Breaking Down the General Rules for Inventories
A discussion of the regulations under Internal Revenue Code § 471 and important information to be aware of.
Breaking Down the General Rules for Inventories
Disclaimer: The information contained within this document is highly summarized and should not be construed to be complete or used as a sole source of information, nor should it be relied upon, interpreted, or used as any type of authority, advice, or opinion, in any form. The information is applicable as of the original publish date. All citations related to federal income tax codes and regulations within this document are abbreviated for readability purposes only, however are intended to be clear as to the sections and subparagraphs referenced. The content is provided for general purposes only; all information within should be independently verified. The use of this disclaimer does not affect the degree of care given to the summary information written or sources referenced. Please contact your tax advisor to discuss any topics pertaining to your business or situation. Originally published June 25, 2021.
Breaking Down the General Rules for Inventories
When starting a cannabis business, one of the first accounting concepts owners become aware of is the term “Section 280E” and the need to account for the cost of goods sold, or “COGS”. Researching this topic further, it is also generally understood across the industry that expenses are not deductible for federal income tax purposes, other than an adjustment for cost of goods sold. The calculation of cost of goods sold is calculated based on inventory costs includible under § 471. But what does this all really mean? And in a legislative environment with multiple bills in Congress designed to legalize marijuana and § 280E potentially likely to no longer apply to the industry sometime in the foreseeable future, how are inventory accounting rules still relevant?
The following information discusses the U.S. Department of Treasury federal income tax regulations §§ 1.471-1 through 1.471-11 pertaining to rules for inventories and the applicable methods of accounting for them. The below content was written with marijuana cultivators, processors, and retailers in mind and attempts to discuss the information in a relatable manner. The purpose of this content is to bring awareness to some of the other tax regulations and codes that may be applicable to inventory that generally are not widely discussed, with the marijuana industry’s historically heavy focus on the nuances of § 280E only. This content is summarized; it should not be relied upon for your specific business and is not inclusive of all tax laws and regulations that may affect it- please contact your tax advisor to discuss any information particular to your specific business or situation. If you are interested in reading about the most prevalently discussed information currently pertaining to the marijuana industry only, keep reading for a brief summary of § 280E, or see § 1.471-3 Inventories at Cost and § 1.471-11 Inventories of Manufacturers.
This content does not discuss the transfer of inventory property under controlled transactions, including the applicability to controlled transactions between ‘vertically integrated’ groups where inventory transactions may apply, or controlled transactions within certain licensing agreements. Please see § 482 and the expanded regulations.
Briefly, what is § 280E and why does it apply to marijuana businesses?
IRC § 280E was added in 1982 and generally states that no deduction or credit is allowed for businesses trafficking a controlled substance (under schedules I or II of the Controlled Substances Act) that is prohibited federally or by the laws of any state. This code was in response to a Tax Court case decision, Jeffrey Edmondson v. Commissioner, in which Edmondson claimed business deductions related to selling cocaine, amphetamines, and marijuana. At the time, the legislation was reflective of the policy against illegal drug dealing and the ‘War on Drugs’. The Court held that while Edmondson was entitled to deduct the cost of goods sold from gross receipts, other deductions in arriving at taxable income were not allowed. More commonly known deductions otherwise traditionally and generally available to federally legal businesses include those deductions granted for ordinary and necessary business expenditures described under § 162, deductions for certain taxes under § 164, deductions for depreciation granted under § 167 (certain taxes and depreciation expenses incident and necessary to a manufacturing process may generally be deductible in nature per § 1.471-11(c)(2)(iii)), casualty and theft loss deductions under § 165, deductions for bad debts under § 166, charitable contribution deductions provided for under § 170, and net operating loss deductions granted under § 172. Today, § 280E is still in place and marijuana businesses are prohibited from exercising these deductions when calculating taxable income. Generally, for manufacturers and merchandisers, business gross income is the total sales, less the cost of goods sold, plus investment and other incidental sources of income. (§ 1.61-3(a).).
