Uniform Capitalization Method

DID YOU GET YOUR BADGE SCANNED? Uniform Capitalization Method #TaxLaw #FBA Username: taxlaw Password: taxlaw18

Uniform Capitalization Method The Grey Areas IRC section 263A, requiring the use of the uniform capitalization ( UNICAP ) method to value inventory for tax purposes, was enacted over 30 years ago. Accordingly, it is surprising that there are so many open issues that exist for which official IRS guidance is lacking. Moreover, in many of those areas where official guidance is lacking, there is often a lack of consensus among tax practitioners about how to handle certain of these issues. The examples that follow explore some of the grey areas in accounting for the UNICAP method. #TaxLaw #FBA

FACTS EXAMPLE ONE Tp uses the uniform capitalization method and allocates additional section 263A costs between ending inventory and cost of goods sold pursuant to the simplified production method. One type of cost that Tp incurs is the cost of commissions paid to buyers that purchase both raw materials and finished goods for the Tp. Under Tp s section 471 costing method (i.e., the costing method employed for financial reporting purposes), Tp treats all purchasing commissions as an overhead cost and, as a result, Tp includes an allocable portion of the commissions in the standard cost of each item of finished goods. None of the purchasing commissions are included in the standard cost of raw materials. However, since the Tp includes all purchasing commissions in inventoriable costs for financial reporting purposes, the purchasing commissions are not treated as an additional section 263A cost and no portion of the purchasing commissions is included in the numerator of the absorption ratio under Tp s simplified production method.

EXAMPLE ONE (CONTD) QUESTIONS Is Tp s method of handling purchasing commissions permissible for UNICAP purposes? If not, what type of adjustments must Tp make to the inventory costing method employed for tax purposes? If some adjustment must be made to Tp s allocation methods, would it be permissible for Tp to leave its section 471 method unchanged for tax purposes and make adjustments for tax purposes only through the computation of the numerator of Tp s absorption ratio under the simplified production method? If so, what types of adjustments to its simplified production method would be acceptable for tax purposes?

EXAMPLE ONE (CONTD) LEGAL CONSIDERATIONS Treas. Reg. 1.263A-1(d)(2)(i) defines section 471 costs as follows: [A] taxpayer s section 471 costs are the costs, other than interest, capitalized under its method of accounting immediately prior to the effective date of section 263A. Treas. Reg. 1.263A-1(d)(2)(ii) provides: In the case of a new taxpayer, Section 471 costs are those acquisition or production costs, other than interest, that would have been required to be capitalized by the taxpayer if the taxpayer had been in existence immediately prior to the effective date of section 263A.

EXAMPLE ONE (CONTD) Prior to the effective date of section 263A, the full absorption regulations provided that the elements of direct production costs are based on the provisions in Treas. Reg. Sec. 1.471-3. Treas. Reg. 1.471-3(b) defines the cost of purchased materials as follows: In the case of merchandise purchased since the beginning of the taxable year, the invoice price less trade or other discounts, except strictly cash discounts approximating a fair interest rate, which may be deducted or not at the option of the taxpayer, provided a consistent course is followed. To this net invoice price should be added transportation or other necessary charges incurred in acquiring possession of the goods.

EXAMPLE ONE (CONTD) In Technical Advice Memorandum 200437035, the National Office of the Service explicitly rejected the taxpayer s allocation method because it treated the costs of storing and handling raw materials as an overhead cost that was allocated exclusively to work-in-process and finished goods inventory because the taxpayer used a burden rate based on direct labor to allocate overhead to the ending inventory and raw materials have no labor content.

FACTS EXAMPLE TWO Tp uses the uniform capitalization method and allocates additional section 263A costs between ending inventory and cost of goods sold pursuant to the simplified production method. When Tp purchases raw materials from vendors, the vendors invoices show a separate charge for out-of-pocket freight costs that vendors incur to deliver the raw materials to the Tp s manufacturing plant. Under Tp s present section 471 method, Tp includes the freight costs that it incurs in the cost of its raw materials. Moreover, no freight costs are included in additional section 263A costs or in the numerator of the absorption ratio under the Tp s simplified production method.

