Inventory trends: the "Wal-Mart" effect.
Two tax inventory methods, LIFO and uniform capitalization (UNICAP), provide opportunities to decrease the tax carrying cost of inventory and to improve cashflow in the face of these inventory trends.
In general, LIFO inventory is calculated by comparing current-year costs to base-year costs to determine an inflation factor (index).The index is used to convert the current-year inventory costs on a FIFO basis to base-year costs.
Taxpayers can calculate their own internal indexes or use indexes published by the Bureau of Labor Statistics (BLS). If taxpayers choose the published indexes, they must elect to use the Inventory Price Index Computation (IPIC) LIFO method as described in Regs. Sec. 1.472-8.
When suppliers to large retailers face significant pricing pressure from their customers, they are forced to keep their costs as low as possible to maintain profitability. They generally want to keep inflation low as they strive to "trim" costs where possible. By keeping costs and internal inflation low, the benefits of LIFO may be reduced when using internal indexes. The use of external indexes that may not consider company-specific pricing pressures can lead to significant tax savings when the published indexes show a higher inflationary factor, as their use produces a lower ending inventory value, resulting in a decrease to taxable income.
Another advantage in using the published indexes over calculating an internal index is the decreased administrative burden; taxpayers do not have to track actual individual item costs needed to compute internal indexes (as required by Regs. Sec. 1.472-8(e)(1)).
While software has been an asset in calculating internal indexes, the variability of products can make valuing base-year costs of new products an undue administrative burden. The IPIC method groups products into similar product classes, taking the hassle out of valuing base-year costs of new products.
By electing to use the IPIC method of LIFO, the taxpayer can choose the method of calculating the cumulative LIFO index, either link-chain or double-extension. The double-extension method extends base-year costs and current-year Costs to compute an increment or decrement and index for the year; see Regs. Sec. 1.472-8(e) (2) (i). The link-chain method compares base-year costs (prior-year costs) to current-year costs, but goes one step further and takes a cumulative index into account; see Regs. Sec. 1.4728(e)(3)(iii). Taxpayers electing the link-chain IPIC LIFO method do not have to justify its use. In contrast, in electing to use internally generated indexes, they must justify the use of the link-chain method to the IRS for computing the index prior to its adoption. In the first year LIFO is elected, the link-chain and double-extension methods would yield the same result. However, over time the link-chain method has the effect of smoothing out inflationary trends, while the double-extension method can result in wild swings in LIFO values (and thus in taxable income) from year to year.
Lastly, taxpayers using dollar-value LIFO must group their separate inventory items into LIFO pools. Each LIFO pool represents a similar group, type or class of inventory items. Pools are important to dollar-value LIFO; inflation indexes are computed at the pool level using a weighted average of the individual items in that pool. Internal index methods require the taxpayer to establish pools based on natural business divisions. Accordingly, this subjectivity of pool selection can be challenged by the IRS. The IPIC method allows the taxpayer to elect to establish dollar-value pools based on the two-digit commodity codes as detailed in the BLS product codes (either from the Producer Price Index or Commodity Price Index) as an approved pooling method, which minimizes IRS scrutiny; see Regs. Sec 1.472-8(b)(4).
UNICAP (Sec. 263A)
Current inventory trends also affect calculations used to capitalize and include certain costs in ending tax inventory as required by the UNICAP rules under Sec. 263A. In practice, many companies' UNICAP calculations have remained the same since the late 1980s when the Sec. 263A rules were first enacted. Due to trends and changes to cost structures, the calculations should be analyzed to determine whether other methods will produce a better result from a tax liability perspective. Taxpayers should also consider evaluating whether they are in compliance with the regulations, to lower IRS audit risk.
Direct costs as determined under Sec. 471 are generally capitalized for GAAP purposes and, among other items, include direct labor and direct materials. General and administrative (G&A) expenses typically contain overhead expenditures that are generally not capitalized for GAAP purposes; however, they may have to be capitalized for tax purposes. To analyze a Sec. 263A calculation, an understanding of the GAAP capitalization calculation is important, to ensure that costs are not being missed or counted twice due to changes in the taxpayer's cost structure.
An example of a UNICAP method that may not match current inventory trends is the simplified production method provided in Regs. Sec. 1.263A-2(b).This method uses a relatively simple formula to compute an absorption ratio. The absorption ratio is determined by taking certain includible G&A costs over certain total Sec. 471 costs for a tax year. The resulting absorption ratio is multiplied by the Sec. 471 costs included in ending inventory to determine the additional amount to capitalize for tax purposes. Includible G&A expenses contain mixed service costs, as defined by Regs. Sec. 1.263A-1(e)(4)(ii)(C), or department expenses, which are partially includible in the Sec. 263A calculation.
A taxpayer may also use a simplified method, such as the simplified service cost method provided in Regs. Sec. 1.263A-1(h), to determine the portion of the G&A mixed service department costs to include. Depending on whether the taxpayer is a manufacturer or a reseller, it may choose one of two ratios under the simplified service cost method--the labor-based allocation ratio or the production cost allocation ratio. In either case, the resulting percentage is multiplied by the total mixed service department expenditures to determine the amount includible in the simplified production method formula mentioned above.
Due to the nature of the simplified method calculations, they assume an invariable business flow and disregard the make-up of inventory at year-end. As discussed, upstream businesses forcing manufacturers to hold inventory longer in the business year can cause an overcapitalization of tax inventory and increase taxable income. As an alternative to the simplified methods, the regulations provide actual product flow methods which should be considered even though they may be burdensome to compute. For example, Kegs. Sec. 1.263A-1(e)(3) provides a method that uses predetermined rates that approximate the actual indirect (i.e., G&A) costs included in ending inventory. This would benefit companies that have ending inventory that includes, for example, primarily raw materials. Purchasing and storage expenditures may be the only G&A costs that would get capitalized in the ending raw materials tax inventory. Under this example, other G&A expenses directly tied to production would not (and should not) be associated with the raw materials portion of ending inventory. This would not be the case when using the simplified methods.
Importantly, inventory method changes involving LIFO and UNICAP are considered changes in methods of accounting that require filing Form 3115, Application for Change in Accounting Method, with the IRS. These method changes may be automatic or nonautomatic, depending on the methods being changed.
FROM DUSTIN C. PETERSEN, CPA, DES MOINES, IA
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|Author:||Petersen, Dustin C.|
|Publication:||The Tax Adviser|
|Date:||Apr 1, 2006|
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