Originally published on Forbes.com.
Whatever they were thinking, assuming they were thinking, when they passed the Tax Cuts and Jobs Act(TCJA), wiping out more than a year’s worth of taxable income of retailers and wholesalers that gross less than $25 million was probably not on the agenda. It looks like that’s what they may have done though.
I learned about this at one of Lucien Gauthier’s Boston Tax Institute seminars. In New England, it takes a really arrogant CPA to say that he thinks Lu Gauthier is wrong about something. I qualify. I told a fellow that I consult for that I thought Lu’s argument that substantial entities could just wipe out their inventories for tax purposes was not right. So the boss told me to dig deeper and my conclusion is that indeed the opportunity exists – at least for the bold. Here is the story.
The Basics
Here is some Accounting 101 stuff that you might need to follow along. Our client in the business of selling tchotchkes. The company has a few retail outlets and a warehouse. Gross sales are around $20 million. Tchotchkes are marked up 50%. Don’t go paying $30 for a tchotchke. I can get it wholesale for you – $20.
That means the gross profit is around $6.7 million. It takes three months for the average tchotchke to get from the loading dock at the warehouse to the cash register in one of the retail outlets. I’ll spare you the complex math involved, but that means that there is usually $3.3 million worth of tchotchkes (at owner’s cost) somewhere in the pipeline of Useless Junk, Inc (UJI).
Mr. Potter, who owns UJI, is pretty old school, so the stuff is not continuously tracked. As invoices from the suppliers come in there is a debit to purchases and a credit to payables. If business is steady in the course of the year there will be about $13.3 million in purchases. Once a year, there is an epic project as all the tchotchkes are counted and sorted and classified and priced. The number that results from these myriad multiplications and additions is the ending inventory for the year just ended and the beginning inventory for the year just begun.
Here it is January 10 and thanks to an efficient accounting system, we know everything about the UJI results of operations except for one thing, the ending inventory, which is still being compiled. UJI had $5 million in operating and other expenses and $20.2 million in sales. By adding purchases of $13 million to opening inventory of $3 million, we get cost of goods available for sale of $16 million. With that information, we can compute something that you won’t read about in the accounting literature, which I learned as a junior accountant – the breakeven inventory, a number that is on Mr. Potter’s mind.
Cost of goods sold is cost of goods available minus the ending inventory. If the ending inventory is $800,000, the company breaks even (20.2 – 5 – 16 + 0.8 = 0). So really, rather than going to all the trouble of counting all that stuff and pricing it and compiling, we could just ask Mr. Potter how much profit he wants to show, add $800,000 and that’s the ending inventory. You may have heard of LIFO and FIFO. The method of just asking Mr. Potter is called WIFL (Whatever I Feel Like). I don’t recommend it.
The Change
The rules for valuing inventory for tax purposes are complicated and they differ from the rules under Generally Accepted Accounting Principles (GAAP). So TCJA does small and, not so small, business a real solid by indicating that if your gross receipts are less than $25 million, you don’t have to bother with the complicated tax rules concerning inventory. File Form 3115 and change your accounting method and you are now free of those nasty inventory rules.
What are your options? Well, if you have an “applicable financial statement”, you can go with what you put on your financials. An applicable financial statement is generally an audited financial statement. “Audited” would be an independent CPA applying generally accepted auditing standards to the financial statements, not some IRS agent coming in and making your life miserable. Another option is to treat the inventory as “non-incidental materials and supplies”.
For a business like Mr. Potter’s UJI, both those numbers will provide pretty much the same answer as all that counting and sorting. So there is really nothing to get excited about. That’s what I thought anyway, but Lu Gauthier is arguing otherwise. Because there is actually a third possibility. Many companies do not have audited financial statements. They get by with a review or a compilation or possibly no financial statements at all.
The third choice is the alternative to an applicable financial statement in 471(c)(1)B(ii) (Emphasis added)
….conforms to such taxpayer’s method of accounting reflected in an applicable financial statement of the taxpayer with respect to such taxable year or, if the taxpayer does not have any applicable financial statement with respect to such taxable year, the books and records of the taxpayer prepared in accordance with the taxpayer’s accounting procedures.
What Does That Mean?
What Lu Gauthier and, according to him, quite a few smart CPAs (And Lu would know how to tell whether a CPA is smart or not.) think “books and record, etc.” (BRAP) means is whatever it is that the taxpayer does. Mr. Potter’s new plan is to take that chapter on taking inventory out of the UJI accounting manual and just deduct purchases. That is an accounting method change so for 2018 the opening inventory will be deducted and there will be no ending inventory. Rather than income of around $1.7 million or so, there is an $800,000 loss to carry-forward to 2019.
Now it is “only a deferral”. you might say. Someday, UJI will recognize that income. But as long as they stay in business and don’t have a significant decline in sales, someday will never come.
