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Close study of the Tax Cuts and Jobs Act appeared to give a fantastic break to businesses with less than $25 million in gross receipts. It appeared that they could change accounting methods and write off their inventories. Lucien Gauthier of the Boston Tax Institute promoted the concept, as I explained in Tax Cut Bonanza For Retailers And Wholesalers in December of 2018. (Full disclosure I am on the faculty of the Boston Tax Institute.)
In a two hour Zoom seminar earlier this week, we got to hash over how recently released regulations have affected the viability of the concept. The IRS seems to be trying to carve back what the legislation seemed to allow. It is a lot of fun listening to Lu with a bunch of other hardcore tax people as he can say “Well under double i …” and we pretty well know what he means. I am going to go easy on the Code and Reg references, but there might be a couple.
The Law Giveth
The Tax Cuts And Jobs Act created an exemption from keeping inventories for “certain small businesses” that are not tax shelters.
There were three ways out. One was to treat the inventory as “non-incidental materials and supplies”. The next was to treat the goods in the same way as you treated them on an “applicable financial statement”. The third option, for those who did not have an applicable financial statement was to conform with “books and records of the taxpayer prepared in accordance with the taxpayer’s accounting procedures” (BRAP).
Door number 3 was the exciting one. I will pass discussion of applicable financial statement as they are pretty uncommon in the circles I move in. Let’s take a look at what you get out of treating your purchases as non-incidental materials and supplies, the less exciting choice behind door number 1.
Non-incidental Materials And Supplies
Incidental materials and supplies are things that you buy and don’t keep track of. You can expense them when you pay for them if you are on the cash basis or when you incur the obligation if you are on the accrual basis.
Non-incidental materials and supplies (NIMS) are stuff other than inventory that you keep track of. It is interesting to note that this might cause some variation in result depending on how intense you are. Our President’s father was noted for picking up nails that had been dropped at construction sites. Possibly to Fred Trump nothing was incidental.
The general rule is that you only get to expense non-incidental materials and supplies after you use them. There is a big exception though which was noted in Footnote 465 of the TCJA Blue Book (link to download).
The footnote noted an election that could be made with respect to NIMS:
…a taxpayer may also be able to elect to deduct such non-incidental materials and supplies in the taxable year the amount is paid under the de minimis safe harbor election of Treas. Reg. sec. 1.263(a)–1(f). Under such election, a taxpayer with an applicable financial statement that has written accounting procedures in place that treat as an expense amounts paid for property costing less than a specified dollar amount may deduct amounts paid for non-incidental materials and supplies at the time of payment
You are required to use the same expense treatment in your applicable financial statements or books and records. The specified dollar amount is $5,000 if you have an applicable financial statement. If you don’t have an applicable financial statement, the footnote indicates the original amount in the regulation of $500, but Notice 2015-82 raised that to $2,500.
That limit would effectively allow many sorts of businesses to expense their inventory when the cost was incurred or paid (depending on accounting method) rather than when it was sold.
Books And Records Of The Taxpayer
“Books and records of the taxpayer prepared in accordance with the taxpayer’s accounting procedures” which I will refer to as BRAP was the really exciting concept for taxpayers selling more expensive items.
The idea was that you just stop recording inventory and expenses all purchases as incurred regardless of their size. That would allow not just liquor stores and gift shops to take advantage, but even automobile dealerships.
What is your justification? That’s the way you keep your books and records.
The Regulation Taketh Away
Reilly’s Third Law of Tax Planning – Any clever idea that pops into your head probably has (or will have) a corresponding rule that makes it not work – proved out with the proposed regulation on inventory.
When it comes to the safe-harbor election under NIMS, we get:
Section 471 materials and supplies are used or consumed in the taxable year in which the taxpayer provides the items to its customer. Inventory treated as nonincidental materials and supplies under this paragraph (b)(4) is not eligible for the de minimis safe harbor election under §1.263(a)-1(f)(2).
In our discussion, Lu pointed out that this seemed to be in direct contradiction of congressional intent as evidenced by the Blue Book footnote. I tend to agree, but the footnote was a little wishy-washy:
…a taxpayer may also be able to elect to deduct such non-incidental materials and supplies in the taxable year the amount is paid under the de minimis safe harbor election... (Emphasis added)
Books And Records Are Cloudy
Prior to TCJA, BRAP (as spelled out) never appeared in the body of tax authority in over a hundred years. So there is some doubt as to what it means, exactly. The IRS even asked for help from commenters in deciding what it means. I guess collectively we let them down because the regulation says:
“The Treasury Department and the IRS decline to define books and records in these proposed regulations. It is well-established under existing law that the books and records of a taxpayer comprise the totality of the taxpayer’s documents and electronically-stored data.”
So if you ask the question as to whether any sort of thing is part of your books and records, the answer is yes. Better not to ask, I guess. Included in the broad “definition” of BRAP would be an inventory record even though it is not recorded on “the books”, as an accountant would think of them
They give us an example of a liquor store, but it would seem that the same principle would apply to a more edifying business such as a book store.
“In E’s electronic bookkeeping software, E treats all costs paid during the taxable year as presently deductible. As part of its regular business practice, E’s employees take a physical count of inventory on E’s selling floor and its warehouse on December 31, 2019, and E also makes representations to its creditor of the amount of inventory on hand for specific categories of product it sells. E may not expense all of its costs paid during the 2019 taxable year because its books and records do not accurately reflect the inventory records used for non-tax purposes in its regular business activity. E must use the physical inventory count taken at the end of 2019 to determine its ending inventory.”
Some businesses might be able to avoid the need for those sorts of reports, but it looks like this might be fatal to a car dealership that is floor planning.
They Are Proposed
The new regulations are not yet effective. They will be effective for years beginning after they are issued as final. And the final regulations may be different. We were agonizing over what would happen to a taxpayer who made the change for 2018 or 2019.
There is some hope that the IRS would issue a procedure that would allow conversion to a then permitted method with a spread over four years for the income pickup. Even if that is not the case, taxpayers who make or have made the switch for 2018 or 2019 might come out ahead, since a loss that is generated can carried back five years.
Regardless, the IRS has taken some of the fun out of TCJA, but of course, the Third Law predicted that.