Because marijuana is a controlled substance, businesses trafficking marijuana inventory are disallowed expense deductions, other than an adjustment for cost of goods sold. Cost of goods sold is generally derived from the value of inventory, calculated under an acceptable method defined in §§ 1.471-3 through 1.471-11. Less commonly discussed regulations codified in the other sections not yet specifically mentioned also may have the potential to apply to cannabis inventories, both currently and as the industry matures and is ultimately legalized. Businesses with inventory should have a general awareness of these other regulations and the potential need to consider them, and others, as laws or business activities change.
§ 1.471-1 Need for Inventories
In general, inventories must be maintained in order to properly reflect taxable income and should include the value of finished goods, work in progress, raw materials, and purchased goods that the business has title to and are intended to become part of goods available for sale. (§ 1.471-1(a).). Maintaining an inventory balance is generally reflective of the practices under the accrual method of accounting.
Certain taxpayers may not be required to maintain an inventory balance on their books, including certain small business taxpayers meeting various tests and who are not restricted from using the cash basis of accounting. Taxpayers who are not restricted and meet the requirements under § 1.448-2(a)-(c) are however in general still required to account for their cost of goods sold as non-incidental materials and supplies calculated in accordance with a method described under § 471 when, generally, the materials are used or consumed by the business, or paid for by the business, whichever occurs later. (§ 1.471-1(b)(1)-(4).).
To note, ‘non-incidental materials and supplies’ is also defined under § 1.162-3(a)(1).
Additionally, note that § 1.471-1 also discusses inventory treatment for small business taxpayers with an applicable financial statement (AFS). This AFS terminology should not be confused with the annual financial statement procedures required by the Michigan Marijuana Regulatory Agency (MRA). Although § 1.451-3(a)(5)(iii) may include for certain financial statements submitted to state agencies, it is not likely the agreed-upon procedures report format required by the MRA would satisfy this overall definition, given its nature.
§ 1.471-2 Valuation of Inventories
Generally, inventory must conform to what may be the best accounting practice in the trade or business and must clearly reflect income. Inventory valuation rules are not uniform across all industries, however a valuation method should be applied consistently and within the scope of the best accounting practice for the business based on the nature of its trade customs. (§ 1.471-2(a)-(b).).
The methods of inventory valuation most commonly used are cost and lower of cost or market. Damaged or otherwise unusable or unsalable inventory should generally be valued at its bona fide selling price, less direct costs of disposition. If damaged inventory is raw materials or partly finished goods, it should be valued with a reasonable basis not less than its scrap value. Records for the disposition and the valuation of damaged goods should be maintained. (§ 1.471-2(c).).
For activities considered to be part of the same trade or business, a taxpayer’s method of valuation must be applied consistently to its entire inventory. For example, a retailer with one line of business would not use both the cost and the retail method of valuing inventory across different products. § 1.446-1(d) may generally allow taxpayers with more than one trade or business to use a different method of accounting for each trade or business with complete and separable books and records, assuming other requirements are also met.
In general, for book inventories maintained in accordance with a sound accounting system where inventory accounts are charged (increased) with the actual cost of the goods purchased or produced, and credited (decreased) with the value of goods used, transferred, or sold, and calculated upon the basis of the actual cost of the goods acquired during the taxable year (including for beginning inventory), the net value as shown by such inventory accounts will generally be deemed to be the cost of the goods on hand. Book inventory balances should be verified by physical inventory counts at reasonable intervals and adjusted to conform when variances exist. (§ 1.471-2(d).). It may be worth highlighting that proper application of accounting methodology for recording expenditures to inventory accounts likely should be carefully considered under this rule, perhaps especially for marijuana businesses as industry accounting best practices continue to develop. Generally, this rule does not state expenditures should be recorded directly to COGS, as might be the practice for taxpayers without inventory and using the cash basis of accounting.
Additionally, inventories should be recorded in a legible manner, properly computed and summarized, and be preserved as a part of the taxpayer’s accounting records. Inventory records are subject to inspection (by the IRS) and the burden of satisfaction is on the taxpayer. (§ 1.471-2(e).).
