Inventory Costing Changes: A New Tax Savings Opportunity for Smaller Manufacturers
Originally published on February 23, 2019
Updated on August 16th, 2022
Due to changes enacted under the Tax Cuts and Jobs Act (TCJA), there are many opportunities for manufacturers to reduce their tax liability and keep more money in their businesses. One such opportunity lies in something you already have—your inventory.
There are three major changes that significantly impact manufacturers:
- The ability to elect out of Uniform Capitalization (UNICAP) rules under Section 263a (a requirement that certain administrative costs be capitalized into inventory)
- The ability to change your method of accounting for inventory
- The ability to convert from accrual basis to cash basis for reporting taxable income.
It’s important to learn more about these changes before filing your final return. So let’s take a look at each.
Electing Out of Section 263a
The Uniform Capitalization (UNICAP) rules under Section 263a provides that direct and certain indirect costs allocable to real or tangible personal property produced by a taxpayer (or purchased for resale) must be capitalized into the basis of that property. This includes direct costs (such as labor, materials and purchase costs), normal overhead, and indirect costs not normally capitalized for GAAP purposes.
However, small businesses can elect out of this requirement—resulting in an immediate tax write-off in the year you elect out for the amount of indirect costs you had to capitalize in the past.
Per the TCJA and IRS code section 448(c), corporations and partnerships with a corporate partner can use the cash method instead of capitalizing if they have average gross receipts of $25 million or less during the three preceding years. This applies to both producers and resellers (prior to tax reform, the exception was only for resellers).
Changing Your Accounting Method for Inventory
For entities that account for inventory in their monthly financial reporting and year-end tax reporting, the TCJA provided new methods of accounting for inventory. For some, this will be a significant new opportunity to deduct some or all of your inventory purchases immediately. Section 471 of the code dictates how inventory is to be accounted for; however, for businesses with average gross receipts of $25 million or less during the three preceding years, you have new options.
The first option is to treat inventory as non-incidental materials and supplies. Non-incidental materials and supplies can be deducted when first used or consumed in operations (which is a different definition than when sold to the customer). In addition, regulations allow inventory purchases under certain threshold be immediately deducted when purchased (and paid).
The second option is to conform to how businesses account for inventory for internal/external reporting purposes. This option provides new opportunities to examine your internal accounting processes and procedures related to inventory to maximize opportunities. The catch, however, is that there can be no difference in how you account for inventory for your internal book purposes versus tax accounting purposes. They MUST be the same.
These options are not for every business. For example, companies that must produce financial statements in accordance with general accepted accounting principle or have other external reporting obligations will likely have to continue accounting for inventory under traditional methods. This is because deducting inventory before it is sold can be distortive to the balance sheet and net income.
Converting from Accrual Basis to Cash Basis
In the past, entities with inventory generally reported taxable income on an accrual basis. What this means is that revenue was reported when the product was shipped or sold, even though cash had not yet been collected. On the other hand, expenses were recognized when incurred rather than when paid.
Accrual basis accounting can be advantageous in certain scenarios—for example, if your accounts payable always exceed your accounts receivable. However, many companies experience the opposite, in which accounts receivable often exceeds your payables. In these cases, it can be advantageous to consider converting to a cash basis tax payer as you will de-recognize the accounts receivable and accounts payable (except those related to inventory). Even with the election to cash basis, inventory can be maintained on the books (unless a new inventory election is made as noted above).
Careful consideration must be given to the potential opportunities we’ve discussed, as there are many options and considerations to ensure the right path for your company. Additionally, the IRS has certain required filings to change accounting methods that must be carefully completed. We recommend you consult your tax CPAs to walk through the many options and opportunities.
All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.
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