Press Release

Operation Fraud Street Mafia Results Announced: Nine Arrested for Drug Trafficking and Committing More Than $550 Million in Attempted Tax Fraud

Friday, February 23, 2024

For Immediate Release

U.S. Attorney's Office, Eastern District of California

Over 180 pounds of methamphetamine, 14 pounds of fentanyl, 9.5 pounds of heroin, and 8.5 pounds of cocaine seized

FRESNO, Calif. — As a result of Operation Fraud Street Mafia, a Kern Valley State Prison (KVSP) inmate has been charged in two separate federal complaints with drug trafficking and COVID-19 fraud. Seven defendants in California and Maryland are also charged in the two schemes.

Making the announcement today are U.S. Attorney Phillip A. Talbert, DEA Special Agent in Charge Brian M. Clark, Acting Special Agent in Charge Mark Remily of the FBI Sacramento Field Office, and IRS Criminal Investigation Oakland Field Office Acting Special Agent in Charge Michael Mosley.

“It is remarkable that a prison inmate coordinated with others on the outside to distribute over 100 pounds of methamphetamine into the community,” said U.S. Attorney Talbert. “But that apparently was not enough: he also conspired to pursue over half a billion dollars in federal tax credits that were meant to help struggling businesses during the COVID-19 pandemic. The U.S. Attorney’s Office is committed to combatting organized crime whether it is drug trafficking or theft of taxpayer money, and whether it is committed inside or outside of prisons.”

“This extensive drug trafficking investigation exposed a massive fraud operation being conducted from behind bars. As a prison inmate engineered a criminal network from coast to coast to peddle poison, law enforcement put their collective authorities together to dismantle this organization brick by brick,” said DEA Special Agent in Charge Clark. “Strong law enforcement partnerships built on action are an invaluable tool to ensure prison is no longer a place where violent criminals can operate without consequence.”

“I applaud the work of our California COVID-19 Fraud Strike Force and the hard-working prosecutors, agents, and analysts in the Eastern District of California who conducted this investigation,” said Michael C. Galdo, Department of Justice Director of COVID-19 Fraud Enforcement. “The Department will continue to work with our law enforcement partners around the country to uncover these schemes and hold those accountable who attempt to steal from the American people—whether they are hiding overseas or, like the allegations in this investigation, operating conspiracies from behind bars.”

“The criminal enterprises we battle today are more sophisticated than ever before,” said FBI Acting Special Agent in Charge Remily. “From interstate drug trafficking rings to massive fraud schemes aimed at stealing pandemic relief funds meant for struggling American businesses, the criminal conspiracies we face are complex and ever-changing. Despite these challenges, the dedicated men and women of the FBI and our local, state, and federal law enforcement partners will continue to diligently investigate these criminals. We will use every investigative technique at our disposal to disrupt their activities and bring them to justice.”

“Kristopher Thomas and his associates being in federal custody are a result of an incredibly detailed, multi-agency OCEDTF investigation and is a critical milestone in this case,” said IRS Criminal Investigation Acting Special Agent in Charge Mosley. “While incarcerated and with the help of his associates, Thomas is accused of leading a conspiracy to defraud taxpayers of over $550 million by falsely claiming COVID-19 Employee Retention Credits. CI agents specialize in financial investigations and remain on the front lines of fighting fraud.”

According to court documents, in August 2022, the DEA began a wiretap investigation into a methamphetamine trafficking operation that was run out of the Kern Valley State Prison in Delano, California, by inmate Kristopher Thomas, 36. Thomas has been incarcerated since December 2010 after being convicted of a gang-related first-degree murder. Thomas is a long-time member of the Main Street Mafia Crips, a street gang located in South Los Angeles.

Agents reviewed recorded jail calls placed by Thomas on a prison-issued tablet to numerous romantic partners, family members, and other individuals believed to be involved in drug trafficking. Agents also intercepted Thomas sending and receiving text messages about what appeared to be a tax fraud scheme. The intercepted text messages contained screenshots of tax information for many businesses with tax refund amounts. This triggered the DEA to request assistance from IRS Criminal Investigation and the FBI.