To note, as the cannabis industry matures it is likely retailers and cultivators may see changes to what an accounting best practice based on the nature of their business may be. Cultivators may potentially find they are able to apply farm accounting methods as best practice in a legalized market for example, and retailers may be more apt to explore other valuation methods that may be applicable as a best practice absent the strict cost and inventory reporting systems currently inherent. Additionally, with the legalization of marijuana more businesses may be best suited using the cash method of accounting, if they are not prohibited from doing so otherwise. Currently many cultivation, processing, and retail marijuana businesses use the accrual method of accounting and the cost method, with full absorption method when allowable, for valuing inventory, and depending on business type. A change in accounting method requires additional consideration under § 1.446-1(e) and also under § 1.481-1 related to adjustments and how to compute taxable income related to the change in accounting method from the previous year.
§ 1.471-3 Inventories at Cost
Here we come to one of the two most discussed regulations under § 471 for marijuana businesses, generally in relation to appropriate adjustments to gross receipts for the cost of goods sold (as limited by § 280E).
In general, under the cost method the cost of merchandise on hand at the beginning of the year is the inventory price of such goods. (§ 1.471-3(a).).
To this beginning inventory value, the following costs should generally be added in the case of a retailer or other purchaser of inventory goods:
The invoice price, less trade or other discounts. Of note, discounts related to cash payment discounts may or may not, in a consistent manner, be included in the inventory cost, if the cash discount is based on a fair interest rate. Businesses that purchase inventory with cash and utilize any related cash payment discounts may want to consider the applicability of this provision.
To the net invoice, transportation or other necessary charges incurred in acquiring possession of the goods. (§ 1.471-3(b).). In response to this provision, marijuana industry businesses might consider relationships that maximize the allowable cost of goods when possible. Purchasers are generally able to include inventory transportation costs in their inventory value; sellers (“vendors”) are not. Additionally, other fees incurred and included in the net invoice price, such as vendor administrative fees, may potentially need to be considered independently in order to determine the best accounting practice based on the nature of the fees and other restrictions applicable to the marijuana industry.
In the case of producers, generally the cost of raw materials, direct labor, and indirect production costs incident to and necessary for the production of inventory are included in the inventory’s cost. Costs of selling or return on capital are not includible. (§ 1.471-3(c).). Additional costs included in uniform capitalization of cost requirements under § 263A are generally not considered includible by businesses subject to § 280E - See Internal Revenue Service Chief Counsel Memorandum Number: 201504011.
Farmers, manufacturers, and retailers have other or additional regulations under § 471 that may be applicable to them, and that are summarized further below.
Generally, unconditional sales based vendor allowances or chargebacks, or in certain instances when wholesalers sell at agreed upon pricing to customers based on discounts negotiated by the manufacturer and provided back to the wholesaler as a credit or rebate, the credit or rebate value should generally be treated as a reduction of cost of goods sold, not as a reduction in inventory value. (§ 1.471-3(e).). Certain cultivator - processor - provisioning center agreements may potentially have applicability under this provision, depending on the nature of the agreements.
§ 1.471-4 Inventories at Cost or Market, Whichever is Lower
When using the lower of cost or market method to value inventory, a taxpayer generally values their inventory at the lower of the market price, or their paid cost to purchase or manufacture the goods. Inventories for goods valued using the lower of cost or market method use the prevailing bid price, or market price, for the basic cost elements of the goods in ending inventory in determining the market value. The market value is then compared to the cost value; whichever value is lower is the value used. If no open market exists, the taxpayer generally must use other evidence that may be available supporting the fair market value, including other specific and reasonable transactions. If inventory is already committed under a non-cancellable fixed priced sales contract and protected from loss at the time of inventory valuation, these items generally must be valued at cost. (§ 1.471-4(a)-(c).).
In a market with lowering prices, valuing inventory under this method generally results in a lower inventory value if market prices drop below costs paid. Related to the marijuana industry for example, if market prices fell significantly such as what many early cannabis businesses experienced a number of years ago when the market price of marijuana dropped below $50 an ounce in certain areas, consideration of the lower of cost or market method and its potential as an accounting best practice may have arisen. Inventory valuation methodology must be applied consistently from year to year, and any change in method requires consideration of additional compliance and reporting needs under § 446 and § 481. This would include a change of valuation method from cost under § 1.471-3 to lower of cost or market under § 1.471-4 (or a change to any of the methods described).
