Reseller's inventory cost is limited to acquisition costs

Plain-English summary

A small reseller valued inventory at cost under Section 471 but did not use a Section 471(c) method or apply Section 263A. The IRS advised that the reseller may capitalize only the goods' net invoice price and transportation or other necessary charges incurred to obtain possession. Purchasing, storage, handling, inspection, packaging, preparation, labor, and selling costs are not part of inventory cost under this method. They may instead be deducted as period costs if otherwise incurred and deductible. The advice does not address the different capitalization rules that would apply under Sections 263A or 471(c).

Ruling snapshot

• Question: Which costs may a reseller capitalize when it values purchased inventory at cost under Section 471 without applying Sections 263A or 471(c)?
• Outcome: Advice. Capitalization is limited to net invoice price and necessary acquisition charges.
• Key authorities: IRC §§ 263A, 461, and 471; Treas. Reg. §§ 1.471-1, 1.471-2, and 1.471-3

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       Memorandum
       Number: 202114019
       Release Date: 4/9/2021
       CC:ITA:B06:EKHewitt
       PRENO-122497-20

UILC: 471.00-00, 471.03-00

date: January 23, 2021

 to:   Luke D. Ortner
       Attorney (Denver, Group 3)
       (Small Business/Self-Employed)

from: John P. Moriarty
Associate Chief Counsel
(Income Tax & Accounting)

subject: Costs Permissibly Capitalized to Inventories for Resellers under Section 471

       You have asked for our advice concerning what costs may a reseller appropriately
       capitalize to goods acquired for resale if a taxpayer is taking inventories under section
       471 of the Internal Revenue Code and the corresponding Income Tax Regulations.
       This Chief Counsel Advice memorandum responds to your request for advice. This
       advice may not be used or cited as precedent.

                                                FACTS

       For purposes of the analysis set forth below, assume the following facts:

       Taxpayer is organized as a C corporation for purposes of Federal income taxation and
       is not classified as a tax shelter (as such term is defined in section 448(d)(3) of the
       Internal Revenue Code). Taxpayer’s average annual gross receipts for the 3-taxable-
       year period ending with the taxable year prior to the current taxable year is $4,000,000.

       Taxpayer has a single trade or business, as defined in section 446(d) of the Code, in
       which it purchases and resells units of tangible personal property (hereinafter referred to
       as “goods”) that constitute merchandise (as such term is used in section 471 of the
       Code and the applicable regulations) in the hands of Taxpayer. Taxpayer does not
       produce any of the goods itself nor does it engage in any production activities on behalf
       other entities.

PRENO-122497-20 2

In purchasing and reselling the goods, Taxpayer incurs various costs. These costs
include costs of acquiring ownership and possession of the goods (the purchase price
of the goods and the cost of shipping the goods from the producer of the goods to
Taxpayer, plus certain other necessary charges incurred in acquiring possession of the
goods) (hereinafter, the “acquisition costs”), as well as, certain purchasing costs, certain
storage and handling costs, costs of preparing the goods for resale (including inspection
costs, packaging costs, and the labor associated with these activities) and of reselling
the goods (selling expenses, including associated labor costs).

Taxpayer takes inventories of its goods as required under section 471(a) of the Code
and values its goods at cost. Although Taxpayer meets the gross receipts test in
section 448(c), Taxpayer does not account for its inventories under any of the methods
set forth in section 471(c) of the Code. Furthermore, Taxpayer meets the gross receipts
test in section 448(c) and does not apply the rules in section 263A of the Code (or the
associated Regulations) in determining the costs that it capitalizes to the goods in its
inventory or the manner in which it allocates costs to the goods.

                                      ISSUE

What costs may Taxpayer capitalize to goods in its inventory if Taxpayer is taking
inventories pursuant to section 471 and its regulations and if such inventory is solely
comprised of goods that are purchased and resold by Taxpayer?

