Rev. Rul. 87-84

1987-2 C.B. 137, 1987-36 I.R.B. 4.

INVENTORIES; FULL ABSORPTION REGULATIONS; CASH BONUSES

Published: September 8, 1987

SECTION 471. - GENERAL RULE FOR INVENTORIES, 26 CFR 1.471-11: Inventories of manufacturers.

(Also Section 263-A; 1.263-1T(b)(2).)

  Inventories; full absorption regulations; cash bonuses. For tax years beginning before January 1, 1987, cash bonuses paid to production and production supervisory employees were direct or indirect labor costs, and should have been included in inventoriable costs under section 1.471- 11(b)(2)(i) or (c)(2)(i)(e) of the regulations without regard to their treatment for financial reporting purposes.

ISSUE

  For tax years beginning before January 1, 1987, whether the cash bonuses the taxpayer paid its production employees under the circumstances described below constituted employee benefits within the meaning of section 1.471- 11(c)(2)(iii)(c) of the Income Tax Regulations so that the taxpayer could have included or excluded such costs from inventoriable costs depending on the taxpayer's treatment of these costs for financial reporting purposes or whether such bonuses should have been included in inventoriable costs  under section 1.471-11(b)(2)(i) or (c)(2)(i)(e) without regard to their treatment for financial reporting purposes.

FACTS

  Taxpayer was a domestic corporation that was a manufacturer and used a calendar year taxable year. Taxpayer paid its employees semi- monthly on one of three bases: piece-work rate, hourly rate, or monthly salary. Production workers were primarily paid on a piecework basis. In addition, for many years taxpayer paid its production and production supervisory employees an annual bonus.

  The bonus reflected the overall incentive philosophy of the taxpayer and was designed to motivate employees and to increase the productivity and efficiency of the company's operations. The Employee Handbook, which was available to each employee, described the bonus as follows under the heading 'Incentive Compensation and Merit Rating':

           The Corporation has paid its production and production

      supervisory employees a substantial bonus for many years. The

      bonus, which is paid on the last day of December, is determined

      by the Board of Directors, based on the overall performance of

      the Corporation for the current calendar year. That is, there is

      no guarantee that the bonus will be paid in any given year;

      whether the bonus will be paid depends upon the success of the

      Corporation, which depends upon efficiencies created in

      production by you.

  The amount of bonus paid to an employee depended on the employee's compensation for the current calendar year and on the employee's merit rating on such factors as dependability, workmanship, output, creativity, and cooperation. Although there had never been an express contract, agreement, or guarantee of payment of the bonus in any year, taxpayer's long uninterrupted history of bonus payments had given rise to a general expectation that it would pay a bonus annually. There had never been any fixed formula for determining the total amount of money to be paid as a bonus to employees as a group or individually.

  The average hourly earnings (not including the bonus) of taxpayer's production and production-related workers were consistently higher than the average hourly earnings of other workers in taxpayer's industrial classification group in its geographical area. The cash bonus had approximated 50 percent of the regular payroll of the taxpayer during the period in which the bonus had been paid.

  Taxpayer computed its inventories in accordance with the full absorption method of inventory costing set forth in section 1.471-11 of the regulations. The taxpayer deducted the full amount of the cash bonus payments in the year of payment on its federal income tax returns. The taxpayer contended that this treatment was appropriate because these bonus payments were 'employee benefits' as described in section1.471-11(c)(2)(iii)(c) of the regulations and the taxpayer deducted such payments currently for financial reporting purposes.

LAW AND ANALYSIS

  Section 471 of the Internal Revenue Code provides that whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.

  Section 263A of the Code, as enacted by the Tax Reform Act of 1986, section 803(a), 1986-3 (Vol. 1) C.B. 267, provides for the nondeductibility of certain direct and indirect costs with respect to real or tangible personal property produced by the taxpayer and certain property acquired for resale. With respect to property that is inventory in the hands of the taxpayer, the direct costs of such property and such property's share of those indirect costs (including taxes) part or all of which are allocable to such property shall be included in inventory costs. Section 1.263A-1T(b)(2)(i) and (ii) of the Temporary Income Tax Regulations provides rules for determining what direct costs and indirect costs, respectively, are properly capitalized with respect to property that is produced or acquired for resale. Those provisions require that the taxpayer in the instant situation include these bonuses in its computation of its inventoriable costs for tax years beginning after December 31, 1986.