§ 1.471-5 Inventories by Dealers in Securities
While this regulation could potentially apply to investment companies dealing in cannabis securities, it would generally not be applicable to cannabis operating companies and is therefore not discussed. Similar and additional concepts noted under the previous two sections generally apply.
§ 1.471-6 Inventories of Livestock Raisers and Other Farmers
Certain farming businesses in which the provisions of § 1.448-2(d) apply are generally not prohibited from using the cash basis of accounting. In general, inventories are not maintained when using the cash basis of accounting.
Farmers may however be able to use an alternative inventory method instead of the cash method at their option, so long as the method is applied consistently and any change in method is compliant under § 446 and § 481, as previously noted. In general, farmers may use the “farm-price method” and value inventory at the market price less direct costs of disposition. Farmers may also need to consider the applicability of § 1.263A-4, rules for property produced in a farming business. In general, § 263A uniform cost capitalization rules likely may not be applicable to the nature of cannabis farming businesses that are not corporations or tax shelters, with hemp or marijuana having a pre-productive period of less than two years under § 1.263A-4(a)(2)(i). Note that certain seeds and genetic plant inventory may not meet this specific exception.
Farm corporations and farm partnerships with corporate members should consider § 447 - Method of accounting for corporations engaged in farming.
When using the farm-price method for valuing inventory, and there are adjustments for returns of inventory after taxable income has been computed based on an incomplete inventory, the abnormality generally should be corrected by submitting a statement for the preceding tax year with the current year’s tax return. The statement should include the adjustment showing the prior year’s closing inventory balance to be reflective of the opening balance of the completed inventory in the current year. Or, if necessary to clearly reflect income, the adjustments may generally be shown to be made to the preceding year or years beginning inventory balance. (§§ 1.471-6(a)-(d) and 1.471-6(i).).
The remainder of this regulation generally applies to farmers with livestock inventories, and therefore is not discussed.
Hemp farmers operating under regulations related to the 2018 Farm Bill and Michigan’s Industrial Hemp Growers Act likely need to consider the applicability of the various farm accounting rules. In the event of federally legalized marijuana, cultivators may also be likely to need to consider the applicability of these rules.
§ 1.471-7 Inventories of Miners and Manufacturers
This regulation largely applies to concepts in the mining industry, or in general might be considered by manufacturers when the other acceptable inventory methods described under § 471 are not considered to be applicable, based on industry or trade best practices. Varying interpretations may create the potential for further consideration of the applicability of this regulation possibly to the nature of certain inventory produced by cannabis manufacturing processors. In general, a taxpayer engaged in mining or manufacturing who by a single process or uniform series of processes derives a product of two or more kinds, sizes, or grades, the unit cost of which is substantially alike, generally may with consent of application for the change, reasonably allocate aggregate costs of production to inventory based on the relation of the selling values of the different kinds or grades.
§ 1.471-8 Inventories of Retail Merchants
In general, a retail merchant may use the retail method of accounting, as an alternative to the cost method or lower of cost or market method described under §§ 1.471-3 and 1.471-4. The retail method values ending inventory by multiplying a cost complement against the retail selling price of the inventory on hand at the end of the tax year. The cost complement is, in general, the inventory cost divided by the inventory selling price, or ( (beginning inventory + cost as determined under § 1.471-3 (except as provided under § 1.471-8) for goods purchased during the year) / (retail selling prices of beginning inventory + retail selling prices of goods purchased during the year and adjusted for permanent markups and markdowns, including markup and markdown cancellations and corrections) ). Vendor allowances or rebates under § 1.471-3(e) are applied directly to the cost of goods sold and generally should not be included to affect the numerator of the cost complement. (§ 1.471-8(a)-(b)(2).).
Interestingly, prior to the inventory and accounting system requirements inherently necessary under the Medical Marihuana Facilities Licensing Act (MMFLA) and Michigan Regulation and Taxation of Marihuana Act (MRTMA), dispensaries in Michigan operating with local approval in response to the Michigan Medical Marihuana Act (MMMA) often applied a crude version of the retail method when determining their ending inventory value on hand and related cost of goods sold.