The drug trafficking and the tax fraud scheme are being prosecuted separately, and Thomas is charged in both cases.

The Methamphetamine Trafficking Scheme

According to court documents, Thomas was the head of a drug trafficking organization (DTO) that was responsible for the shipment of large quantities of methamphetamine to Hawaii, Oklahoma, Alabama, New Jersey, and elsewhere, as well as the smuggling of fentanyl into Kern Valley State Prison.

The investigation began after DEA agents identified Thomas as a source of methamphetamine supply in Hawaii. Subsequent recorded negotiations with Thomas resulted in the seizure in Oahu, Hawaii, of more than 90 pounds of methamphetamine. These seizures became the basis for the initiation of the wiretap investigation into multiple contraband cellphones in Thomas’s possession at KVSP.

The wiretap investigation revealed that Thomas orchestrated the interstate shipment of more than 54 pounds of methamphetamine to other states, including Oklahoma, Alabama, and New Jersey. Thomas was assisted by other gang associates. In addition, wire intercepts led to the seizure of an additional 40 pounds of methamphetamine, over 14 pounds of fentanyl, 9.5 pounds of heroin, and 8.5 pounds of cocaine. A half a pound of fentanyl was seized after it was smuggled into KVSP at Thomas’s direction.

Charged with Thomas in the drug trafficking scheme are Justin Damonte Mitchell, 31, of Los Angeles; Derrick D. Charles, 41, a former inmate at KVSP; Natasha Michelle Bailey, 44, of Bakersfield; Antrell Maeshack Sr., 41, of Santa Clarita; and Marie Joo-Yeon Choi, 29, of Los Angeles.

The IRS Employee Retention Credits Scheme

According to court documents, from January 2022 through at least July 2023, Thomas led a multi-million-dollar tax refund fraud scheme whereby Thomas and his co-conspirators filed payroll tax returns with the IRS that claimed Employee Retention Credits (ERC) for businesses that were not entitled to receive the credits so that they would receive large tax refunds.

Others charged with Thomas in the ERC scheme are Thomas’s mother, Kettisha Thompson-Dozier, 55, and her spouse Charmane Dozier, 44, both of Waldorf, Maryland, and Sharon Vance, 36, of Hawthorne, California.

During the COVID-19 pandemic, the ERC became available as a refundable federal tax credit for employers as a way to encourage businesses to keep employees on their payrolls. The credit was available to eligible employers that paid wages to some or all employees during the pandemic.

IRS records show Thomas and his co-conspirators filed hundreds of payroll tax returns that claimed over $550 million in tax refunds. The payroll tax returns were for fake business entities, actual businesses with overstated wages and numbers of employees, and businesses that were defunct at the time the payroll tax returns were filed. The defendants used the proceeds for improper personal expenditures. For example, in December 2022, Thomas celebrated his birthday by paying for his family members and friends to be driven to Las Vegas from Los Angeles, party for the night at a luxury penthouse, and then fly back to Los Angeles on a private jet.

The drug trafficking case is the product of an investigation by the DEA with assistance from the U.S. Marshals Service. Assistant U.S. Attorney Karen Escobar is prosecuting the case.

The ERC tax fraud case is the product of an investigation by the IRS Criminal Investigation and the FBI. Assistant U.S. Attorneys Joseph Barton and Jeffrey Spivak are prosecuting the case.

The crimes charged today carry the following penalties: (1) conspiracy to distribute and to possess with intent to distribute methamphetamine and fentanyl and distribution of methamphetamine – both of which carry a 10-year mandatory minimum prison term and maximum penalty of life in prison; and (2) conspiracy to defraud the United States by submitting fraudulent ERC claims – which carries a maximum penalty of five years in prison.

Any sentence, however, would be determined at the discretion of the court after consideration of any applicable statutory factors and the Federal Sentencing Guidelines, which take into account a number of variables. The charges are only allegations; the defendants are presumed innocent until and unless proven guilty beyond a reasonable doubt.

