Internal Revenue Service
Revenue Ruling
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smRev. Rul. 79-25
1979-1 C.B. 186
Section 61
Section 471
IRS Headnote
Inventory costing rules; adoption of full absorption method. Taxpayers adopting the full absorption method of inventory costing and wishing to include in the computation of inventoriable costs some or all of the costs listed in section 1.471-11(c)(2)(ii) of the regulations that were previously excluded must establish to the satisfaction of the Service that income will be more clearly reflected by including these costs.
Full Text
Rev. Rul. 79-25
ISSUE
Does a taxpayer that is adopting a full absorption method of inventory costing as required by section 1.471-11 of the Income Tax Regulations have a right to change from a method of accounting that does not provide for the inclusion in inventory of a cost(s) listed in section 1.471-11(c)(2)(ii) to a method that provides for such inclusion?
FACTS
The taxpayer is a manufacturer that is electing to adopt a full absorption of inventory costing in 1979, and with the application to the Internal Revenue Service containing the election, the taxpayer asserts a right to include marketing and advertising costs listed in section 1.471-11(c)(2)(ii) of the regulations as inventoriable costs. The taxpayer's present inventory costing method does not provide for the inclusion of such costs as inventoriable costs.
The taxpayer contends that section 1.471-11(c)(2) of the regulations gives a taxpayer that adopts a full absorption method of inventory costing the right to include any cost listed in section 1.471-11(c)(2)(ii) in inventoriable costs and to subsequently exclude such costs, as the taxpayer determines appropriate.
LAW AND ANALYSIS
Section 471 of the Internal Revenue Code of 1954 provides that whenever the Secretary determines that a taxpayer should use inventories to clearly determine the taxpayer's income, the taxpayer shall use inventories on such basis as the Secretary prescribes as conforming to the best accounting practice and as most clearly reflecting the taxpayer's income.
Section 1.471-11(a) of the regulations provides that in order for a manufacturer or producer to conform to the best accounting practices and to clearly reflect income (as required by section 471 of the Code), both direct and indirect production costs must be taken into account in the computation of inventoriable costs in accordance with the "full absorption" method of inventory costing. Under the full absorption method of inventory costing, production costs must be allocated to goods produced during the taxable year, whether sold during the taxable year or in inventory at the close of the taxable year. The taxpayer must include as inventoriable costs all direct production costs and, to the extent provided by paragraphs (c) and (d) of section 1.471-11, all indirect production costs.
Section 1.471-11(c)(2) of the regulations contains three categories of indirect production costs: (i) those costs that are inventoriable regardless of the taxpayer's treatment of such costs in its financial reports, (ii) those costs that are not required to be included for tax purposes in the computation of inventoriable costs regardless of the taxpayer's treatment of such costs in its financial reports, and (iii) those costs that are to be included or excluded as inventoriable costs in accordance with the taxpayer's treatment of such costs in its financial reports and generally accepted accounting principles.
Section 1.471-11(c)(2)(ii) of the regulations contains two sentences. The first sentence is a list of 13 examples of costs (hereinafter Cat. (ii) cost(s) that for tax purposes are not required to be included in the computation of inventoriable costs. The second sentence provides that notwithstanding the provision that taxpayers are not required to include any of the costs listed in the previous sentence in their computation of inventoriable costs, if a taxpayer consistently includes any such costs in such computation, a change in such method of inclusion shall be considered a change in method of accounting within the meaning of sections 446 and 481 of the Code and section 1.471-11(e)(4).
Thus, section 1.471-11(c)(2)(ii) of the regulations provides that a taxpayer cannot be required to include a Cat. (ii) cost in inventoriable costs, but if a taxpayer has been consistently including one or more of such listed costs in its computation of inventoriable costs, such inclusion is considered to be a method of accounting that cannot be changed without permission from the Service. The inclusion of any Cat. (ii) cost where a taxpayer has been excluding such cost from inventoriable costs would also be a change in accounting method within the meaning of sections 446 and 481.
The inventory treatment of some Cat. (ii) costs may be specifically dealt with in certain other regulations or in publications of the Service. The treatment as an inventoriable cost is controlled by the specific provision. For example, sections 1.61-3(a) and 1.471-3(c) of the regulations provide that two manufacturer's costs, selling expenses and losses (that also happen to be Cat. (ii) costs) are not allowed to be included in inventoriable costs.
Section 1.471-11(c)(2)(ii) of the regulations does not provide a taxpayer that adopts a full absorption method of accounting with a right to include a cost listed therein in the computation of inventoriable costs. Regulations section 1.471-11(c)(2) indicates that Cat. (ii) costs ordinarily should not be included in inventoriable costs. The regulations implicitly recognize that the exclusion of Cat. (ii) costs from a taxpayer's inventoriable costs will not distort income, except in unusual cases.
HOLDING
A taxpayer that wishes to include Cat. (ii) cost(s) in inventory must establish to the satisfaction of the Service that its income will be more clearly reflected by including the particular Cat. (ii) cost in its inventoriable costs. Unless this is established the Service will not permit a taxpayer to change its method of accounting to include any Cat. (ii) cost in inventoriable costs.