Unveiling the Truth About Section 471(c)

Well 471(c).  Nobody knows if it’s a godsend or a tax trap, and I’ve been quiet on this subject, but I’ve been getting questions about it recently, so I decided I’d state my piece.

So what is 471(c)?

Well, 471(c) says that a small business with less than $25 million in average gross receipts for the last 3 years can calculate inventory consistent with its own accounting procedures, assuming it doesn't have applicable financial statements.

This means, theoretically, taxpayers could classify operating expenses as inventory, and then eventually cost of goods sold.  The ordinary taxpayer subject to IRC 162 would have very little benefit in doing something like this, since cost of goods sold can only be recognized with sales, while operating expenses are recognized when incurred.

However, some companies may prefer COGS to operating expenses.  For example, a cannabis company subject to 280E, which as we all know disallows ordinary deductions and credits, might like to put operating expenses into inventory. 

This would be very compelling to the taxpayer looking to reduce taxes from 280E, as it would seem to imply that a once can write off expenses that are normally disallowed, so long as they base their books on the subjective standards of IRC 471(c)

The thing is that the IRS has specifically said that they do not interpret IRC 471(c) as allowing taxpayers to reduce taxable income with ordinarily disallowed items, but the code’s language does seem to imply that it is possible.  So it’s a gray zone.  And nobody really knows what’s going to happen with this one.

Historically speaking, the IRS tends to win court cases like these, and there hasn’t been any way to dramatically reduce the impact of 280E yet.  But you never know, and there hasn’t been a court case that we can reference on this position yet.  So claiming this exposes a taxpayer to audit risk, but looks potentially appealing.  

So should you do it?

Well, you can find any answer to that question that you want.

Most CPAs will tell you not to do it, while some attorneys will hype you up with potential tax savings.  The attorney wants to go to court.  The accountant wants to be safe. 

Personally, I wouldn't file a 471(c) return.   However I'm not going to say that the position is a yes-or-no black-and-white always-or-never decision.

I'd say the main drivers are:

1) is the worst-case scenario affordable?

2) is the best-case scenario truly compelling?

Defending a position like this can be costly, and you will likely need to defend it.  A 471(c) claimant must be prepared for IRS negotiations at the least, possible tax courts, and losing the position at the worst.  If the business can't afford these outcomes, it's not a viable strategy.

But for a business that can afford high back taxes, interest, penalties, and legal fees, are the tax savings high enough to justify the effort of taking this position?  Some companies already claim high COGS in totally legal methods, so adding another 5-10% to COGS, for example, might not really justify the drama of audits and tax courts.

But if the worst-case scenario is affordable and the best-case scenario is truly compelling then it may make sense for a taxpayer to take an approach like this.  That said, a company that can afford to eat losses like that probably won’t meet the under $25 million dollar gross receipts test anyway.

So in general, for around 97.8%, of taxpayers this is probably not a reasonable approach.  But there are cases where it could be sensible to do something like this, (although even then it's probably just as viable not to do it).

And that's my opinion on this.  Again if you're looking for somebody to file for 471c tax return, I’m not your guy.  But if you're looking for someone to help grow your business, then reach out today and see how we can help.