When using the retail lower of cost or market method to value inventory, additional rules and methods for calculating the cost complement apply. Among these, retailers using the retail lower of cost or market method do not adjust the selling price in the denominator of the cost complement formula by markdowns; markups generally must be reduced by markdowns made to cancel or correct them. (§ 1.471-8(b)(3)(B).). This is different from the retail cost method described above, under which all permanent markups and markdowns are generally included. (§ 1.471-8(b)(2)(B).).
Other provisions in this regulation allow for further alternative calculations related to margin protection payments, or vendor rebates, discounts, or allowances intended to compensate for a reduction in the retail selling price of inventory.
Temporary markdowns or markdowns that are not actual reductions of a retail price generally may not be included when determining the price of ending inventory value per § 1.471-8(b)(4). Additionally, the retail inventory method may generally be used for different departments, classes, or SKUs, however requires separate calculations of the cost complements used if gross profit percentages differ by grouping. (§ 1.471-8(d).).
To note, alternative methods also exist under § 472 for the use of LIFO inventory method (last in first out). LIFO use is generally being phased out for most manufacturers under § 1.471-11(e)(1)(i) and is not an acceptable method under international financial reporting standards (IFRS). Its use is considered acceptable under U.S. GAAP and for federal income tax purposes in general, as conceptually it may better represent the value of nonperishable inventory on hand, if new inventory is sold or used in favor of old inventory. Overall the use of LIFO today is rare however. Similar to the above information, LIFO regulations include multiple methods and provisions related to retailers. The accounting nuances of electing the use of LIFO are complex and companies in general would likely require systems changes in order to account for them properly.
§ 1.471-9 Inventories of Acquiring Corporations
Additional requirements for corporate acquisitions of inventory assets for scenarios related to certain corporate reorganizations or liquidations of subsidiaries generally apply. In general, the acquired inventory is valued using the method used by the distributing/transferring company. If several methods were used, generally the acquiring corporation shall use an applicable method(s) described under other relevant regulations. (§ 381(c)(5).). If the acquiring or distributing company does not maintain an inventory or uses the cash receipts method of accounting, § 381(c)(4) generally would instead need to be considered, per § 1.381(c)(5)-1(e)(10).
§ 1.471-10 Applicability of Long-Term Contract Methods
Pointing specifically to long-term manufacturing contract rules under § 1.460-2, this regulation generally requires manufacturers to use the percentage of completion method when valuing inventory under a long-term contract in which the inventory is unique or requires more than 12 months to complete. (§ 1.460-2(a).). Given the surrounding context, applicable regulations may have the potential to apply to certain long-term contracts of marijuana or hemp processors, especially as the cannabis industry matures and seeks to create new and exclusive inventory products that may require long development periods.
An item is considered unique if, in general, it is designed for the needs of a specific customer. To determine if an item is for the needs of a specific customer, the taxpayer would consider the extent of customizing activities, such as research, development, engineering, retooling, and other elements of customization, and also include consideration of the customized activity needed to produce the first unit vs. subsequent units, and whether the item can be sold to other customers with little or no modification. (§ 1.460-2(b)(1).). An item is generally not considered unique if the production period is less than 90 days, if allocable costs of customization are less than 10% of the total costs to produce the item under contract, or if similar items are normally included in inventory. (§ 1.460-2(b)(2).).
There are additional regulations surrounding required methods of accounting and cost allocation for long-term contracts, which are not discussed here in this summary.
§ 1.471-11 Inventories of Manufacturers
For marijuana cultivators and processors, this is the most widely referenced regulation in terms of determining allowable inventory costs when using the full absorption method for inventory costing.
In order to clearly reflect income and to conform as nearly as possible to industry accounting best practices, generally manufacturers take into account both direct and indirect production costs when valuing inventory. This is known as the full absorption method of inventory costing. Property produced or acquired for resale may also be subject to uniform capitalization of cost rules under § 263A. (§ 1.471-11(a).). Marijuana businesses however generally exclude recognition of uniform cost capitalization rules currently due to the limitations of § 280E. Upon legalization, the applicability of § 263A likely will need to be considered for inventory property both produced and acquired.