I am a bit of a worrywart, so a highly leveraged company doing this sort of thing really concerns me. If sales ever drop and they need to pay down debt, there will be taxable income without cash flow. I’m sure you think that the immediate tax saving will be put aside for that eventuality. Dream on.
The other thing I worry about is that there is an actual business reason for tracking inventory, and some companies will continue to do so in side reports that they claim are not really accounting records. Remember Reilly’s Fourth Law of Tax Planning – Execution isn’t everything but it’s a lot. At IRS audit time, have a clean set of books that reflects the method you are using for tax purposes.
What Does It Really Mean?
“Books and records of the taxpayer prepared in accordance with the taxpayer’s accounting procedures” (BRAP) is probably a good example of the sloppy hurried methodology used in drafting TCJA . Although the individual words seem pretty ordinary, strung together like that BRAP does not appear in over a century of tax authority – regulations, rulings, case law, etc. So nobody knows what it really means and how much flexibility there might exist.
The IRS does have something to say on the subject. Revenue Procedure 2018-40 explains the automatic procedure method for changes in accounting method allowed by TCJA. Possibly even bigger than the inventory change is the ability to switch to the cash method, but that is probably already well-covered. In the procedure, the IRS does get into the meaning of BRAP. It was way down in the bottom of the procedure.
The Treasury Department and the Service invite comments containing suggestions for future guidance …… how “books and records of the taxpayer prepared in accordance with the taxpayer’s accounting procedures” should be interpreted
So they want us to tell them what it means.
Caution
There is a cautionary note in the revenue procedure.
The consent granted under section 9 of Rev. Proc. 2015-13 for a change made under section 22.19(1)(b) of this revenue procedure is not a determination by the Commissioner that the proposed inventory method of accounting is permissible, and does not create any presumption that the proposed method is a permissible method of accounting under a provision of the Code. The director will ascertain whether the proposed method is permissible under the Code.
I contacted a couple of the really smart CPAs I know. A couple of them indicated that they would run this notion by their accounting methods experts. I’ve never run into an accounting method expert. They must be in a back room that is even further back than the SALT group. I have not heard back.
Alan Osmoloski of Blum Shapiro told me that he had witnessed a heated debate about this at a Surgent seminar. Blum Shapiro is taking a cautious approach:
For the time being we are taking a conservative approach and will be keeping an eye out for further guidance. I would say we have concerns around the clear reflection of income doctrine as it applies to the issue we discussed.
A New Measure For Taxation
If the aggressive attitude toward inventory sticks and you combine it with other relaxations in allowable accounting methods (most importantly cash basis) and the unlimited expensing of most capital assets, businesses under $25 million of receipts (that’s indexed for inflation) and their owners and lenders will no longer be taxed on income. They will be taxed, in effect, on what is called free cash flow.
A common measure is to take the earnings before interest and taxes multiplied by (1 − tax rate), add depreciation and amortization, and then subtract changes in working capital and capital expenditure
I can’t rule out the notion that this might not be such a bad idea. Certainly, free cash flow is a measure that is highly correlated with ability to pay. On the other hand, a system like that seems destined to fuel wealth inequality and also encourage gaming. If Mr. Potter is having a better year than he had planned, he can have his suppliers transfer title to goods that have not shipped. There will be a real incentive for channel stuffing, particularly from suppliers that are public companies more interested in earnings growth and less tax-sensitive.
If taxing on free cash flow rather than income is what TCJA was really aiming for, maybe it should have been mentioned.
Disclosure
I taught a Boston Tax Insitute seminar, like a million years ago, and am making a comeback this spring in that period approaching June 30 when procrastinators will sign up for anything.
Alan Osmoloski and I have worked together for many years. I was his boss and he’s been mine (That’s what happens to you when you are a slacker). I’m retired now, but you never know.
Other Coverage
Patti Scharf has a piece (with an embedded video) where she adopts a cautious approach – Can Inventory Now Really Be Deductible When Bought??
My advice is that I would tread lightly when coming up with your own wild interpretations of the rules, because the IRS included in its guidance a blatant warning that just because you pick an alternate accounting method does not mean that it’ll necessarily be accepted by the IRS. They reserve the right to audit you, disagree with you, and then charge you interest and penalties if you get it all wrong.
Ms. Scharf was responding to a podcast by Scott Voelker – Huge Tax News For Amazon Sellers (Game Changer)
Mark Tew of Not Your Dad’s CPA is more encouraging. He recounts a discussion with an IRS attorney that is more encouraging (and sounds familiar. I’m not saying I also talked to an IRS attorney, but I’m not saying I didn’t.).
I don’t believe allowing all small businesses the option to account for inventory using the cash method was the intent of the new TCJA wording (just my opinion), but it does appear to be one result of it.