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On August 8, 2023, the IRS Large Business & International Division (LB&I) announced a new compliance campaign focusing on taxpayers that give indications of inflating cost of goods sold to reduce taxable income.

Overview

Campaigns are designed to select returns with identified potential compliance risks. According to the announcement, LB&I identified the campaigns through its data analysis and suggestions from IRS compliance employees. LB&I's stated goal for its campaigns is to "improve return selection, identify issues representing a risk of non-compliance and make the greatest use of limited resources."

A link to the list of active LB&I campaigns can be found here. For discussion of the LB&I campaign around success-based fees, see Tax Alert 2020-2298.

Cost of goods sold

A company's tax inventory basis and associated cost of goods sold can increase for various reasons. Proper application of IRC Section 263A generally will increase a company's tax inventory basis and associated cost of goods sold (as IRC Section 263A often requires companies to capitalize certain costs to tax inventory that were originally expensed for book purposes). For companies that use the Last-In-First-Out identification method, cost of goods sold will increase in inflationary times, as the higher cost of goods most recently purchased or produced are deemed to be sold first under that cost-follow assumption. Companies may desire to make certain elections that allow for the capitalization of certain otherwise deductible costs to inventory depending on the impact of other provisions in the code (e.g., interest deductions limited under IRC Section 163(j), the Base Erosion and Anti-Abuse Tax (BEAT), etc.).

The IRS announced the campaign with a single sentence, nothing further.

Implications

As noted, there are several reasons why a company's tax inventory basis and cost of goods sold may be higher than its book basis. While the IRS did not provide information indicating the specific focus of the campaign, the use of the term "inflated" may imply that the IRS is concerned about taxpayers recovering costs that cannot be capitalized to inventory through cost of goods sold. For example, a company could treat certain expenses that are not capitalizable to inventory (e.g., research and experimental expenses under IRC Section 174, marketing expense, costs of providing services, etc.) as cost of goods sold and exclude them from base erosion payments. A company could also capitalize more of a certain type of cost than a permissible method would allow. While many required or permissible methods provide for the capitalization of costs to inventory, a careful analysis of the rules and the specific facts is required to appropriately implement these methods.

The new campaign suggests that the IRS may select an increasing number of companies reporting cost of goods sold for examination. Companies selected for exam may receive detailed IDR requests around the determination of inventory costs and cost of goods sold for federal income tax purposes, and should be prepared to respond to these requests. Accounting method changes are generally available to taxpayers wishing to change their inventory costing (including IRC Section 263A) methodologies and many such changes can generally be made using the automatic procedures in Revenue Procedure 2015-13 and Revenue Procedure 2023-24 (or successor). If the taxpayer has changed the inventory costing methodology within the last five years, however, the accounting method change may have to be filed under the non-automatic procedures before the end of the tax year.

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Published by NTD’s Tax Technical Knowledge Services group; Maureen Sanelli, legal editor