Tax Reform Impact on Inventory Deductions

 

The changes made to Internal Revenue Code (IRC) §471 Rules for Inventory of the Tax Cuts and Jobs Act (“Act”) present some tax-savings opportunities for “small” mold shops. The rules define small businesses as those with less than $25-million of average gross receipts for a trailing three-year period. The shops that have not been in business for three years must use the average gross receipts of the years in operation.

The first step to evaluating the inventory treatment change is understanding how the shop treated inventory before the Act. An asset is a "resource owned by a company which has future economic value that can be measured and expressed as dollars." Inventory is the most crucial asset regarding operations. IRC §471 and a basic accounting principle known as the "matching" principle require producers of inventory to capitalize raw materials, work-in-process (WIP), finished goods, associated labor and other subordinate costs, known as overhead. The reason shops must capitalize inventory, labor and overhead costs is to "match" the expense(s) of producing (or acquiring) the inventory with the revenue received from selling the inventory. This concept was true for both financial and tax accounting with potential minor adjustments in the tax realm.

On August 3, 2018, the Internal Revenue Service (IRS) issued guidance to provide small businesses procedural guidance on accounting methods affected by the Act. This guidance also provides "automatic consent" if a shop changes its accounting method. By making the change automatic, mold shops will not be required to request permission from the IRS or pay a fee to change their method.

One of these provisions permitted small businesses to avoid the application of IRC §471, as described above. Rather than capitalizing inventory costs when purchased and produced, small businesses are permitted to treat inventory as non-incidental material and supplies under the treasury regulations. These regulations clarify that non-incidental materials and supplies are deductible at the time a shop "uses or consumes" them, rather than at the time a shop purchases, transfers or sells them to the next user of the sales cycle. Also, mold shops may elect a "de minimis" safe harbor exemption for raw materials, which mirrors the de minimis safe harbor election government introduced with the tangible property regulations.

This inventory adjustment has slipped through the proverbial crack due to a majority of the coverage of the Act revolving around individual income tax changes, the 20-percent flow-through deduction, and the 100-percent accelerated bonus depreciation deduction. For small shops, this seemingly untouched change could result in large tax savings.

 

Impact on Small Mold Shops

Small mold shops must immediately expense raw materials after purchase, which are subject to limitations and an immediate write-off for currently capitalized WIP and finished goods inventory. Here is a two-step process for mold shops to follow:

1. De Minimis Inventory Purchases

Treasury regulations permit all mold shops to immediately expense the cost of property used in a trade or business, if the cost of the property does not exceed $2,500 per item. If the shop has an "applicable financial statement" (AFS), that limitation is $5,000 per item. The most common applicable financial statements for small businesses are financial statements audited by an independent CPA firm used for credit purposes, shareholder reporting or other substantial non-tax purposes.

Manufacturers that meet the definition of a small business are now eligible to immediately expense, via an annual election, raw material purchases under $2,500 per item, per invoice.  There is a small caveat, however, in that the de minimis election binds both financial and tax reporting, meaning that if a mold shop capitalizes the qualifying de minimis inventory for financial purposes, the shop is required to capitalize the inventory for tax purposes as well. 

Small businesses may not elect to immediately expense inventory because many shops have covenants tied to long-term financing that an inventory reduction can negatively affect. Also, excess losses from these changes may not be deductible by an individual taxpayer. Instead, a shop must assess each on a case-by-case basis.

2. Non-incidental Materials and Supplies

Shops can now deduct non-incidental materials and supplies when a shop uses or consumes the materials. This change leads to the elimination of WIP and finished goods inventory for tax purposes. Unlike the de minimis rule in step one, the tax treatment of non-incidental materials and supplies does not have to follow the financial accounting treatment, which requires a book-tax adjustment on the shop's annual tax return. 

Next, a shop must consider WIP and finished goods that were still in inventory on December 31 of the prior year and current year WIP and finished goods stemming from the manufacturing of raw materials that could not be expensed under the de minimis rule. A shop must identify to which year the inventory is attributed, ensuring correct tax adjustments. Also, if a shop elects to treat certain inventory costs as non-incidental materials and supplies, direct labor and overhead costs associated with the production of the inventory will be fully deductible as incurred.

 

Making the Changes

The shop can write off raw materials under its respective de minimis safe harbor election when preparing its tax return. However, the change must be reflected on the financial statements. Shops must report the §471 inventory change on Federal Form 3115: Application for Change in Accounting Method under the automatic method change procedures. The shop must identify which WIP and finished goods were present as of January 1 of the prior tax year and report the amount, known as a 481(a) adjustment, as an additional expense item in Cost of Goods Sold. 

Once this method change is elected, a shop must record the cumulative increase or decrease in the amount of WIP and finished goods between two tax years as a book-tax adjustment on its tax return.

This inventory adjustment has slipped through the proverbial crack due to a majority of the coverage of the Act revolving around individual income tax changes, the 20-percent flow-through deduction, and the 100-percent accelerated bonus depreciation deduction. For small shops, this seemingly untouched change could result in large tax savings.