Editor: Rick Klahsen, CPA
With the release of Rev. Proc. 2009-39, taxpayers may now obtain automatic IRS consent to change their method of accounting for nonincidental materials and supplies to comply with the rules in Regs. Sec. 1.162-3. Prior to the release, taxpayers were required to file an advance consent request and submit a user fee in order to obtain explicit permission from the IRS to make a change to properly account for nonincidental materials and supplies.
Many taxpayers face the issue of how to treat materials and supplies used in their trade or business. Depending on their book treatment, for tax purposes the cost of supplies may either be deducted upon purchase as an ordinary and necessary business expense (i.e., in the case of incidental materials and supplies) or be capitalized under Regs. Sec. 1.162-3 and expensed as consumed (i.e., in the case of nonincidental materials and supplies). Specifically, incidental materials and supplies on hand at the end of the year may be deducted in the year of purchase as long as no record of consumption is kept or no physical inventories are taken, provided the taxpayer’s taxable income is clearly reflected by this method.
When a taxpayer takes a physical inventory or keeps a record of consumption, the materials and supplies are generally nonincidental. If a taxpayer does not take a physical inventory or keep a record of consumption, the materials and supplies are generally incidental. Typically, the taxpayer’s treatment of materials and supplies for financial reporting purposes will dictate the tax treatment. The capitalization of materials and supplies on hand at the end of the year for book purposes most likely means that a physical inventory was taken or a record of consumption was kept, in which case the taxpayer generally must capitalize the materials and supplies for tax purposes as well.
Supplies Are Not Inventory
While nonincidental materials and supplies on hand at the end of the year generally must be capitalized, they are not capitalized as inventory if they:
- Were not acquired for sale to customers; and
- Will not physically become a part of merchandise held for sale (Regs. Sec. 1.471-1).
Therefore, by escaping inventory classification, supplies generally do not have to be included in uniform capitalization calculations under Sec. 263A unless it is appropriate to include them as an inventoriable overhead cost under Sec. 263A and the regulations thereunder. It also means, however, that the carrying value of supplies may not be written down below cost. Taxpayers should be sure to differentiate between raw materials that are subject to the inventory rules under Sec. 471 and supplies that are subject to the capitalization rules of Regs. Sec. 1.162-3.
Taxpayers that take physical inventories or keep a record of consumption of their materials and supplies are generally required to capitalize the amounts on hand at the end of their tax year and expense such items as consumed or used in their trade or business. Taxpayers that do not do so—by, for example, deducting nonincidental materials and supplies when purchased—may be using an erroneous method of accounting and should consider filing an application for a change in accounting method (i.e., Form 3115, Application for Change in Accounting Method) to change to the correct method under Regs. Sec. 1.162-3 and obtain back-year audit protection. In addition, by voluntarily changing to a permissible method, taxpayers may spread any resulting increase in income over four tax years rather than realizing it all in one year if the method is changed under exam (see Rev. Procs. 2008-52 and 2002-18).
Rev. Proc. 2009-39
On August 27, 2009, the IRS released Rev. Proc. 2009-39 to amplify, clarify, and modify Rev. Proc. 2008-52. It added new Appendix Section 3.05 to Rev. Proc. 2008-52, which grants automatic consent to taxpayers to make a change to treat the cost of nonincidental materials and supplies on hand as a deferred expense to be taken into account in the tax year in which such items are actually consumed and used in operation, consistent with Regs. Sec. 1.162-3 (automatic change number 143). Previously, taxpayers had to apply for such a change using the nonautomatic consent procedures of Rev. Proc. 97-27.
Taxpayers that may want to consider making this change include those that are erroneously expensing the cost of non-incidental materials and supplies when purchased (e.g., in the case of spare parts that are kept on hand and tracked), treating nonincidental materials and supplies as inventory (e.g., in the case of a service provider that consumes supplies in the provision of its services and such supplies are not an income-producing factor), or capitalizing and depreciating the cost of nonincidental materials and supplies (e.g., in the case of uniforms). Further, taxpayers are permitted to make a concurrent change to include nonincidental materials and supplies as a cost subject to capitalization under a simplified uniform capitalization (UNICAP) method if not previously including these costs in the method.
Taxpayers eligible for automatic consent must generally file Form 3115 by the extended due date of the tax return for the year of change (see Sections 4 and 6 of Rev. Proc. 2008-52, as modified by Rev. Proc. 2009-39). It is important to note that taxpayers may not make a change to deduct incidental materials and supplies (e.g., office supplies) in the year of purchase under this new automatic consent provision. Such a change still requires the taxpayer to file a nonautomatic change request under Rev. Proc. 97-27 by the end of the year of change, subject to a $4,200 user fee (see Appendix A of Rev. Proc. 2010-1).
The rules governing nonincidental materials and supplies may be affected by the issuance of anticipated final regulations under Sec. 263(a) regarding the capitalization of expenditures related to tangible property. To the extent the final regulations are inconsistent with the current provisions of Regs. Sec. 1.162-3, taxpayers will be required to follow instructions in the final regulations or other published guidance to comply with the new rules governing materials and supplies in future tax years.
With the release of Rev. Proc. 200939, the IRS has simplified procedures as an incentive for taxpayers to correct erroneous methods of accounting for non-incidental materials and supplies. Taxpayers in this position should strongly consider filing an automatic change to comply with Regs. Sec. 1.162-3 while obtaining audit protection and a beneficial four-year spread period for any resulting increase in income.
Rick Klahsen is managing director, Tax Services, with RSM McGladrey, Inc., in Minneapolis, MN.
Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.
For additional information about these items, contact Mr. Klahsen at (952) 921-7630 or firstname.lastname@example.org.