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Federal Register / Vol. 86, No. 2 / Tuesday, January 5, 2021 / Rules and Regulations accordance with the taxpayers accounting procedures. For purposes of the non-AFS section 471c inventory method, an inventory cost is a cost of production or resale that the taxpayer capitalizes to inventory property produced or property acquired for resale in its books and records, except as provided in paragraph b6ii of this section. Costs that are generally required to be capitalized to inventory under section 471a, but that the taxpayer does not capitalize in its books and records are not required to be capitalized to inventory. However, an inventory cost does not include a cost that is neither deductible nor otherwise recoverable but for paragraph b5 of this section, in whole or in part, under a provision of the Internal Revenue Code for example, section 162c, e, f, g, or 274. In lieu of the inventory method described in section 471a, a taxpayer using the non-AFS section 471c inventory method recovers its applicable costs through its book inventory method of accounting. A
taxpayer that has an AFS for such taxable year may not use the non-AFS
section 471c inventory method.
ii Timing and amounts of costs.
Notwithstanding the timing of costs reflected in the taxpayers books and records, a taxpayer may not recover any costs that have not been paid or incurred under the taxpayers overall method of accounting, as described in 1.4461c1. For example, in the case of an accrual method taxpayer or a taxpayer using an accrual method for purchases and sales, inventory costs must satisfy the all events test, including economic performance, under section 461h. See 1.4461c1ii, and section 461 and the accompanying regulations.
iii Examples. The following examples illustrate the rules of paragraph b6 of this section.
A Example 1. Taxpayer E is a C
corporation that is engaged in the retail trade or business of selling beer, wine, and liquor. In 2019, E has average annual gross receipts for the prior 3taxable-years of $15 million and is not otherwise prohibited from using the cash method under section 448a3. E
does not have an AFS for the 2019
taxable year. E is eligible to use the nonAFS section 471c inventory method of accounting. E uses the overall cash method, and the non-AFS section 471c inventory method of accounting for Federal income tax purposes. In Es electronic bookkeeping software, E
treats all costs paid during the taxable year as presently deductible. As part of its regular business practice, Es employees take a physical count of
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inventory on Es selling floor and its warehouse on December 31, 2019, and E uses this physical count as part of its books and records for purposes of capitalizing and allocating costs to inventory. E also makes representations to its creditor of the cost of inventory on hand for specific categories of product it sells. E may not expense all of its costs paid during the 2019 taxable year because its books and records do not accurately reflect the inventory records used for non-tax purposes in its regular business activity. Instead, E must use the physical inventory count taken at the end of 2019 to determine how its capitalized costs are allocated and recovered.
B Example 2. Same facts as Example 1 in paragraph b6iiiA of this section but E does not use the physical count to capitalize and allocate costs to inventory and does not make any representations about inventory on hand to any creditors. Although E pays or incurs costs that are generally required to be capitalized to inventory under section 471a, because such costs are not capitalized to inventory in Es books and records, they are not required to be capitalized to inventory under paragraph b6i of this section.
C Example 3. Same facts as Example 1 in paragraph b6iiiA of this section but E does not use the physical count to capitalize and allocate costs to inventory in its electronic bookkeeping software and does not make any representations about inventory on hand to any external parties. E does use the physical count to value inventory on hand for internal reports to its shareholders. The internal reports to its shareholders are part of Es books and records and must be taken into account for Es non-AFS section 471c inventory method. E recovers its inventory costs consistent with its non-AFS section 471c inventory method.
D Example 4. Taxpayer F is a C
corporation that is engaged in the manufacture of baseball bats. In 2019, F
has average annual gross receipts for the prior 3-taxable-years of less than $25
million and is not otherwise prohibited from using the cash method under section 448a3. F does not have an AFS for the 2019 taxable year. For Federal income tax purposes, F uses the overall cash method of accounting, and the non-AFS section 471c inventory method of accounting. For its books and records, F uses an overall accrual method and maintains inventories. In December 2019, Fs financial statements show $500,000 of direct and indirect material costs. F pays its supplier in January 2020. Under paragraph b6ii
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of this section, F recovers its direct and indirect material costs in 2020.
E Example 5. Taxpayer G is a baker that reports its baking trade or business on Schedule C, Profit or Loss From Business, of the Form 1040, Individual Tax Return. In 2020, Gs baking business has average annual gross receipts for the prior 3-taxable years of less than $100,000 and is not otherwise prohibited from using the cash method under section 448a3. G does not have an AFS for the 2020 taxable year. For Federal income tax purposes, G uses the overall cash method of accounting and the non-AFS section 471c inventory method. In Gs books and records for 2020 that properly reflects its business activities for non-tax purposes, G
capitalizes the cost of its cookie ingredients to inventory but immediately expenses the cost of labor for Gs employee who bakes the cookies.
Under paragraphs b6i and ii of this section, G treats as an inventory cost the cost of its cookie ingredients and recovers such costs in accordance with the accounting procedures used to prepare its books and records, or, if later, when paid. Additionally, although the cost of direct labor is generally required to be capitalized to inventory under section 471a, because such cost is not capitalized to inventory in Gs books and records, it is not required to be capitalized to inventory under paragraph b6i of this section.
Further, because such direct labor cost is generally deductible under section 162, and not otherwise required to be capitalized under section 263a, G may deduct the cost of labor in the year G
pays that expense.
F Example 6. Taxpayer H is a partnership engaged in the resale of beer, wine, and liquor. In 2020, H has average annual gross receipts for the prior 3-taxable-years of less than $25
million and is not otherwise prohibited from using the cash method under section 448a3. H does not have an AFS for the 2020 taxable year. For Federal income tax purposes, H uses the overall cash method of accounting, and the non-AFS section 471c inventory method of accounting. For its books and records, H uses the overall cash method.
As part of its regular business practice, Hs employees take regular physical counts of the inventory on the shop floor and in the storeroom, however Hs method of accounting for inventory for its books and records does not allocate costs between ending inventory and cost of goods sold, and instead expenses the cost of the inventory in the year it was paid for. Prior to December 2020, H
acquires and pays for $500,000 of beer, wine, and liquor. In addition, on
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