IRS refines simplified methods for determining inventory costs, prohibits negative amounts

The IRS has issued proposed regulations that clarify the "simplified methods" for determining inventory costs under the Code Sec. 263A uniform capitalization rules. In a significant change from prior guidance, the proposed regulations would prohibit the use of negative numbers for adjustments to inventory costs, unless particular exceptions apply. Among the exceptions is that the IRS will allow the use of negative amounts by companies using the simplified resale method and by certain small producers.

Code Sec. 263A in a nutshell

Code Sec. 263A requires certain business taxpayers that produce intangible property to capitalize the costs of producing that property. Code Sec. 263A generally requires taxpayers to allocate these costs that must be capitalized to specific items in inventory, which can become complicated for many taxpayers. However, the Code Sec. 263A regulations authorize taxpayers to use alternative simplified methods to allocate costs.

The proposed regulations provide a simplified production method and a simplified resale method for allocating costs to inventory. The simplified methods are an exception to allocating costs to specific items of property. Instead, they allocate a pool of capitalizable costs ("additional Code Sec. 263A costs") between ending inventory and cost of goods sold (COGS) using the "absorption ratio."

Negative amounts

A negative amount (a reduction in capitalizable costs) could occur under different scenarios, for example, if a business capitalizes a Code Sec. 471 cost (such as depreciation) for book purposes in a higher amount than the cost capitalized for tax purposes. A negative amount results if the business removes the excess depreciation by adjusting additional Code Sec. 263A amounts (the numerator of the absorption ratio), rather than the Code Sec. 471 amounts (the denominator). The IRS indicated that these negative amounts could significantly distort the additional Code Sec. 263A costs allocated to ending inventory.

Proposed rules

The proposed regulations would supersede Notice 2007-29 and would generally prohibit the use of negative amounts in applying the simplified production method. However, the proposed regs provide several exceptions. One exception applies to smaller producers with average annual gross receipts of $10 million or less. The proposed regs also allow the use of negative amounts by retailers and wholesalers under the simplified resale method. The regulations also provide an alternative simplified production method that would reduce overcapitalization and distortion, the IRS predicted. While not yet "finalized" and therefore officially operative, taxpayers are advised to start following IRS's revised views now or face time and expense in defending the reasonableness of a contrary position.