                                  CONCLUSION

Because Taxpayer is not applying section 263A or section 471(c) in determining the
cost of its inventory, it may only include the invoice price of the resale goods (less trade
or other discounts, except strictly cash discounts approximating a fair interest rate,
which may be deducted or not at the option of the taxpayer, provided a consistent
course is followed) and the transportation or other necessary charges incurred in
acquiring possession of the goods.

                                       LAW

Under section 471(a) of the Internal Revenue Code, “[w]henever 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.”

Under section 1.471-1(a) of the Income Tax Regulations, “. . . in order to reflect taxable
income correctly, inventories at the beginning and end of each taxable year are
necessary in every case in which the production, purchase, or sale of merchandise is an
income-producing factor.”
PRENO-122497-20 3

Section 1.471-2 of the Regulations sets forth that a taxpayer’s inventories are generally
valued at cost, with certain exceptions for taxpayers permitted to value inventories at
the lower of cost or market and for “subnormal” goods (that is, goods in an inventory
which are unsalable at normal prices or unusable in the normal way because of
damage, imperfections, shop wear, changes of style, odd or broken lots, or other similar
causes, including second-hand goods taken in exchange). See section 1.471-2(c). In
order to value inventories at cost, a taxpayer capitalizes to goods in its inventory those
costs determined by the Regulations to constitute a part of the total “cost” of those
goods. The sum of all costs capitalized to a good constitutes the “cost” of that good.

Section 1.471-3 of the Regulations defines how the “cost” of a taxpayer’s inventories is
determined; specifically, by defining what costs make up the “cost” of the goods of
which the taxpayer takes an inventory. In the case of goods on hand at the beginning of
the year that was produced or purchased in a previous taxable year, section 1.471-3(a)
states that cost is defined as “the inventory price of such goods.” The cost of goods that
a taxpayer produces or acquires during the taxable year (as well as the “inventory price”
of the goods on hand at the beginning of the taxable year) is determined by different
rules, depending on whether the goods were produced by the taxpayer or purchased by
the taxpayer for resale.

Under section 1.471-3(b), for goods purchased for resale:

  Cost means . . . the invoice price less trade or other discounts, except
  strictly cash discounts approximating a fair interest rate, which may be
  deducted or not at the option of the taxpayer, provided a consistent course
  is followed. To this net invoice price should be added transportation or
  other necessary charges incurred in acquiring possession of the goods.
  But see section 1.263A-1(d)(2)(iv)(C) for special rules for certain direct
  material costs that in certain cases are permitted to be capitalized as
  additional section 263A costs by taxpayers using a simplified method
  under section 1.263A-2(b) or (c) or section 1.263A-3(d). For taxpayers
  acquiring merchandise for resale that are subject to the provisions of
  section 263A, see sections 1.263A-1 and 1.263A-3 for additional amounts
  that must be included in inventory costs.

Broadly summarized, section 1.471-3(b) defines the cost of goods purchased for resale
to be the sum of the purchase price of the goods (less certain discounts) and costs
incurred to acquire possession of the goods (i.e. transportation or other necessary
charges incurred in acquiring possession of the goods.)

                                   ANALYSIS

Because Taxpayer purchases and resells goods that constitute merchandise, Taxpayer
is required to take inventories of its goods pursuant to section 471(a) of the Code and
PRENO-122497-20 4

section 1.471-1(a) of the Regulations.1 In taking an inventory under section 471, the
regulations under 1.471-2 require Taxpayer to “value” the goods for which it is taking an
inventory. The section 1.471-2 regulations set forth certain permissible methods of
valuation, including valuing inventories “at cost.” Section 1.471-3 defines what it
“means” for inventories to be valued at cost.