EXAMPLE TWO (CONTD) Starting in 2017, in an effort to reduce transportation costs, Tp purchased a fleet of trucks and hired its own drivers to pick up the raw materials at the suppliers locations and deliver the raw materials to Tp s factory. As a result of this change in operations and the absence of a direct freight charge on each invoice for raw materials purchases, Tp s SAP accounting system no longer is able to treat freight costs with respect to raw materials as a direct cost of the raw materials acquired. Instead, under its new mode of operations, Tp s SAP accounting system accumulates the compensation and benefits paid to the drivers that Tp hired and the depreciation that Tp claims on the trucks that Tp acquired in a general ledger account labelled internal freight costs. Tp proposes to treat the internal freight costs in this general ledger account as an overhead cost under Tp s section 471 method. Accordingly, through a burden rate, the internal freight costs would be allocated to finished goods, but not to raw materials.

EXAMPLE TWO (CONTD) QUESTIONS May Tp follow the same method for tax and financial reporting purposes and, therefore, make no adjustment for the internal freight costs in the taxpayer s simplified production method? If not, what method must Tp follow for tax purposes? Tp wishes to remain on its simplified production method. Is Tp required to modify its section 471 method or may Tp make adjustments to the cost of inventory through Tp s simplified production method? If so, what would be the nature of the adjustments? Would the adoption of new accounting procedures for 2017 constitute a change in method of accounting for which Tp must obtain the consent of the Commissioner?

EXAMPLE TWO (CONTD) If the change in treatment in question 3, above, constitutes a change in method of accounting, would the accounting method change under either alternative 1 or 2, above, be eligible for the automatic consent procedures Rev. Proc. 2017-30? Alternatively, would this be considered a change for purposes of recharacterizing section 471 costs as additional 263A costs (or vice-versa) for which an automatic change is not available?

EXAMPLE TWO (CONTD) LEGAL CONSIDERATIONS: Treas. Reg. 1.263A-1(d)(2)(i) defines section 471 costs as follows: [A] taxpayer s section 471 costs are the costs, other than interest, capitalized under its method of accounting immediately prior to the effective date of section 263A. Treas. Reg. 1.263A-1(d)(2)(ii) provides: In the case of a new taxpayer. Section 471 costs are those acquisition or production costs, other than interest, that would have been required to be capitalized by the taxpayer if the taxpayer had been in existence immediately prior to the effective date of section 263A. Prior to the effective date of section 263A, the full absorption regulations provided that the elements of direct production costs are based on the provisions in Treas. Reg. 1.471-3.

EXAMPLE TWO (CONTD) Treas. Reg. 1.471-3(b) defines the cost of purchased materials as follows: In the case of merchandise purchased since the beginning of the taxable year, the invoice price less trade or other discounts, except strictly cash discounts approximating a fair interest rate, which may be deducted or not at the option of the taxpayer, provided a consistent course is followed. To this net invoice price should be added transportation or other necessary charges incurred in acquiring possession of the goods. In a number of consent letters issued by the IRS to taxpayers that changed their UNICAP methods, the IRS National Office inserted the following language in those consent letters, regardless of the nature of the UNICAP change made by the taxpayer:

EXAMPLE TWO (CONTD) The acquisition and storage of raw materials to be used in the production process are considered to be production or resale activities. Further, costs incurred with respect to work-in-process and finished goods inventories are costs incurred in production or resale activities. Section IV (M) of 1988-2 C.B. 401, Notice 88-86, states that property shall be considered to be under production until the property is held for sale, and that storage costs are subject to capitalization for each year during which the raw materials, workin-process, and finished goods are physically held by the taxpayer. Further, Section 1.263A-1T(b)(2)(ii) of the Temporary Income Tax Regulations states that indirect costs, which directly benefit or are incurred by reason of the performance of a particular activity of the taxpayer, are required to be allocated to each activity of the taxpayer to which these costs are attributable. Thus, under Section 263A of the Code, the taxpayer is required to allocate purchasing, storage, and warehousing costs to raw materials (not yet used), work-in-process, and finished goods (on hand at any time during the tax year).

EXAMPLE TWO (CONTD) Treas. Reg. 1.446-1(e)(2)(ii)(b) provides that a change in method of accounting does not occur where a taxpayer changes its treatment of an item as a result of a change in facts and circumstances, although a change in the time for deducting an item is normally regarded as a change in method of accounting. Treas. Reg. 1.446-1(e)(2)(ii)(a). Section 12.02(1)(b)(iv) of Rev. Proc. 2017-30 provides that the automatic consent procedures do not apply to the reclassification of costs from section 471 to section 263A or vice-versa.