The case was investigated under the Organized Crime Drug Enforcement Task Forces (OCDETF). OCDETF identifies, disrupts, and dismantles the highest-level criminal organizations that threaten the United States using a prosecutor-led, intelligence-driven, multi-agency approach. For more information about OCDETF, please visit Justice.gov/OCDETF.

24mj7.crmp_.thomas.fsm_.pdf

THE IRS CONTINUES ATTACK ON "ZERO OUT" OF PROFITS BY CLOSELY-HELD C CORPORATIONS[1]

 As we all know “C” corporation owners, because of the double tax regime, can be subject to claims by the IRS of excessive compensation. In two recent case the IRS attacked the use of the "zero out" technique. The IRS focused on how closely-held corporations taxed as "C" corporations compensate their shareholders. Under this approach, a "C" corporation compensates its shareholders by paying a portion of its anticipated pre-tax operating profits as compensation (salary) in regular increments during the tax year and then distributes the bulk of its profits in bonuses that are paid at year-end. Both the salary and year-end bonuses are deducted as compensation in order to reduce or even eliminate federal income taxes.

 

The potential tax risk of this method for compensation is that even though the shareholders provided services to the corporation, the IRS could disallow the compensation deduction for the "salary" and bonuses paid and treat the payments as non-deductible dividends made by the corporation to its shareholders on either or both of two grounds: (1) that the payments made were unreasonably excessive based on the services provided, and/or (2) that the payments made were not purely for services.

 

Two recent cases provide insight into how the zero out approach to compensation can be properly structured to support the deductibility of payments of salary and year-end bonuses made by closely-held "C" corporations to their shareholders as compensation for services provided. In one case, the Tax Court issued a lengthy opinion in support of its denial in part of the deduction of compensation paid to the sole owner of a construction business organized as a C corporation. In another case, the Eighth Circuit Court of Appeals affirmed a 2021 Tax Court case that upheld the IRS's characterization of payments made by an asphalt paving company to or for its owners as non-deductible dividends rather than deductible compensation.

 

The Aspro Case

The Eighth Circuit Court of Appeals affirmed a Tax Court case that had upheld the IRS's characterization of payments made by a "C" corporation as non-deductible dividends rather than as deductible compensation payments for management services.[2] In Aspro, the taxpayer was a "C" corporation that operated an asphalt paving business and obtained business by bidding on paving contracts through the efforts of its owners. Even though the taxpayer generated income throughout the year, it made no payments for services to or for the benefit of its three shareholders until the end of the year, when it paid "management fees" for assistance provided to the taxpayer on how to bid for projects.

 

The Tax Court had found that the payments made during each of three tax years by the corporate taxpayer to its three shareholders were non-deductible dividends and could not be deducted as compensation for personal services provided to the corporation. The Tax Court indicated that to be deductible under the applicable regulation, compensation payments must be made purely for services.[3] This regulation states in part that "[a]ny amount paid in the form of compensation, but not in fact as the purchase price of services, is not deductible. An ostensible salary paid by a corporation may be a distribution of a dividend on stock. This is likely to occur in the case of a corporation having few shareholders, practically all of whom draw salaries... ."

 

The Tax Court noted that the corporation had never previously paid any dividends to its shareholders, the payments made were in roughly the same proportions as share ownership of the taxpayer, and that two recipients of the payments were corporations that were shareholders of the taxpayer, both of which were "paid" the same amounts each year for services ostensibly performed by the individuals who owned these two shareholder-corporations.

 

The court also pointed out that the personal services for which compensation was paid were performed throughout the entire year but the payments were made annually at the end of each year and thus lacked a compensatory purpose. Additionally the payments eliminated almost 90% of the taxpayer's taxable income in two of the three years and just under 80% of its taxable income in the third year. Because the corporation had never paid dividends an inference could be made that the management fees paid were not compensation for services but dividends.

 

The amounts paid had little relation to the value of the services provided by the three shareholders (or their owners) to the corporation.

