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IRS rules favorably on Section 263A simplified method

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Tax Hot Topics newsletter The IRS published private letter ruling (PLR 201848012) explaining how the simplified production method under Section 263A works in a year during which a taxpayer using the first-in, first-out (FIFO) method for inventory does not have a complete inventory turn. It is common for taxpayers with short tax years and for taxpayers in certain industries with slow-moving goods to not have a complete inventory turn.

The letter ruling was requested by a manufacturer that used the FIFO method to identify inventory and the simplified production method (SPM) to allocate additional Section 263A costs to ending inventory. The taxpayer requested two rulings related to whether it was performing the computations under the simplified production method correctly in Year 2, when the taxpayer had not sold all of its ending inventory carried over from Year 1.

The ruling generally held that for its Year 2 taxable year, notwithstanding the fact that a portion of the taxpayer's Year 1 ending inventory remained on hand in its Year 2 ending inventory, a taxpayer using the FIFO method and the SPM properly follows the method by including only Section 263A costs that it incurred during the Year 2 taxable year in the SPM formula. Specifically, a taxpayer should include only the Section 471 costs that it incurred during the Year 2 taxable year and that remained in its inventory at the end of the Year 2 taxable year in the Section 471 costs on hand at year’s end in the ending inventory multiplicand for purposes of the simplified production method formula. Therefore, if a taxpayer’s ending inventory does not turn over at least once during a taxable year, the ending inventory multiplicand must be adjusted to remove any costs remaining from the prior year’s ending inventory.

Additionally, the ruling held that for its Year 2 taxable year, notwithstanding the fact that a portion of the taxpayer's Year 1 ending inventory remained on hand in its Year 2 ending inventory, a taxpayer using the FIFO method and the simplified production method properly recovers as cost of goods sold in Year 2 the additional Section 263A costs that were allocated to ending inventory in Year 1 using the SPM.

The second holding is particularly significant because taxpayers and practitioners may have taken different positions in the past. Some taxpayers and practitioners may have continued to capitalize a pro rata portion of the additional Section 263A costs capitalized in the prior year based on how much of the prior year’s ending inventory still remained in ending inventory in the current year. Note also that the ruling only applies to FIFO method. The simplified production method operates very differently for a taxpayer using the last-in, first-out (LIFO) method. Taxpayers using the LIFO method only recover as cost of goods sold additional Section 263A costs capitalized in prior years when there is a decrement in the layers.

As noted previously, it is common for taxpayers with short tax years to not have a complete inventory turn. Therefore, this is a welcome interpretation by the IRS because short tax years often have anomalous results when using the simplified methods under Section 263A. Taxpayers on FIFO using the SPM or the simplified resale method that recently had a short tax year may want to review whether they recovered all of the prior year additional Section 263A costs at the end of the short year.

Contacts:
Sharon Kay
Partner, Washington National Tax Office
T +1 202 861 4140

John Suttora
Managing Director, Washington National Tax Office
T +1 202 521 1523

Debbie Shi
Manager, Washington National Tax Office
T +1 202 521 1501

Caleb Cordonnier
Manager, Washington National Tax Office
T +1 202 521 1555

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