EXAMPLE THREE FACTS Tp uses the uniform capitalization method and allocates additional section 263A costs between ending inventory and cost of goods sold pursuant to the simplified production method. Assume that all of Tp s additional section 263A costs relate to finished goods produced by the Tp. Tp wishes to change from the simplified production method to a facts and circumstances allocation method for additional section 263A costs. The facts and circumstances method that Tp proposes to use would accumulate the annual amount of additional section 263A costs. The Tp proposes to allocate the aggregate annual amount of additional section 263A costs only to the items in Tp s ending inventory (a so-called Treas. Reg. 1.263A-1(f)(4) other allocation method.

EXAMPLE THREE (CONTD) QUESTIONS Does this accounting method change qualify for the automatic consent procedures in Rev. Proc. 2017-30? Under the proposed facts and circumstances allocation method, may Tp allocate the additional section 263A costs exclusively to the items in Tp s ending inventory, rather than throughout the year as goods are produced? Tp would prefer to simply add the total additional section 263A allocated to the aggregate section 471 costs of the ending inventory, without apportioning such costs to individual items of inventory. Is this approach permissible for tax purposes?

EXAMPLE THREE (CONTD) If Tp is required to allocate the aggregate amount of additional section 263A costs allocated to its ending inventory among the particular items in Tp s ending inventory, is Tp permitted to allocate the additional section 263A costs to each item in ending inventory using a burden rate based on the relative amount of section 471 costs of each item? If the answer to question 4 is negative, what allocation bases would Tp be permitted to use to allocate additional section 263A costs to each item in inventory?

EXAMPLE THREE (CONTD) LEGAL CONSIDERATIONS Section 12.02(1)(a) of Rev. Proc. 2017-30 provides that the automatic consent procedures apply to a producer of property that wishes to change its method for allocating additional section 263A costs to a method specifically described in the regulations. Section 12.02(1)(b)(2) of Rev. Proc. 2017-30 provides that an allocation method specifically described in the regulations does not include a socalled other reasonable allocation method within the meaning of Treas. Reg. 1.263A-1(f)(4). Treas. Reg. 1.263A-1(f)(4) provides that a reasonable allocation method allocates the taxpayer s additional section 263A costs among the units produced or acquired during the taxable year.

EXAMPLE THREE (CONTD) Treas. Reg. 1.263A-1(f)(4) provides that an allocation method is reasonable if the allocation method does not result in the capitalization of an amount of costs that is significantly different from one of the allocation methods specifically described in the regulations, the method is used consistently and the method is not used to circumvent the requirements in the regulations.

EXAMPLE FOUR FACTS Tp is a calendar-year taxpayer that uses the dollar-value LIFO method. For UNICAP purposes, Tp uses a facts-and-circumstances allocation method for additional section 263A costs. Tp is in the wine production business. Assume that at the beginning of 2017, the federal excise tax on wine removed from a federally-bonded warehouse is increased by $1/gallon. To equalize the excise tax on existing wine in the taxpayer s inventories, a corresponding floor stocks tax of $1/gallon is imposed on wine still inbond that was produced prior to the effective date of the excise tax rate increase.

EXAMPLE FOUR (CONTD) QUESTIONS How is Tp required to treat the excise tax rate increase on wine removed from bonded warehouses, but remaining in Tp s ending inventory at December 31, 2017? How is Tp required to treat the floor stocks tax imposed on wine that was produced prior to January 1, 2017, the effective date of the floor stocks tax? Is any part or all of the floor stocks tax allocated to the wine produced on or after January 1, 2017? If Tp is not following a proper inventory method for the floor stocks tax, would a change in method of accounting to correct such method be eligible for the automatic consent procedures in Rev. Proc. 2017-30?

EXAMPLE FOUR (CONTD) LEGAL CONSIDERATIONS Rev. Rul. 2001-8, 2001-1 C.B. 726, provides that a floor stocks tax adjustment is an adjustment to the cost of the units on which the floor stocks tax adjustment is physically imposed. However, the determination of how that adjustment affects a taxpayer s taxable income is determined based on the taxpayer s choice of inventory flow methods (i.e., FIFO, LIFO, average, or specific identification). A change to the method in Rev. Rul. 2001-8 was eligible for the automatic consent procedures in Rev. Proc. 99-49, 1999-2 C.B. 725. This method change is not described in Rev. Proc. 2017-30.