 

The Tax Court[4] noted Reg. 1.162-7(a) which provides that payments made that "correspond or bear a close relationship to the stockholdings of the officers or employees" are subject to recharacterization as dividends. Since the Tax Court had identified "numerous indicia of disguised distributions," the court found that the payments were not deductible, and the taxpayer was liable for corporate income taxes based on its net income determined without the denied compensation deductions.

 

The Court of Appeals then addressed each of the factors relied upon by the Tax Court in making its decision and expanded on the Tax Court's analysis. For example, the Court of Appeals noted that all compensation arrangements within closely-held corporations should be closely scrutinized, that the payments made by the taxpayer were made in a lump sum at the end of the year (a true "zero out" approach), and that the corporation did not pay and had never paid dividends to its owners.

 

As a result, the Court of Appeals upheld the Tax Court decision that denied in their entirety the deductibility of the payments made to or for the benefit of the taxpayer's three shareholders as compensation.

 

The Clary Hood case

In Clary Hood, Inc.,[5] the Tax Court redetermined the deductible portion of the salary and the substantial "one-time" bonuses in the amount of $5 million that the taxpayer, a construction company owned by one shareholder, paid its CEO/founder during each of two tax years. Based in part on testimony provided by the IRS expert and applying the multifactor test utilized by the Tax Court in the Aspro case as to whether or not the payments made were reasonable based on the services provided, the Tax Court found that a significant portion but not all of the salary and bonuses paid to the sole shareholder of the construction company in each tax year could be deducted as reasonable compensation for services provided to the corporation.

 

Even though the Board of Directors of the construction company consisted only of the sole shareholder and his spouse, prior to Board approval of payment of the two significant bonuses, the corporation had engaged its accountants to determine the extent to which the corporation's owner had been "undercompensated" during the tax years prior to the review of the compensation paid and to obtain the accountants' recommendations as to how to compensate the taxpayer's sole shareholder for services provided going forward.

 

Working with the corporation's accountants, an officer and the corporation's shareholder reviewed the accountants' report and determined that the owner had been undercompensated on an historical basis and that any compensation paid to the shareholder going forward should also take into account the ongoing financial risk incurred by the shareholder in personally guaranteeing the performance bonds of the taxpayer corporation. This analysis by the corporation's accountants used publicly available industry specific compensation data in its findings and recommendations.

 

In support of its decision, the Tax Court cited several facts:

·       prior to the payment of the first annual bonus, the taxpayer had conducted a detailed study to confirm that its sole shareholder/founder had been undercompensated during its startup years,

·       that he personally agreed to guarantee claims of the companies that provided performance bonds for construction contracts of the corporation, and

·       that the detailed analysis provided by an expert engaged by the taxpayer's Board of Directors established a reasonable method to compensate the owner for the ongoing financial risk he incurred in guaranteeing personally the construction company's performance bonds and other significant factors.

 

The Tax Court also noted that the taxpayer had bonused out to the founder during the two tax years in question a relatively small portion of the business's pre-tax operating profits. Specifically, the Tax Court concluded that "[w]hile such amounts are not insignificant, we do not necessarily consider them telling of an egregious pattern of disguised dividends . . . [since paid for prior services]. " The amounts found by the Tax Court to be deductible were those determined as reasonable by the IRS's compensation expert who testified at trial.

 

Even though the taxpayer corporation's Board of Directors (the sole shareholder and his spouse) set annual compensation on a subjective basis (i.e., not using an objective formula), the Board solicited and accepted input and advice from the corporation's accountants for this purpose. In addition, prior to the tax years in question, the corporation had not compensated the shareholder for the financial risk he had personally incurred in annual guarantees of the corporation's performance bonds.

 

Lessons from Aspro and Clary Hood

These two cases provide valuable lessons to closely-held corporations organized as "C" corporations as they develop methods for compensating employed shareholders for services rendered:

 

•       Do not wait until the end of the year to pay bonuses to the corporation's shareholders. Instead, make periodic payments of base compensation as salary during the year, using an objective formula that takes into account the value of the services provided by each shareholder.

•       If the corporation is owned by more than one shareholder, do not pay compensation to the corporation's shareholders in the same percentages as their relative share ownership.