Production costs generally include costs incident to and necessary for the production or manufacturing operations or processes, and include both direct and indirect costs, whether fixed or variable. Direct production costs generally include direct materials and direct labor. Direct materials and direct labor costs are generally considered those that become an integral part of the manufactured product, are consumed in the ordinary manufacturing process, and are identifiable to particular units or groups of units. Direct labor cost elements generally include wages, overtime, paid time off for vacation, holiday, and certain sick days, payroll taxes, and other direct labor related costs listed under § 1.471-11(b)(2)(i).
Indirect production costs include fixed and variable costs incident and necessary to the manufacturing process and generally may be classified and accounted for based on manufacturing activities or other consistent and reasonable identification groupings thereof. Fixed indirect costs may include rent and property tax payments on buildings and machinery incident and necessary to the manufacturing process, as examples. Variable indirect costs generally vary significantly based on production levels and might include costs such as utilities or factory janitorial supplies. When costs contain both fixed and variable components, these components should be separated into fixed and variable classifications as necessary under the taxpayer’s method of allocation, described below. (§ 1.471-11(b)(3).).
Indirect production costs are listed in three categories. Category one costs described under § 1.471-11(c)(2)(i) generally must be included in the computation of inventory costs for tax purposes. Subparagraph (2)(i) indirect production costs include repair and maintenance expenses, utilities such as heat, power, and light, rent, indirect labor costs generally similar in nature to the inclusions for direct labor costs listed above, indirect materials and supplies, tools and equipment not capitalized, and costs of quality control and inspection. All costs listed must be incidental and necessary to the manufacturing process. (§ 1.471-11(c)(2)(i)(a)-(h).).
The second category of indirect costs includes costs that are not required to be included in inventoriable costs. These include marketing and advertising expenses, selling and other distribution expenses (transportation out), interest, research and experimental costs including product engineering and development, losses under § 165, percentage depletion greater than cost depletion (generally applicable to oil or timber businesses, for example), depreciation and amortization reported for federal income tax purposes in excess of depreciation and amortization reported for financial (book) purposes, income taxes attributable to the sale of inventory such as state income taxes, certain pension contributions, and general and administrative expenses or officer salary expenses incident and necessary to the business’s activities as a whole, rather than to the manufacturing process. (§ 1.471-11(c)(2)(ii)(a)-(m).).
It is generally common practice in the marijuana industry to exclude these category two costs in inventoriable costs (despite possible attempts to maximize cost of goods), even though the regulation does not specifically state these costs are prohibited from being included. Surrounding context and publicly available guidance acknowledge a potential likelihood of these types of costs being disallowed under § 280E. It may also be worth noting that certain state agency regulatory fees might potentially be interpreted to be included under this category, if interpreted to be required as a condition of operating a cannabis business and its related activities as a whole and not incident and necessary to the production process only.
The third category of indirect costs includes costs that if also included in the taxpayer’s financial reporting/book accounting method for inventory and are not treated inconsistently with generally accepted accounting principles, must also be included for tax purposes. The costs included in subparagraph (2)(iii) must all be incident and necessary to the manufacturing process, and may include taxes otherwise allowable under § 164 such as property taxes on production assets, depreciation, certain employee benefits, costs attributable to strikes, rework, scrap, and spoilage, factory administrative costs of production, certain officer salaries for services provided, and insurance. If the taxpayer does not use the same method of accounting for financial reporting and tax purposes, certain costs listed above are not includible. (§§ 1.471-11(c)(2)(iii) and 1.471-11(c)(3).). In determining whether methods are not inconsistent with generally accepted accounting principles referenced in this subparagraph, certain financial accounting standards may also need to be referenced, such as rules within the contents of ASC 360 and ASC 740, among others.
As a general note, consistency in application between financial reporting and tax reporting is often of high importance.
Allocation Methods under § 1.471-11(d) for Indirect Costs
The indirect production costs that are described above in categories one and three are required to be allocated to ending inventory using an allocation method which fairly a-portions these costs among the various items produced. Acceptable methods for allocating indirect production costs to ending inventory include the manufacturing burden rate method and the standard cost method.