FACTS EXAMPLE FIVE Tp is a calendar-year taxpayer that uses the dollar-value LIFO method, For UNICAP purposes, Tp uses a facts-and-circumstances allocation method for additional section 263A costs. Tp is in the business of producing chemicals. Tp has two manufacturing plants located in the U.S. and one manufacturing plant located in Mexico. In coordination with each other, government agencies in both the U.S. and Mexico determine that chemical waste is leaking from one of Tp s two plants in the U.S. and from its lone plant in Mexico. The authorities require both leaking plants to to be shut down at the beginning of 2017, so that the plants can be remediated. As a result, nothing is produced during 2017 from either of the plants that are being remediated. Tp incurs $10 million of costs during 2017 to remediate the shuttered plant in the U.S. and $5 million of costs during 2017 to remediate the shuttered plant in Mexico. Assume that these remediation costs are otherwise deductible, but are treated as additional section 263A costs for 2017.

EXAMPLE FIVE (CONTD) QUESTIONS For UNICAP purposes, may Tp treat the $10 million and $5 million of remediation costs as production costs pertaining to goods produced in prior years, to the extent LIFO layers remain in the Tp s ending inventory from such prior years? Is there a different answer for U.S. costs because there is U.S. production during 2017, whereas there is no production in Mexico during 2017? If Tp must allocate all of the remediation costs incurred in 2017 both in the U.S. and Mexico to goods produced from the sole U.S. plant that is still operating in 2017, how would the IRS reconcile this position with its views in Example Four, above?

EXAMPLE FIVE (CONTD) In allocating the remediation costs included in cost of goods sold between gross income from domestic and foreign sources, would the $10 million of U.S. remediation costs be allocated to U.S. sources and the $5 million of Mexican remediation costs be allocated to foreign sources? How would the answer to Question 3, above, affect Tp s section 199 calculations for 2017? LEGAL CONSIDERATIONS Rev. Rul. 2004-18, 2004-1 C.B. 509, provides that environmental remediation costs incurred with respect to a manufacturing plant must be treated as an inventoriable cost in the taxable year that the expense would otherwise be deductible.

EXAMPLE FIVE (CONTD) Rev. Rul. 2005-42, 2005-2 C.B. 67, amplifies Rev. Rul. 2004-18, and analogies environmental remediation costs to repair costs and provides that environmental remediation costs must be allocated to costs produced in the same taxable year that the remediation costs would otherwise become deductible, irrespective of whether the remediation costs relate to the goods produced in the taxable year in which the remediation costs would otherwise be deductible. In Letter Ruling 200946037, the IRS ruled that for section 199 purposes a cost that is deductible in the current taxable year, but is treated as an inventoriable cost, may not be allocated against the gross receipts from sales of inventory that were produced and sold in a taxable year prior to the taxable year in which the cost became deductible.

FACTS EXAMPLE SIX Tp is a calendar-year taxpayer that uses the dollar-value LIFO method, For UNICAP purposes, Tp uses the simplified production method to allocate additional section 263A costs between ending inventory and cost of goods sold. Vendors of raw materials purchased by Tp sometimes offer a cash discount to Tp on its raw material purchases provided that Tp pays the invoice within 10 days of its receipt. When Tp posts purchases to its general ledger, TP is unable to associate any cash discount that may be earned with the associated raw materials to which the cash discounts relate. Accordingly, Tp carries the cost of its raw materials in its general ledger at the gross purchase price of the raw materials, without regard to whether a cash discount was offered by the vendor or was earned by Tp.

EXAMPLE SIX (CONTD) For purposes of determining the section 471 cost of its inventory (i.e., both book and tax), Tp reduces the aggregate cost of its purchases by the average percentage of cash discounts offered by vendors with respect to its purchases during the taxable year. Accordingly, Tp makes no adjustments to such section 471 costs in its section 263A calculations.

EXAMPLE SIX (CONTD) QUESTIONS For UNICAP purposes, is Tp s present method permissible? If the answer to Question One is positive, could Tp base the calculation on the amount of cash discounts earned, rather than on the amount of cash discounts offered to the Tp. If the answer to Question One is negative, at what level of detail must Tp match the cash discounts offered with particular purchases of raw materials, if the Tp wishes to use the net method of accounting for cash discounts? Is the answer to Question Two different for taxpayers using FIFO and LIFO? If the discounts involved in this situation were trade discounts, rather than cash discounts, would the answers to any of the preceding questions be different?