•       The Board of Directors of the closely-held corporation should engage competent accountants, tax preparers, or compensation consultants to provide advice and counsel in structuring any compensation method, and the Board of Directors should review and consider written guidance and reports from these advisors prior to approval of any compensation method (or prior to payment of any year-end bonuses based on that method). Make sure that these compensation advisors rely upon available industry specific compensation studies to support their analysis.

•       Do not zero out all corporate pre-tax profits each year as compensation, but declare and pay annual dividends of a portion of these profits and pay federal income taxes on the remaining pre-tax profits of the corporation.

•       Enter into a written employment agreement with each individual shareholder that contains an objective formula for determining at least the contingent portion of compensation.

 

Further Lessons

Today many small businesses are operated as pass through entities such as S corporations as there is largely no double taxation. Therefore, the tax incentive is to pay as little compensation as possible and pass profits as S corporation distributions. This is done to avoid FICA, Medicare taxes and other taxes. These two cases illustrate that a corporation must pay reasonable compensation to its owners lest it be subject to underpayment of compensation with the S corporation distribution being converted to compensation.

 

Like many things in taxation adherence to guide lines established by statutes, regulations, cases, rulings etc. provide a road map to be followed. Its when the taxpayer “takes a wrong turn” that she finds herself facing additional taxes and penalties.

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[1] This is an abstract of an article published in Corporate Taxation (WG&L), Sep/Oct 2022 issue by Ralph Levy.

[2] Aspro, Inc. v. Comm’r., 129 AFTR 2d 2022-1581, 32 F.4th 673 (8^th Cir. 2022), 2022-1 USTC P 50,147 (8^th Cir. 2022).

[3] Reg. 1.162-7(a).

[4] TC Memo 2021-8.

[5]  TC Memo 2022-15.

New rules for New Jersey captive insurance companies; New Jersey credit for tiered subsidiary dividends;New Jersey adopts regulation permitting Director to decombine unitary groups.

 

New Jersey—Corporate Income Tax—New Jersey adopts regulation on combinable captive insurance companies. The New Jersey Division of Taxation has adopted N.J. Admin. Code § 18:7-1.24, effective September 19, 2022, to support its existing policy that combinable captive insurance companies are subject to the corporation business tax. A combinable captive insurance company is exempt from the insurance company premiums tax imposed pursuant to N.J. Rev. Stat. § 17:47B-12 and any other insurance premiums taxes imposed pursuant to any other laws of the State of New Jersey. A combinable captive insurance company that has nexus with New Jersey, but is not included as a member of a New Jersey combined return, must file a separate return. Captive insurance companies that do not meet the definition of a combinable captive insurance company are exempt from the corporation business tax and are excluded from the combined group reported on the combined return. Such captive insurance companies are subject to the insurance premiums tax at N.J. Rev. Stat. § 17:47B-12. For the purposes of determining whether a captive insurance company is a combinable captive insurance company, the entity must use the same method of accounting used for federal purposes. 

New Jersey—Corporate Income Tax—New Jersey credit for tiered subsidiary dividends. Effective September 19, 2022, the New Jersey Division of Taxation has adopted N.J. Admin. Code § 18:7-3.28 to provide rules for the deduction of tiered subsidiary dividends. In order for a taxpayer to qualify for the Tiered Subsidiary Dividend Pyramid Tax Credit, the taxpayer must have received the same dividends and deemed dividends from a subsidiary that paid tax to New Jersey. Such subsidiary must have received the same dividends and deemed dividends from other subsidiaries and included those dividends and deemed dividends in its entire net income for the purposes of determining its tax liability and paid tax on those dividends and deemed dividends to New Jersey on a timely filed New Jersey corporation business tax return. The Tiered Subsidiary Dividend Pyramid Tax Credit is a credit for: (1) dividends and deemed dividends from non-combined group subsidiaries that file separate New Jersey returns and paid the corporation business tax on dividends and deemed dividends from other subsidiaries; and (2) dividends and deemed dividends from a separate lower-tier combined group that files a New Jersey combined return separate and apart from another (dividend paying) combined group and that paid the corporation business tax on dividends and deemed dividends from other subsidiaries. A member of a combined group cannot receive a Tiered Subsidiary Dividend Pyramid Tax Credit for taxes paid by another member because the members of a combined group are one taxpayer. The Tiered Subsidiary Dividend Pyramid Tax Credit can only reduce the regular tax liability of the taxpayer. However, the Tiered Subsidiary Dividend Pyramid Tax Credit cannot exceed the regular tax liability and is not refundable. The Tiered Subsidiary Dividend Pyramid Tax Credit does not contain a provision permitting the credit to be carried forward. 