  On the other hand, for tax years not covered by section 263A of the Code and section 1.263A-1T of the temporary regulations, the relevant authority is section 1.471-11 of the regulations (the full absorption regulations). Thus, the following discussion addresses the proper tax treatment of these bonuses for tax years beginning prior to January 1, 1987.

  Section 1.471-11(a) of the regulations provides that in order to conform as nearly as may be possible 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 or in inventory at the close of the taxable year determined in accordance with the taxpayer's method of identifying goods in inventory.

  Section 1.471-11(b)(1) of the regulations provides that costs are considered to be production costs to the extent that they are incident to and necessary for production or manufacturing operations or processes. Production costs include direct production costs and fixed and variable indirect production costs.

  Section 1.471-11(b)(2)(i) of the regulations provides that 'direct production costs' are generally those production costs that are components of the costs of either direct material or direct labor. Direct labor costs include the costs of labor that can be identified or associated with particular units or groups of units of a specific product. The elements of direct labor costs include such items as basic compensation, overtime pay, vacation and holiday pay, sick leave pay (other than payments pursuant to a wage continuation plan under section 105(d)), shift differential, payroll taxes, and payments to a supplemental unemployment benefit plan paid or incurred on behalf of the employees engaged in direct labor. Section 1.471- 11(b)(2)(ii) provides that under the full absorption method, a taxpayer must take into account in inventoriable costs all items of direct production cost.

  Section 1.471-11(b)(3)(i) of the regulations provides that the term 'indirect production costs' includes all costs that are incident to and necessary for production or manufacturing operations or processes other than direct production costs.

  Section 1.471-11(c)(1) of the regulations states that, except as provided in section 1.471-11(c)(3) (not relevant here), in order to determine whether indirect production costs referred to in section 1.471-11(b) must be included in a taxpayer's computation of the amount of inventoriable costs, three categories of costs have been provided in subparagraph (2). Regardless of their treatment by the taxpayer in its financial reports, costs described in section 1.471- 11(c)(2)(i) must be included in the taxpayer's computation of the amount of inventoriable costs, and costs described in section 1.471- 11(c)(2)(ii) need not enter into the taxpayer's computation of the amount of inventoriable costs. Finally, costs listed in section 1.471-11(c)(2)(iii) must be included in, or excluded from, the taxpayer's computation of the amount of inventoriable costs in accordance with the treatment of those costs by the taxpayer in its financial reports and generally accepted accounting principles. In the case of costs that are not included in subdivision (i) or (ii) of section 1.471- 11(c)(2), nor listed in section 1.471-11(c)(2)(iii), whether such costs must be included in or excluded from the computation of inventoriable costs for tax purposes depends upon the extent to which such costs are similar to costs included in subdivision (i) or (ii), and if such costs are dissimilar to costs in subdivision (i) or (ii), these costs shall be treated as included in or excludable from the amount of inventoriable costs in accordance with section 1.471-11(c)(2)(iii).

  Indirect labor and production supervisory wages are costs described in section 1.471-11(c)(2)(i) of the regulations and thus must be included in the taxpayer's computation of inventoriable costs. Included in the cost of indirect labor and production supervisory wages are basic compensation, overtime pay, vacation and holiday pay, sick leave pay (other than payments pursuant to a wage continuation plan under section 105(d)), shift differential, payroll taxes, and contributions to a supplemental unemployment benefit plan. See section 1.471-11(c)(2)(i)(e).

  Included in the costs listed in section 1.471-11(c)(2)(iii) are employee benefits. Section 1.471-11(c)(2)(iii)(c) defines employee benefits as follows:

      Pension and profit-sharing contributions representing current

      service costs otherwise allowable as a deduction under section

      404, and other employee benefits incurred on behalf of labor

      incident to and necessary for production or manufacturing

      operations or processes. These other benefits include workmen's

      compensation expenses, . . . amounts of a type which would be

      includible in the gross income of employees under nonqualified

      pension, profit-sharing and stock bonus plans, premiums on life

      and health insurance and miscellaneous benefits provided for

      employees such as safety, medical treatment, cafeteria,

      recreational facilities, membership dues, etc., which are

      otherwise allowable as deductions under chapter 1 of the Code.