EXAMPLE SIX (CONTD) LEGAL CONSIDERATIONS Treas. Reg. 1.471-3(b) provides taxpayers with a choice whether to use the gross or net method of accounting for cash discounts. See also Rev. Rul. 73-65, 1973-1 C.B. 216; Warfield-Pratt-Howell Co. v. Commissioner, 13 B.T.A. 305 13 B.T.A. 305 (1928): J.M. Radford Grocery Co. v. Commissioner, 19 B.T.A. 1023 (1930), nonacq. 1931-1 C.B. 90; F. Brewer Co. v. Commissioner, 1 B.T.A. 417 (1925), acq. 1925-1 C.B. 1. In G.C.M. 35072 (Oct. 10, 1972), the IRS rejected a requirement that the cash discounts must actually be taken before year-end in order to qualify for the net method of accounting for cash discounts. At one point, a prior ISP for inventory at LMSB had drafted an ISP paper that would require discounts to be tracked to the specific purchases to which they relate in order for a taxpayer to be eligible to use the net method of accounting for either cash or trade discounts.

EXAMPLE SIX (CONTD) The preamble to the proposed UNICAP regulations relating to a new modified simplified production method indicates that the IRS is soliciting guidance from taxpayers on the treatment of cash and trade discounts for purposes of both the simplified production method and the facts-and-circumstances allocation method. See Prop. Treas. Reg. 1.263A-1 & 2 (Sep. 5, 2012).

FACTS EXAMPLE SEVEN Tp is a calendar-year taxpayer that uses the FIFO method. For UNICAP purposes, Tp uses the simplified production method to allocate additional section 263A costs between cost of goods sold and ending inventory. Tp uses a standard cost method to determine the section 471 cost of its ending inventory. If Tp experiences variances between its standard and actual costs for the year, Tp accumulates all of such variances during the taxable year. At the end of the year, for financial reporting purposes, Tp adjusts the section 471 cost of its ending inventory by the appropriate fraction of such aggregate amount of variances based on the turnover rate of the Tp s inventory. Tp determines the fraction of the annual amount of production variances that must be allocated to ending inventory by computing the number of times that its inventory turns over during the year. For example, if Tp s inventory turns over four times per year, Tp allocates ¼ of the annual amount of variances to the section 471 cost of its ending inventory. The Tp adds this amount to the section 471 cost of its ending inventory in total. The variances are not allocated to individual items in the ending inventory.

EXAMPLE SEVEN (CONTD) QUESTIONS May Tp use this same method for tax purposes? Is this answer affected by Tp s use of the simplified production method? Would the answer be different if Tp used a facts and circumstances allocation method for additional section 263A costs, keeping in mind that variances are treated as a section 471 cost, not an additional section 263A cost. If the answers to Questions One or Two are negative, what alternative approaches would be permissible for tax purposes?

EXAMPLE SEVEN (CONTD) LEGAL CONSIDERATIONS Treas. Reg. 1.263A-1(f)(3)(B) provides as a general rule that standard cost variances must be allocated in part to ending inventory. 2However, these regulations provide that if the variances are not significant in amount, such variances are deducted in the taxpayer s financial statements and are treated consistently, then the variances may be included entirely in cost of goods sold.

EXAMPLE EIGHT FACTS Tp is a calendar-year taxpayer that uses the FIFO method. For UNICAP purposes, Tp uses a facts and circumstances allocation method for additional section 263A costs. Tp uses a standard cost method to determine the section 471 cost of its ending inventory. If Tp experiences variances between its standard and actual costs for the year, Tp currently expenses all of such variances in its financial statements and in its section 471 costs for tax purposes. Currently, Tp does not treat its variances as an additional section 263A cost for UNICAP purposes or otherwise capitalize variances for tax purposes despite the fact that in most years the variances are material in amount.

EXAMPLE EIGHT (CONTD) QUESTIONS Tp wishes to change to the simplified production method and include standard cost variances in the numerator of the absorption ratio. Is this a permissible method? If so, is Tp permitted to implement this accounting method change pursuant to the automatic consent procedures in Rev. Proc. 2017-30? Is this answer affected by whether the overall amount of variances is positive or negative? Is this answer affected by whether indvidual variances are positive or negative? If, in addition to the foregoing changes, Tp also wishes to remove marketing expenses from inventory costs, would that accounting method change be eligible for the automatic consent procedures?

EXAMPLE EIGHT (CONTD) LEGAL CONSIDERATIONS Section 12.02(1)(a) of Rev. Proc. 2017-30 provides: This change applies to producers... that wants to change to a UNICAP method (or methods) specifically described in the regulations, including any necessary changes in the identification of costs subject to 263A that will be accounted for using the proposed method. In Notice 2007-29, 2007-1 C.B. 881, the IRS announced that it would temporarily permit taxpayers to account for negative additional section 263A costs pursuant to the simplified production method. In proposed regulations issued in 2012, the IRS proposed a new modified simplified production method as a way to deal with the perceived distortion resulting from the use of the regular simplified production method to remove negative additional section 363A costs from ending inventory.

