Simplified Production Method not Required for Restaurants
posted Nov 24, 2014 by Laura H. Yalanis, CPA, MST in the Restaurateur Blog
Under IRC Sec. 263A restaurants have previously been required to capitalize costs of ingredients and related labor costs to ending inventories that haven’t yet been processed into finished meals or beverages. The rules under this section require that producers of tangible property must include the indirect and direct costs of production under inventory. The IRS recently decided in a Chief Counsel Advice (CCA) that, depending on certain factors, restaurants are not required to use this simplified production method.
Problems with the Sec. 263A Rule
The simplified production method is certainly not the most burdensome method under section 263A, but it does have numerous issues:
- Capitalized cost increase- Under the section 263A simplified production method, a company’s costs which are able to be capitalized are allocated between ending inventory and costs of sales depending on the number of times the company’s inventory turns over during the year. Generally, the cooks’ and bartenders’ labor costs as well as a portion of the occupancy costs are included in the 263A expenses, which results in an increase in capitalized costs.
- Tax Burdens- As a result of these increased capitalized costs, taxable income increases, which is not the most beneficial result for the taxpayer.
- The method does not consider the fact that restaurants may have few to no finished goods in inventory when the year is over. The method capitalizes preparation costs to raw materials.
How can I avoid issues under Sec. 263A?
- Avoid the rule altogether- Restaurants can avoid the Sec. 263A rule if they agree to develop a reasonable facts-and-circumstances method instead.
- Section 471 costs instead of 263A- If restaurants do choose to use the simplified production method, the IRS will treat all direct production costs, including kitchen labor, as Section 471 costs rather than Sec. 263A costs. Section 471 costs include direct material, direct labor, and allocated indirect costs which are included in cost of sales rather than 263A costs.
- Standard cost or burden rate method under section 1.263A- 1 (f)(3)- This alternative will allow the taxpayer to allocate costs to the specific inventory components that encounter those costs.
- Analysis of the cooks’ and bartenders’ actions- This analysis could pinpoint activities like cleaning that, under Sec. 263A, may not be deemed production activities. Not all cook and bartender costs, then, may have to be capitalized.
- Form 3115- If you find that your tax capitalization method does not fulfill the requirements of Sec. 263A, consider filing a Form 3115 (Application for Change in Accounting Method) because it will provide the taxpayer with audit protection based on its previously used 263A process.
By analyzing all aspects of business, specifically inventory, restaurant operators can be sure that their current tax capitalization methods agree, or disagree with IRC Sec. 263A. To ensure the best tax benefits while still complying with IRS rules and regulations, it is valuable to scrutinize current operations to the fullest extent. Questions? Contact us.