LIFO and section 263A exams focus on calculation documentation
INSIGHT ARTICLE |
The IRS released two practice units in February related to inventory valuation on the last-in, first-out (LIFO) method and the simplified production method (SPM) for Uniform Capitalization (UNICAP). It is perhaps unsurprising that the IRS has released practice units focusing on inventory, given the release of final UNICAP regulations in November of 2018, which were generally effective for the 2019 taxable year. These two recent practice units are in addition to one issued in December for the modified simplified production method (MSPM).
These practice units focus as much on documentation as the soundness of the calculation methodologies themselves. They instruct agents to request documentation to verify the calculation inputs are legitimate via detailed records of costs, items, activities, departments, and original filings or methods. Additionally, these practice units seem to indicate that the lack of appropriate documentation to establish proper treatment is a justification for the IRS to implement its own calculation under UNICAP.
LIFO practice unit
The LIFO practice unit indicates that agents shall confirm that a taxpayer under exam has maintained “supplemental and detailed LIFO inventory records that support the current value of the inventory and clear reflection of the income.” The practice unit focuses on the maintaining the necessary documentation to compute the LIFO calculation from LIFO inception to date in accordance with the method listed on the originally filed Form 970 to elect LIFO. Further, the practice unit seems to indicate a preference for terminating a LIFO election over correction of the LIFO calculation method if documentation is insufficient. The guidance refers to Rev. Proc. 79-23, Section 3.01(d), which requires adequate books and records for LIFO inventory and calculations.
Some of the IRS suggested documentation includes:
- Maintenance of current cost detail for every year of LIFO from date of election
- Maintenance of the stock keeping unit (SKU), item description, quantity, and current cost of each item of inventory
- Detailed records of current cost, base cost, and index determinations of all items in inventory
- Sample invoices showing unit costs for duration of statute of limitations
- The original Form 970 filing for the LIFO election and all Forms 3115 filed
SPM practice unit
The simplified production method practice unit also focuses on substantiating the calculation. The practice unit focuses on requests for sample cost center reports, personnel activities, allocations from administrative departments, and officer activities. The key aspect of the requested documentation is to identify areas in which supporting documentation for labor or activities either does not exist or does not support exclusion of potential production related activity in mixed service and administrative departments from capitalization under the UNICAP regulations.
The new regulations were not specifically covered in this practice unit, but themes and approaches would equally apply to the new regulations.
The practice units further confirm expectations of increased IRS exam activity involving inventory and specifically UNICAP. The interesting development in these practice units, however, is their apparent focus on documentation of the relevant positions as much as the calculations themselves.
If a method change is imposed by the Service upon examination, the section 481(a) adjustment will generally be made as of the first day of the earliest tax year under examination. Additionally, there will be no spread of the section 481(a) adjustment for an involuntary method change. This could lead to the assessment of additional tax, penalties and interest for our clients in addition to being locked into the service-imposed method. As first choice advisors, we should redouble our efforts with clients to adopt, update, and rigorously document inventory methods as needed to blunt any increased IRS exam activity that may be on the horizon.