3. Making a late depreciation or amortization election, or revoking a timely made depreciation or amortization election (a letter ruling is usually required) 4. Changing the placed-in-service date of a depreciable asset The change from an impermissible method of accounting to a permissible method of accounting qualifies for an automatic change request and is made in Part I of Form Usually, if a taxpayer or related entity is under examination, he or she is not eligible to use the automatic change request. However, if the taxpayer qualifies for an exception, he or she must notify the examiner of the change and provide a copy of Form Additionally, if the business that is involved in the change ceases to exist in the tax year of the change, it is not eligible for the automatic change request. The asset or assets involved in the change must be owned by the business and in use when the change is made. 8 Change in Method of Accounting The following changes are considered a change of accounting method [Treas. Reg (e)(2)(ii)(d)(2)]: 1. Changing from an impermissible method of computing depreciation, if the impermissible method was used for 2 or more tax years Section 481(a) Adjustment A negative adjustment (an adjustment that reduces income) can take into account the difference between the improper method and the proper method of accounting as far back as necessary, and the total adjustment is allowed as a deduction in the year the change is filed. The adjustment can cause a loss, and it can increase any suspended losses. If it is a positive adjustment Section 481(a) Adjustment 293

32 (an adjustment that increases income) that is less than $50,000, the taxpayer can choose to make the entire adjustment in the current year. Otherwise, a positive adjustment is taken over 4 years. Change in De Minimis Amount Rev. Proc increased the I.R.C. 481(a) de minimis amount from $25,000 to $50,000. The adjustment is entered in Section IV of Form 3115, and the appropriate box is checked if it is under $50,000. The adjustment for the current and future years is also reported on the appropriate line of the taxpayer s current and future income tax returns. Form 3115 FINAL COPYRIGHT 2015 LGUTEF Form 3115 must be filed in duplicate. The original is filed with the taxpayer s tax return in the year of the change, and a copy must be filed with the IRS prior to filing the tax return. The IRS does not send a notice of acceptance of an automatic change request. Generally, a separate Form 3115 must be filed for each accounting method change. However, if there are multiple changes under the same method entered on line 1 of the form, then the taxpayer can file one Form 3115 for all of the changes. Example 8.20 Rental Property On January 1, 2006, Luis Garcia purchased a rental property for $500,000. He allocated $100,000 of the purchase price to the land and $400,000 to the building. Luis is a sole proprietor. He did his own taxes and did not depreciate the property. In 2015 Luis hired an accountant to prepare his taxes. Luis and his accountant filed Form 3115 to correct this error. They calculated $130,303 of missed depreciation, which is claimed as a section 481(a) adjustment, and $14,545 of depreciation for Luis is not currently under examination. Figure 8.6 shows the portions of Form 3115 that contain entries for Luis. Luis reports the $130,303 section 481(a) adjustment on line 19 of his 2015 Schedule E (Form 1040), Supplemental Income and Loss. He reports the $14,545 current-year depreciation for the building on line 18 of his Schedule E (Form 1040). The following notes explain the entries on Luis s Form 3115 that are not self-explanatory and describe the portions of the eight-page Form 3115 that are not included in this example because they do not apply to Luis. 1. Part I, Information for Automatic Change Request a. Line 1a: Luis enters 7, the change number for unclaimed depreciation (the change numbers are listed in the instructions for Form 3115). b. Line 2: Luis does not have a tax return under examination, so he checks No. 2. Part II, Information for All Requests: Luis answered all of the applicable questions. 3. Part III, Information for Non-Automatic Change Request, does not apply to Luis. 4. Part IV, Section 481(a) Adjustment: Luis entered his $130,303 negative adjustment on line The following schedules are not shown in this example because they do not apply to Luis: a. Schedule A Change in Overall Method of Accounting b. Schedule B Change to the Deferral Method for Advance Payments c. Schedule C Changes Within the LIFO Inventory Method d. Schedule D Changes in the Treatment of Long-Term Contracts Under Section 460, or Other Section 263A Assets 6. Schedule E Change in Depreciation or Amortization: Luis attached the statement shown in Figure 8.7, which provides answers to questions 4 7. Figure 8.7 is the statement that must be provided pursuant to Part II, lines 14, 15, 16; Part IV line 26; and Schedule E lines ISSUE 11: CORRECTING DEPRECIATION ERRORS

33 FIGURE 8.6 Form 3115 for Luis Garcia 8 Form

34 FIGURE 8.6 Form 3115 for Luis Garcia (Continued) 296 ISSUE 11: CORRECTING DEPRECIATION ERRORS

35 FIGURE 8.6 Form 3115 for Luis Garcia (Continued) 8 Form

36 FIGURE 8.6 Form 3115 for Luis Garcia (Continued) 298 ISSUE 11: CORRECTING DEPRECIATION ERRORS