Among the various challenges your business may face as a result of new tariffs, inventory tax accounting might not be your top concern. However, considering inventory accounting in your tax planning now could help you avoid unpleasant surprises.
Proper tax inventory accounting, especially amid new tariffs in an inflationary environment, can help your company align your book and tax cost allocations, minimize unfavorable adjustments, and ensure compliance with federal regulations—and ultimately manage tax obligations effectively.
Accounting methods, inventory costs and tariffs
Financial accounting and tax accounting methods have different rules that dictate which costs to include as part of inventory. Both generally require capitalization of acquisition costs and direct costs into inventory. Acquisition costs include freight-in and tariffs, and direct costs include direct labor and materials. How companies measure and record these direct costs, however, could differ in a few important ways.
Financial accounting considers whether tariffs constitute a material cost in the total costing of a product. Additionally, financial accounting may employ a net realizable value methodology to value inventory, as outlined in Accounting Standards Codification (ASC) 330. This method subtracts the costs of completion, disposal and transportation from the estimated selling price.
The inclusion of tariffs in product costing is further complicated by the use of standard costing, which relies on predetermined standard costs to establish a product's cost basis. Typically, companies update their standard costs annually, and if tariffs represent a significant portion of the costs, the standard cost may differ substantially from the actual costs at the year's end, especially if tariffs change multiple times in the period.
For income tax purposes, cost is predominantly used as the basis of valuation. Additionally, federal income tax regulations are more explicit about the types of costs that must be capitalized and the extent to which variances can remain uncapitalized.
Generally, the tax cost of inventory better reflects the total actual costs of the inventory, whereas financial accounting better reflects the market value and salability of inventory.
With that in mind, consider the following planning steps:
Planning consideration: Review how cost accounting procedures affect tax
Issue: Potential large book-to-tax adjustments for uncapitalized tariff costs or uncapitalized variances
Action: A review of current book and tax cost allocations can identify opportunities to reduce book-tax differences by capturing any increases in costs through book capitalization, thereby creating alignment with or decreasing the required tax capitalization.
Companies using standard and burden rate costing should be reviewing their cost allocations at least regularly. However, if you haven’t been doing so, or if you anticipate significant effects from tariffs, these rates should be revisited and updated appropriately to avoid downstream tax issues. Two potential impacts of tariffs on tax cost allocation are:
- Potential increases in uncapitalized acquisition costs
- Uncapitalized inventory variances.
Generally, any tariffs paid on inventory acquired for resale goods or direct materials are required to be capitalized under the tax inventory and uniform cost allocation (UNICAP) rules. Similarly, any variances or over/under burdens for inventory are likewise required to be capitalized.
Any such costs treated as period costs for book will need to be capitalized for tax to the extent they relate to goods on hand at year-end. Depending on the current tax methods used, this may result in a substantial unfavorable book-to-tax adjustment addback and potential underpayment of tax if not adequately accounted for in any relevant estimates for the tax year.
Additionally, costs in excess of the final determined customs value cannot be attributed to inventory imported from related parties. The general concept being that related party transactions demonstrate parity between the declared customs value for purposes of duty payments and the amount claimable as a deduction on a tax return. There are limited exceptions for adjustments related to freight, insurance, commissions, mark-ups, and construction or assembly costs. If the inventory cost value exceeds the custom value and does not meet one of the specified exceptions, the deduction for the inventory may be limited to the final liquidated custom value and there may be an unfavorable book-tax adjustment.
Companies can reduce the book-tax adjustments either by increasing their book capitalization to include such costs, or by revisiting the tax cost allocation procedures to determine if more favorable methods may be available to reduce the tax capitalization required.
As no single answer is appropriate for all taxpayers, companies should consider:
- Their need for cash flow
- Their tolerance for underpayment penalties and potentially large book-tax add-backs
- The ease of updating their book costing allocation procedures
- Their preference for simplicity in their book and tax inventory methods
Planning consideration: Capturing inflation to reduce taxable income
Issue: Your company is experiencing an increase in goods acquired for resale or costs of materials, labor, etc. for goods produced
Action: Review if a last-in first-out (LIFO) methodology yields a greater cost of goods sold (COGS) deduction
An urgent and obvious impact of potential tariff increases is the review of your tax inventory cost flow method, as tariffs are generally inflationary to costs. Although it is an oversimplification, many taxpayers may be able to increase their COGS deductions and decrease their taxable income from adopting or modifying their LIFO cost flow method in an inflationary environment.
Many taxpayers opt to use the producer price index (PPI) or consumer price index (CPI) tables provided by the Bureau of Labor Statistics (BLS) to compute the inflationary index utilized in their tax LIFO calculation. For financial accounting purposes, companies may have to utilize an internal index versus a BLS index. Companies that report under International Financial Reporting Standards (IFRS) cannot utilize LIFO accounting.
For income tax purposes, it is important to consider which index is more appropriate. Often taxpayers expect the PPI to reflect any price increases earlier than the CPI, as price increases generally flow from producers to consumers. However, differences in the PPI and CPI components sometimes create deviations from this expectation. To respond effectively to increasing tariffs, taxpayers must consider the intent and makeup of the producer and consumer price indices:
The BLS on its website best explains the dynamics of how the impact of tariffs eventually affects the PPI:
“The PPI measures the average change in prices U.S. producers receive for the sale of their products. Since tariffs and taxes are not retained by producers as revenue, they are explicitly excluded from the PPI.
“However, pricing decisions producers make in reaction to tariffs are included in the PPI. For example, if a domestic producer is manufacturing a product that is subject to import competition and tariffs are placed on those imports, the domestic producer may increase its own prices in order to maximize revenue. In this case, the price increase for the domestic producer would be included in the PPI.
“Similarly, if a domestic producer exports products to a foreign country that placed tariffs on U.S. products and the domestic producer lowered its prices either to better compete in the export market or to sell domestically excess inventory that resulted from those tariffs, those price decreases would also be reflected in the PPI.”
The BLS uses different indices to measure inflation. As described above, the PPI measures inflation in an indirect way through the prices producers charge for their product.
In contrast, the CPI measures inflation relative to how it is experienced by consumers through a measurement of a basket of goods and services at today’s prices compared to prices during a previous period.
Taxpayers who can choose an inflation index for their LIFO costing should note that while the PPI does not directly include tariffs, imports, or sales and excise taxes in its price indices, the CPI does include imports and all relevant taxes. In contrast, the PPI includes exports, which the CPI does not.
Although import tariffs may not be immediately reflected in the PPI, they may influence manufacturers' indirect price adjustments over time due to market conditions. Taxpayers affected by import or tariffs should evaluate whether internal indexes or the CPI provide better results if eligible, especially if they currently use a PPI-based index.
Companies contemplating such a change should consider the compliance cost related to LIFO—the LIFO book conformity requirement, the annual maintenance of a book and tax LIFO calculation, and the cost of analysis and implementation of either a method change to adopt LIFO or to make a change within the LIFO method.
Tax accounting and tariff mitigation
Reviewing your tax inventory accounting is part of a comprehensive approach to tariff mitigation.
An experienced tax advisor with deep knowledge of accounting methods can help you understand how tariffs affect product costing, the need for regular review of cost allocations, the benefits of adopting or modifying LIFO methodology and other important steps. In addition, trade advisory services can help you understand your supply chain, what goods are being tariffed, and steps that can be taken to mitigate the impact of tariffs overall.