New Jersey—Corporate Income Tax—New Jersey adopts regulation permitting Director to decombine unitary groups. Effective September 19, 2022, the Division of Taxation has adopted N.J. Admin. Code 18:7-21.24. This regulation permits the Director upon audit of the combined return and review of the facts and circumstances, to decombine and require a member or members to file a separate return instead of the members being included as part of the combined group filing a mandatory unitary combined return, if the Director determines that the members were not unitary and the principle purpose of including the members was to either shelter income, dilute the allocation factor of the combined group, improperly increase the combined group net operating losses, or the inclusion was for the purpose of sharing tax credits that were not related to any function of the combined group.

New Technical Guide for Business Leagues, Issue Snapshot on Self-Dealing

 

Dear Colleagues and Friends, 

I know from time to time we are asked to form or consult non-profit organizations. The IRS has recently published a new technical guide to help tax-exempt business leagues to maintain their tax-exempt status, TG 6 IRC 501(c)(6) Business Leagues, as well as a new Issue Snapshot on Private Foundations and Self-Dealing. https://www.irs.gov/government-entities/tax-exempt-and-government-entities-issue-snapshots

New TG on business leagues. The newly released TG discusses how tax-exempt business leagues described under Code Sec. 501(c)(6), such as chambers of commerce, real estate boards, and boards of trade, can obtain and maintain their exempt status. The TG also covers IRS examination techniques. The IRS has other tools to help leaders and volunteers of exempt organizations obtain and maintain their organization's exempt status, See Maintaining 501(c)(3) Tax-Exempt Status course, https://www.stayexempt.irs.gov/home/existing-organizations/existing-organizations and the Small to Mid-Size 501(c)(3) Organization Workshop, which provides additional information on the benefits, limitations, and expectations of tax-exempt organizations. https://www.stayexempt.irs.gov/home/resource-library/virtual-small-mid-size-tax-exempt-organization-workshop 

I hope this is a helpful aid.

Frank L. Brunetti

How Should You Maintain Inventory in a Gig Economy?

One of the most misunderstood accounting concepts in the ecommerce and reselling space involves how to deduct your inventory costs. Small business that sell on a digital platform such as eBay, Esty, Shopify, etc. must contend with rules relating to maintain inventory.

Before 2018, all taxpayers were required to maintain inventory even if they were a cash basis taxpayer.

The Tax Cuts and Jobs Act (TCJA) of 2017 changed the inventory rules for the small business taxpayer. 

Recently in January 2021 the IRS issued final regulations to answer questions raised by the TCJA.

New Rules for Deducting Inventory

Under the TCJA a small business taxpayer (basically any business with sales under $25 million) can account for inventory for tax purposes either:

1.               as non-incidental materials and supplies (this is not new and is described below…hint: it doesn't do you much good), or

2.               as conforms to the taxpayer's method of accounting.

The TCJA raised the threshold to $25 million[1] (it was $1 million for retailers before 2018) and now allows the small business taxpayer to report inventory for tax purposes according to his or her method of accounting.

Cash method vs. Accrual method

The difference between these two methods is timing.

Cash-basis

A business that is on a cash basis recognizes revenue when cash or a cash equivalent is received from a customer. It recognized expenses (deduction) when the cost item is paid.

Accrual-basis

With the accrual basis of accounting, revenue is recognized when it is earned.  Expenses are recognized when they are incurred–which is often at a different time from when the payment is made. If a taxpayer maintains accounts payable or accounts receivable it is likely using the accrual method.