  Lincoln Electric Company v. Commissioner, 444 F.2d 491 (6th Cir. 1971), aff'g 54 T.C. 926 (1970), involved a similar bonus plan with respect to tax years predating the promulgation of section 1.741-11 of the regulations by T.D. 7285, 38 F.R. 26184 (September 14, 1973). Although Lincoln Electric does not interpret the full absorption regulations, they should be construed in light of the holding in that case. In Lincoln Electric, the United States Tax Court held that, in order clearly to reflect income pursuant to sections 446 and 471 of the Code, the taxpayer's bonus payments allocable to production and production- oriented workers must be included in inventoriable costs. The court stated that probably the most significant reason for treating the bonus as an inventoriable cost was that it derived from production. An additional basis for the holding was a finding by the Tax Court that the bonus represented a distribution that was obligatory rather than discretionary. Although payment of the bonus was at the discretion of the Board of Directors, the court noted that the taxpayer consistently paid it over a 30-year period resulting in an understanding between taxpayer and its employees that it would pay an annual bonus. In affirming the judgment of the Tax Court, the Sixth Circuit concluded that, regardless or whether payment of the bonus was obligatory, the bonus payments must be regarded as compensation for labor performed and necessarily a direct or indirect cost of labor with respect to which allocable portions should be included in inventory in a manner similar to overtime pay, vacation pay, and payroll taxes.

  In the instant situation, taxpayer's bonuses paid to its production employees and production supervisory employees were compensation for production work. See Lincoln Electric. Except to the extent excluded under section 1.471- 11(c)(2)(ii) or (iii), all compensation for production is included in the cost of direct or indirect labor under section 1.471-11(c)(2)(i) or section 1.471- 11(c)(2)(i)(e). Thus, the issue is whether the bonuses were properly characterized as 'employee benefits' under section 1.471- 11(c)(2)(iii)(c), and thus excluded from section 1.471-11(b)(2)(i) or section 1.471-11(c)(2)(i)(e).

  The bonuses that the taxpayer paid in the instant situation do not come within the ambit of section 1.471-11(c)(2)(iii)(c) of the regulations as 'employee benefits.' The term 'employee benefits,' as used in the regulations, is limited to certain noncash and similar benefits and deferred compensation. The bonus paid by the taxpayer was cash compensation that was in no sense deferred compensation. See generally section 404(a)(5) and (b) of the Code and the regulations thereunder. Even assuming the bonus was sufficiently dependent on corporate profits to constitute a form of profit-sharing, it was not deferred compensation and therefore was not paid pursuant to a nonqualified profit-sharing plan within the meaning of section 1.471- 11(c)(2)(iii)(c) of the regulations. Thus, the arrangement does not fall under section 1.471- 11(c)(2)(iii)(c).

  Moreover, the size of the bonuses that the taxpayer paid in relation to the employees' overall compensation and the regularity with which the bonuses were paid suggest that the bonuses played an integral role in the determination of the basic compensation of production employees. Thus, based on the foregoing, the bonuses constituted a direct production cost under section 1.471- 11(b)(2)(i) of the regulations.

HOLDING

  The bonuses taxpayer paid to its production and production supervisory employees were direct or indirect labor costs, not costs ('employee benefits ') described in section 1.471-11(c)(2)(iii) of the regulations. Therefore, the taxpayer should have included these bonuses in its computation of the amount of its inventoriable costs as required by section 1.471-11(b)(2)(i) or 1.471- 11(c)(2)(i)(e). For tax years beginning after December 31, 1986, the taxpayer must include these bonuses in its computation of its inventoriable costs pursuant to section 1.263A-1T(b)(2) of the temporary regulations.

  Any change in a taxpayer's method of accounting for cash bonuses from not allocating them to inventory to treating them under either section 1.471- 11(b)(2)(i) or section 1.471-11(c)(2)(i)(e) (or under section 1.263A-1T(b)(2) of the temporary regulations for tax years beginning after December 31, 1986) as required by this revenue ruling is a change in method of accounting. Accordingly, the provisions of sections 446 and 481 of the Code and the regulations thereunder apply.

Rev. Rul. 87-84, 1987-2 C.B. 137, 1987-36 I.R.B. 4