The term “means” as used in section 1.471-3 indicates that the language that follows
such term in section 1.471-3 is intended to be an exclusive, rather than illustrative, list of
costs that constitute the “cost” of goods when a taxpayer values such goods at cost
under section 1.471-2. The Supreme Court has explained that “[a]s a rule, a definition
which declares what a term ‘means’ . . . excludes any meaning that is not stated.”
Burgess v. United States, 553 U.S. 124, 130 (2008) (quoting Colautti v. Franklin, 439
U.S. 379, 392–393, n.10 (1979)). The best reading of the regulation, therefore, is that
the term “cost” as used in section 1.471-3(b) for a taxpayer that purchases and resells
goods means “the invoice price less trade or other discounts” plus “transportation or
other necessary charges incurred in acquiring possession of the goods.” Thus, section
1.471-3(b) does not permit the capitalization of additional amounts beyond the amount
that constitutes the cost of such inventories under such section; instead, the regulations
specify exactly how the cost of certain goods in inventory must be determined. 2

As such, because Taxpayer values its goods at cost, Taxpayer must determine the cost
of its goods pursuant to the applicable rules in section 1.471-3(b) of the Regulations.
Therefore, under Taxpayer’s facts, the amounts that Taxpayer capitalizes to determine
the cost of its goods are the invoice price of the goods that it purchases, plus the
transportation costs and the other necessary charges Taxpayer incurred in having the
goods shipped from the producer (Taxpayer’s “acquisition costs”). These are the
amounts that Taxpayer incurred that are described in section 1.471-3(b) as constituting
the “cost” of Taxpayer’s goods.

All other amounts incurred by Taxpayer, including the purchasing costs, the storage and
handling costs, the costs of preparing the goods for resale, including any inspection
costs, packaging costs, and the labor associated with these activities, and selling
expenses, including the associated labor, are not considered to be part of the “cost” of
the merchandise under section 1.471-3(b). As such, these amounts are not permissibly
capitalizable pursuant to the rules for determining cost under section 1.471-3(b) as they
are not part of the “cost” of the goods as defined under section 1.471-3(b), but may
instead be deducted as period costs assuming that such costs have been incurred
under section 461 of the Code and are permissibly deductible under a section of the
Code and/or the Regulations.

1 This statement would be inapplicable if a taxpayer permissibly chooses to account for its inventory using

a method described in section 471(c) of the Code (and the applicable Regulations).
2 This analysis is not applicable to the capitalization of costs by taxpayers under sections 1.471-3(c) and

1.471-11 to property produced, and under authorities such as Adolph Coors Co. v. Commissioner, 519
F.2d 1280 (10th Cir., 1975) cert. denied 423 U.S. 1087. The treatment of such taxpayers is beyond the
scope of this memorandum.
PRENO-122497-20 5

Taxpayer does not apply the rules in section 263A of the Code (or the associated
Regulations) in determining the costs that it capitalizes to the goods in its inventory or
the manner in which it allocates costs to the goods. Therefore, the sentences in section
1.471-3(b) coordinating such section with the rules under section 263A and its
corresponding regulations do not apply to Taxpayer. Further, this Chief Counsel Advice
neither expresses nor implies any opinion concerning what additional costs would be
permitted or required to be capitalized to the goods had Taxpayer applied the rules
under section 263A and its regulations.3

Also, because Taxpayer is not using a method of accounting described in section 471(c)
of the Code, this Chief Counsel Advice neither expresses nor implies any opinion about
what costs would be permitted or required to be capitalized to the goods had Taxpayer
applied the rules under section 471(c).

Finally, if Taxpayer desires to change its method of accounting, Taxpayer must obtain
permission from the Commissioner using either the automatic or advance consent
accounting method change procedures described in Rev. Proc. 2015-13 to change its
method of accounting.4

Please call Evan K. Hewitt at (202) 317-7007 if you have any further questions.

3 It should be noted that for taxpayers applying the rules under section 263A, “section 471 costs” and

“additional section 263A costs” are terms of art under section 263A with specific rules for identifying which
costs fall in one of those two categories; consequently, the specific costs a taxpayer capitalizes under
section 471 as described in this Chief Counsel Advice do not necessarily correspond to the specific costs
treated as “section 471 costs” for taxpayers applying section 263A.
4 For example, if Taxpayer desires to change to a method of accounting that applies the rules under

section 263A and the corresponding regulations and/or incorporates a method of accounting described in
section 471(c).