EXAMPLE NINE FACTS Tp is a calendar-year taxpayer that uses the dollar-value LIFO method. For UNICAP purposes, Tp uses the simplified production method to allocate additional section 263A costs between cost of goods sold and ending inventory. Previously, Tp used a standard commercial general ledger system for preparing its financial statements. However, Tp wants to upgrade its general ledger system to an SAP system. Under the Tp s new SAP costing system, numerous changes will be made in the Tp s general ledger accounts. Certain types of costs previously treated as direct costs under Tp s financial reporting method will under SAP be treated as overhead costs. In addition, certain costs related to raw materials that were previously treated as overhead costs would instead be treated as direct costs under the SAP system.

EXAMPLE NINE (CONTD) QUESTIONS Would Tp be required to file an accounting method change request if it desired to employ the SAP system for purposes of computing its section 471 costs for tax purposes? If the answer to the first question is affirmative, would this type of accounting method change be eligible for the automatic consent procedures in Rev. Proc. 2017-30? If an accounting method change request must be filed to change to the SAP system for UNICAP purposes, how would Tp calculate the section 481(a) adjustment if Tp elects to change its method pursuant to the three-year average transition method?

EXAMPLE NINE (CONTD) LEGAL CONSIDERATIONS Treas. Reg. 1.446-1(e)(2)(ii)(b) provides that a change in method of accounting does not occur where a taxpayer changes its treatment of an item as a result of a change in facts and circumstances, although a change in the time for deducting an item is normally regarded as a change in method of accounting. Treas. Reg. 1.446-1(e)(2)(ii)(a). Section 12.02(1)(a) of Rev. Proc. 2017-30 provides that the automatic consent procedures apply to a producer of property that wishes to change its method for allocating additional section 263A costs to a method specifically described in the regulations. Section 12.02(1)(b)(iv) of Rev. Proc. 2017-30 provides that the automatic consent procedures do not apply to the reclassification of costs from section 471 to section 263A or vice-versa. Treas. Reg. 1.263A-7(c)(2)(v) describes the three-year average transition method.

EXAMPLE TEN FACTS Several states have legalized the production and sale of marijuana for recreational purposes. Tp opened up a business in the State of California during 2018 to grow marijuana plants and to produce and sell marijuana for recreational purposes. The Tp establish a rudimentary general ledger system and will prepare annual financial statements. In those financial statements, the Tp intends to expense the costs of raising the marijuana plants. However, the Tp intends to include all of the indirect production costs that it incurs in the cost of inventoriable costs. The Tp also intends to include marketing expenses in inventoriable costs.

EXAMPLE TEN (CONTD) QUESTIONS May Tp deduct any of its production costs as cost of goods sold, notwithstanding the existence of section 280E? May Tp include the costs of growing marijuana plants in cost of goods sold? May the Tp include marketing expenses in cost of goods sold? What would be the answers to these questions if Tp did not prepare formal financial statements.

EXAMPLE TEN (CONTD) LEGAL CONSIDERATIONS Section 280E denies taxpayers a deduction for expenses incurred in the distribution and sale of drugs that are illegal under federal law. However, cost of goods sold is a not a deduction and the courts have held that a taxpayer must be permitted to deduct cost of goods sold even if the costs were incurred in a transaction that is illegal. Max Sobel Wholesale Liquors v. Commissioner, 670 F.2d 630 (9th Cir. 1980); Pittsburgh Milk Co. v. Commissioner, 26 T.C. 707 (1956). In CCA 201504011, the IRS ruled that taxpayers engaged in the sale of marijuana may deduct the cost of goods sold associated with the sale of the marijuana and that the cost of goods sold is determined under the costing rules in effect prior to the enactment of 263A.

EXAMPLE TEN (CONTD) Treas. Reg. 1.471-11 contains the rules for determining the cost of inventory prior to the enactment of 263A. CCA 201504011 suggests that taxpayers engaged in farming marijuana plants for the production of marijuana products and that deduct the cost of raising marijuana plants under the cash method of accounting may nevertheless treat the cost of the marijuana plants as cost of goods sold without necessarily changing to the accrual method for the cultivation costs. However, the IRS is reportedly working on a new CCA to clarify its position on this issue.