The Final Regulations addressing the small business taxpayer safe harbor accounting methods introduced by the Tax Cuts and Jobs Act (TCJA) are applicable to tax years beginning on or after January 5, 2021.
The primary area of concern for most taxpayers is the small taxpayer inventory safe harbor methods. Many small taxpayers adopted methods that are not consistent with the rules outlined in the Final Regulations. The Final Regulations provide three permissible safe harbor methods of accounting for inventories.
Each of these methods has specific requirements and limitations so taxpayers will need to select the appropriate method based on their unique facts and circumstances. All three methods can result in a reduction in the total inventory costs capitalized for tax purposes but only one method allows taxpayers to accelerate the timing of their inventory deduction.
The following chart summarizes the considerations for each of the three safe harbor methods:
|NIMS||AFS Section 471(c)||Non-AFS Section 471(c)|
|Costs capitalized||Direct materials only||Direct materials, labor and overhead capitalized for book purposes||Costs capitalized in taxpayer’s books and records|
|Acceleration of Deduction||No||No||Yes – depending on method chosen|
|Benefits||Allows current deduction of labor and overhead costs||Easiest to implement and maintain as it does not require any tax-specific adjustments||Allows taxpayers to craft an accounting policy that matches their business and potentially accelerate the timing of the inventory deduction|
|Requirements / Limitations||Taxpayers must be able to identify the portion of their inventory balance that relates to direct materials, labor and overhead to claim current deduction for labor and overhead||None||Taxpayers must treat inventory consistently in all accounting records. To currently deduct inventory, taxpayers must stop tracking inventory on all accounting records|
The NIMS safe harbor method is available for all taxpayers. This method allows taxpayers to capitalize only direct material costs in their ending inventory and to currently deduct labor and overhead costs. Taxpayers wanting to currently deduct labor and overhead costs will need to be able to distinguish among the materials, labor and overhead costs in their inventory balance.
Unlike the NIMS method currently used by some taxpayers, this method does not allow taxpayers to deduct the capitalized inventory costs until the inventory items are transferred to a customer.
The AFS Section 471(c) method applies to taxpayers that have an audited financial statement or a financial statement that is provided to a government or regulatory agency (“AFS”). Under this method, taxpayers follow the method of accounting for inventories in their AFS. This method is the easiest to apply as no tax adjustments are needed but will also likely result in the least favorable outcome as it may result in the highest balance of capitalized costs.
The non-AFS Section 471(c) method provides taxpayers with the most flexibility and is the only method that may allow taxpayers to currently deduct the entire cost of their inventory items. This method is only available to taxpayers that do not have an AFS and allows taxpayers to account for inventory for tax purposes in accordance with the method of accounting used in their books and records that properly reflect their business activities for non-tax purposes and are prepared in accordance with their accounting policies.
Taxpayers using the non-AFS Section 471(c) method have significant flexibility in accounting for their inventory. The primary requirement is that the taxpayer’s treatment of the inventory for tax purposes must be consistent with how the inventory is reflected in their books and records.
For example, a taxpayer wanting to deduct the cost of inventory when purchased would need to stop tracking the inventory on their books and records and could not reflect inventory on their balance sheet, general ledger, trial balance, tax return or other accounting report. They could continue to maintain an inventory system that tracked quantities of items on hand for re-ordering purposes but could not reflect an inventory asset on their financial records for any purpose.
Taxpayers whose inventory methods are not consistent with the options outlined will need to determine if the change to the permissible method will result in an adjustment to taxable income. If so, the taxpayer will need to file a Form 3115, Application for Change in Accounting Method, to adopt a permissible small taxpayer inventory method with their 2022 tax return.
The IRS has waived the 5-year scope limitation on filing accounting method changes related to this safe harbor so most taxpayers will be eligible to request an automatic accounting method change with their 2022 return. Taxpayers will need to spread any unfavorable Section 481(a) adjustment arising from the change over the shorter of 4-years or the number of years the taxpayer used the small taxpayer method. For example, a taxpayer that made a change to the small taxpayer inventory method in 2020 would spread the unfavorable Section 481(a) adjustment over two years.
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This article is provided for general informational purposes only. It is not legal, accounting or other professional advice, as it does not address any individual facts, circumstances or concerns. Before making personal or business related decisions, please consult with appropriate legal, accounting or other qualified professionals.