15 February 2016 President's FY 2017 Budget request includes proposals affecting tax accounting methods and inventories The President's Fiscal Year 2017 Budget Request (Budget Request), released February 9, 2016, includes provisions that have appeared in prior budget proposals, including repealing the last-in, first-out (LIFO) and lower-of-cost-or-market (LCM) accounting methods for inventories. The Budget Request also proposes repealing the Section 197 anti-churning rules. Inventory tax accounting methods are prescribed in Sections 471 and 472. These sections provide a number of methods that a taxpayer may use to determine the value of its inventories and compute the cost of goods sold. Many taxpayers have elected to use the LIFO method. Under the LIFO method in Section 472, current sales are matched with the most recently acquired (or manufactured) inventory items. In an environment of rising inventory costs, the cost of goods sold under the LIFO method would be higher than that under the FIFO method because it is based on the more recent, higher inventory values, resulting in lower taxable income. If inventory prices are falling, however, a LIFO taxpayer could have higher taxable income because the more recent, lower-cost inventory values would be included in the cost of goods sold. Section 472 includes a so-called book-tax conformity requirement, which requires taxpayers to use LIFO for financial reporting purposes to be eligible to use it for tax purposes. Under the Administration's proposal, LIFO would no longer be a permitted accounting method for tax years beginning after December 31, 2016. Taxpayers that currently use the LIFO method would be required to change their method of inventory accounting, which would result in the inclusion of income of prior-years' LIFO inventory reserves (i.e., the amount of income deferred under the LIFO method) in the first tax year beginning after December 31, 2016. The resulting Section 481(a) adjustment, which is a one-time increase in gross income, would be taken into account ratably over 10 years, beginning with the year of change. The LIFO method is widely used by companies in various industries, including oil and gas, manufacturing and retail, and many of these companies have built substantial LIFO reserves (i.e., the difference between the LIFO cost of inventory and the cost of the inventory under the FIFO method). LIFO repeal has been proposed numerous times and will likely continue to be a topic of discussion that will raise questions from taxpayers currently utilizing that method. An extended spread period for the income associated with the potential LIFO repeal is something that has also been included in the various proposals Although LIFO repeal is not certain, it has been included in tax reform proposals, as well as the President's Budget Proposal. Most proposals include a spread period for the inclusion of income associated with the repeal of LIFO. Taxpayers can benefit by maximizing their LIFO reserve prior to the repeal, and including the income generated from the Section 481(a) adjustment over a period of years in the future, potentially at a lower tax rate. As provided in the Section 471 regulations, taxpayers not using the LIFO method of inventory accounting may value their inventories under the LCM method. In addition, taxpayers may currently write down the cost of "subnormal" inventory goods (i.e., those that are unsalable at normal prices or unusable in the normal way because of damage, imperfection, or other similar causes) to net realizable value if certain conditions are met. Furthermore, retailers may also use what is known as the retail inventory method (RIM) LCM, which allows for the valuation of inventories based on approximate cost or market, whichever is lower. Retailers using the retail inventory method for tax currently are not required to use that method for financial statement reporting purposes. The proposal would statutorily prohibit the use of the LCM and subnormal goods methods of inventory accounting. Appropriate wash-sale rules also would be included to prevent taxpayers from circumventing the prohibition. The proposal would result in a change in the method of accounting for inventories for taxpayers currently using the LCM and subnormal goods methods, and any resulting Section 481(a) adjustment generally would be included in income ratably over four years, beginning with the year of change. This proposal would be effective for tax years beginning after December 31, 2016. The repeal of LCM has also been proposed previously. Taxpayers that do not use the LIFO inventory method often benefit under the FIFO LCM method. If these write-downs are no longer available, many taxpayers will have higher ending inventory values and, as such, higher taxable income. Taxpayers should explore opportunities to utilize all available LCM and subnormal goods write-downs in the current year. Limited repeal of the domestic manufacturing deduction for oil, natural gas, coal and other hard mineral fossil fuels For tax years beginning after 2009, Section 199 generally allows a deduction for domestic production activities in an amount equal to 9% of the lesser of a taxpayer's qualified production activities income (QPAI) or taxable income for the tax year, limited to 50% of the taxpayer's W-2 wages for the year. QPAI is defined as domestic production gross receipts (DPGR) in excess of related cost of goods sold and other allocable general and administrative expenses. DPGR includes gross receipts derived from: (1) any lease, rental, license, sale, exchange, or other disposition of qualifying production property manufactured, produced, grown or extracted by the taxpayer, in whole or significant part within the United States, any qualified film produced by the taxpayer, or electricity, natural gas or potable water produced by the taxpayer in the United States; (2) certain construction of real property performed in the United States; and (3) certain engineering or architectural services performed in the United States. The purpose of Section 199 is to effectuate a tax rate reduction up to 3% when fully phased in. Currently, the domestic manufacturing deduction is available to taxpayers generating QPAI from the sale, exchange or disposition of oil, natural gas or primary products thereof, produced in the United States. For taxpayers with oil-related QPAI, however, the deduction would decrease for tax years beginning after 2009, by 3% of the lesser of the taxpayer's oil-related QPAI for the tax year, the taxpayer's QPAI for the tax year, or taxable income (see Tax Alert 2008-1495). The Administration's proposal would retain the overall Section 199 domestic manufacturing deduction, but exclude from the definition of DPGR all gross receipts derived from the sale, exchange or other disposition of oil, natural gas, coal, other hard-mineral fossil fuels, or primary products thereof, for tax years beginning after December 31, 2016. The hard mineral fossil fuels to which the exclusion would apply include lignite and oil shale to which a 15% depletion rate applies. President Obama has asked Congress to repeal the domestic manufacturing deduction for these fossil fuels in previous budget proposals, but the initiatives have failed to gain traction in either the House or the Senate. Taxpayers in the energy industry should review the Budget Request, monitor legislation and become engaged in the process. Section 197 allows the amortization of certain intangibles (e.g., goodwill and going concern value). Section 197(f)(9) prohibits the amortization of an intangible if: (1) the intangible was held or used at any time on or after July 25, 1991, and on or before August 10, 1993 (the transition period), by the taxpayer or related person; (2) the taxpayer acquired the intangible from a person who held it at any time during the transition period, and, as part of the transaction, the user of the intangible does not change; or (3) the taxpayer grants the right to use the intangible to a person (or a person related to that person) who held or used the intangible at any time during the transition period. The Administration's proposal would repeal Section 197(f)(9) for acquisitions after December 31, 2016. This proposal would be welcomed by many taxpayers that have to do the annual diligence to determine whether they have acquired assets or reacquired assets that they or a related party might have owned over 20 years ago. While this provision might have been effective shortly after the enactment of Section 197, it likely now has little meaning, other than to make taxpayers undertake additional effort to make sure they are not subject to the anti-churning rules.
Document ID: 2016-0323 | |||||||||
