Wednesday, October 22, 2014

IRS to Restaurants: Comply with UNICAP!

On September 26, 2014, the Service released Chief Counsel Advice 201439001 on restaurants' UNICAP compliance. Historically, few restaurants complied with UNICAP. This led to LB&I examining a number of restaurants on this issue.  In this memo, Chief Counsel advised the Field that restaurants willing to adopt a reasonable facts-and-circumstances UNICAP method should not be required to use the Simplified Production Method.

Background: Section 263A requires certain taxpayers to capitalize additional costs into inventory. Even though section 263A was enacted as part of the Tax Reform Act of 1986 and final UNICAP regulations were adopted in 1993, some industries continue to have high rates of UNICAP non-compliance. Restaurants are the textbook example.

Under prior law, the restaurant industry failed to qualify as a manufacturer under the former Investment Tax Credit and successfully avoided classification as a manufacturer under the full absorption inventory capitalization regulations. This changed with the enactment of UNICAP in 1986. As relevant here, UNICAP requires producers to capitalize additional section 263A costs. Production is defined broadly enough to include restaurants that prepare food for sale. In recent years, the Service has stepped up its enforcement activity in this area. This increased examination activity led to this chief counsel advice memo.

In this CCA, the Service describes how restaurants maintain inventories of raw materials and expend significant sums on kitchen labor ("back-of-the-house" costs). Under the Simplified Production Method, all of the back-of-the-house costs allocable to production would be capitalized to the ending raw material inventory based on overall inventory turns. Using a facts-and-circumstances UNICAP method, a restaurant could allocate these costs just to the finished goods inventory. Since restaurants rarely have finished goods inventories, these costs would be expensed via cost of goods sold. Chief Counsel advised the Field that it would not support forcing restaurants on the Simplified Production method if the restaurants are willing to adopt a reasonable facts-and-circumstances UNICAP. Chief Counsel went on to note that restaurants may come in for accounting method changes to either use a reasonable facts-and-circumstances UNICAP method or to treat back-of-the-house production costs as section 471 costs and use the Simplified Production Method.

Practitioner Insights:
  • Chief Counsel assumed that the restaurants were producers. Though highly unlikely, some "restaurants" may not be producers.
  • Treating the back-of-the-house production costs as section 471 costs or adopting a facts-and-circumstances UNICAP method using actual costs are both non-automatic accounting method changes that require filing the method change during the year of change and paying the Service a $7,000 user fee. (Taxpayers with less than $1 million in gross receipts would generally qualify to use the cash method under Rev. Proc. 2001-10 and are exempt from UNICAP.)
  •  Restaurants could use the automatic consent change procedures to adopt a burden rate method, but would have to use predetermined burden rates and capitalize any variances. This increases the complexity and number of UNICAP calculations each year.
  • Though the Service can put taxpayers on the most disadvantageous, permissible tax accounting method, it does not have to do so. This CCA announces to the Field and to Appeals that a reasonable facts-and-circumstances UNICAP method should be accepted. 
  • When I have run across this issue in practice, the use of a facts-and-circumstances UNICAP method can reduce the additional section 263A costs capitalized to ending inventory by up to 90%. If a smaller restaurant treats back-of-the-house labor costs as section 471 costs, it could completely eliminate the additional costs capitalized to ending inventory.
If you have any questions, please feel free to reach out to me at +1 (202) 681-6359.

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