In general, manufacturing burden rates may be developed in accordance with acceptable accounting principles and applied in a reasonable manner. Taxpayers may also generally choose to allocate different indirect production costs using different manufacturing burden rates. For example, a different burden rate may be used to allocate rent than to allocate utilities. Generally, the method used for allocating costs in the financial reporting will be given weight in terms of whether the method used for tax purposes fairly allocates indirect costs to ending inventory. Note that a change in concept of how a manufacturing burden rate is developed generally constitutes a change in accounting method and further compliance with § 446. (§ 1.471-11(d)(2)(i).).
If for example indirect production costs are allocated using a burden rate based on a cannabis facility’s activity square footage usage, and then subsequently the business chooses to allocate based on a burden rate using machine or equipment usage hours to instead more accurately reflect indirect cost allocation, compliance related to a change in accounting method and related adjustments should be considered.
Factors such as relevant activity over a period of time reflective of operating conditions for units produced, statistical information such as direct labor hours or dollars, machine hours, or a combination thereof, and appropriate budgeting and analysis of expenses including fixed and variable costs, are factors that may be used in developing a burden rate, though it may be appropriate to use other factors as well.
The purpose of the manufacturing burden rate method used with the full absorption method of inventory costing is to allocate an appropriate amount of indirect production costs to goods in ending inventory, using predetermined rates developed with the intention to approximate the actual amount of indirect production costs incurred. Variances between predetermined indirect production costs and actual indirect production costs should generally be treated as an adjustment to ending inventory in the tax year the difference arises. However, if the adjustment is not significant in relation to the total indirect production costs, then it generally does not need to be allocated to ending inventory, unless the adjustment is allocated in this manner for financial reporting purposes. Both negative and positive adjustments must be treated consistently. (§ 1.471-11(d)(2)(ii)-(iii).).
The standard cost method of allocating inventoriable costs to ending inventory may also be used. Variances in direct and indirect production costs computed using the standard cost method compared to actual direct and indirect costs should generally be netted based on type (direct or indirect), and then reallocated pro ratably to items in ending inventory. Similar to the manufacturing burden rate method, variances other than insignificant variances not allocated for financial reporting purposes, are allocated to ending inventory. Variances must be treated consistently. (§ 1.471-11(d)(3).).
The practical capacity concept may be used in conjunction with either of the above methods to determine the total amount of fixed indirect production costs allocable to ending inventory. Practical capacity is often described as the level of activity and utilization of facilities and equipment for production assumed to be at approximately their capacity during operations. The selection of the level of production activity to base the calculation on should generally be based on the taxpayer’s experience and the conditions expected during the period costs are to be determined. Practical capacity may generally be computed based on pounds, tons, labor or machine hours, or any other unit of production appropriate to the cost accounting system used.
Practical capacity may also generally be established using “theoretical” capacity, which is then adjusted for estimated allowances related to the inability to operate at full capacity, such as due to equipment breakdowns, idle time, and work stoppages. Theoretical capacity is the level of production reachable if all machines and departments continuously operate at peak efficiency. (§ 1.471-11(d)(4).).
In general, manufacturers are mandated to transition to using the full absorption method of inventory costing. (§ 1.471-11(e)(1)(i).). The remainder of this regulation generally discusses rules surrounding this mandatory change. Generally, marijuana manufacturers already apply the full absorption method as a best practice (largely driven by the intent to maximize allowable cost of goods sold, if not for the mandate). Therefore, the provisions related to this transition are not discussed.
Other Considerations Related to Inventory
Beyond the scope of this discussion and outside of § 471, several other tax codes and related regulations may apply to the treatment of inventory. In the event of marijuana legalization and the industry no longer being subjected to the limitations under § 280E, the need to consider the applicability of other inventory rules becomes even greater. To highlight, specific regulations apply for contributions of inventory for charitable purposes, distributions of inventory to owners, consolidated and inter-company inventory transactions, and for inventory produced outside of the United States, along with several others not mentioned.
Inventory rules and valuation methods can be complex, depending on a business’s operations, chosen method, or overall nature of activities. Having a general awareness of this complexity can be a powerful tool in maintaining inventory compliance and opening discussion topics with your CPA or tax advisor as your business continues to mature and expand, or ultimately experiences systematic legal changes.
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