The Inventory Rules Before TCJA (pre 2018)

Most small businesses use the cash method for simplicity. Notwithstanding cash basis businesses with inventory were generally required to account for the inventory on an accrual basis.

Accordingly, a cash basis taxpayer could deduct the cost of the inventory when the inventory was sold, not when it was purchased.

The IRS regulations provided certain businesses exempt from accounting for inventory using the accrual method. These were businesses which had less than $1 million average gross receipts. (the TCJA increases this threshold to $25 million.)

If the taxpayer qualified for the alternative treatment, which included most small businesses, it was not required to account for inventory using the accrual method.

Having said that the taxpayer still had to account for non-incidental expenses but could deduct currently

“Inventoriable items as materials and supplies that are not incidental”.

The regulations provided that if you produce, purchase, or sell merchandise in your business, you must keep an inventory and use the accrual method for purchases and sales of merchandise. However, the small business taxpayer [$1 million or less of average annual gross receipts] could use the cash method of accounting even if they produce, purchase, or sell merchandise. These taxpayers had to account for inventoriable items as materials and supplies that are not incidental.

In order to understand how accounting for inventory works we have to clarify what is meant by accounting for “inventoriable items as materials and supplies that are not incidental.”

Accounting for inventoriable items as materials and supplies that are not incidental

“Not incidental” materials are those that required to manufacture your products. They are essential to the creation and selling of your product.

“Incidental” materials, on the other hand, are materials that are not directly involved in the production of your finished product.

The IRS regulations provides that “not incidental” materials and supplies are deductible in the year they are used or paid, whichever is later.

This means that all materials and supplies that are directly used to produce your goods must be accounted for:

1.               In the year you provided them as finished goods to customers, or

2.               In the year you originally paid for the material

Whichever is later.

Most businesses pay for their goods before selling them. If that’s the case, you were required to account for your inventory using the accrual method–recognizing the cost when you sell it (#1).

But if for some reason you don’t pay for your goods until after you sell them (#2), you can recognize the cost when you pay.

TCJA: “Taxpayer's Method of Accounting”

The TCJA gave the taxpayer the option to report inventory on using the “method of accounting used in the taxpayers’ books and records prepared in accordance with the taxpayer's accounting procedures.”

What is meant by the “taxpayer's method of accounting? and What is meant by “books and records”?

A “method of accounting” has the following characteristics:

•           It affects the computation of a material item;[2]

•           It is consistently applied and is predictable;[3]

•           It conforms to generally accepted accounting principles;[4]

•           It clearly reflects income;[5] and

•           It has been adopted.[6]

 

The IRS defines books as: “Except as provided in paragraph (b) [of Reg. §1.6001-1], any person subject to tax under subtitle A of the Code…or any person required to file a return of information with respect to income, shall keep such permanent books of account or records, including inventories, as are sufficient to establish the amount of gross income, deductions, credits, or other matters required to be shown by such person in any return of such tax or information.[7]”

Clearly Reflects Income

Neither the Code nor regulations define what clearly reflects income. The concept of “ clear reflection of income” is central to tax accounting; clear reflection of income is influenced by many factors but not controlled by any one.[8] If a taxpayer's method of accounting challenged by the Commissioner were to prevail, the taxpayer must demonstrate that the Commissioner's determination is arbitrary, capricious, and without a sound basis in fact or law.[9] A method of accounting which reflects the consistent application of generally accepted accounting principles in a particular trade or business in accordance with accepted conditions or practices in that trade or business will ordinarily be regarded as clearly reflecting income, provided all items of gross income and expense are treated consistently from year to year.[10] However, the fact that an accounting method is consistent with GAAP does not, by itself, satisfy the clear-reflection-of-income standard.[11]

An often-cited definition is found in Caldwell v. Commissioner,[12] where the Second Circuit said “clear reflection of income” means that income should be reflected with as much accuracy as standard methods of accounting practice permit.[13] The IRS generally wants to see accounting treatment that “clearly reflects income.” Historically this has meant that the deduction of the inventory should be recognized at the same time as the sale.

The TCJA specifically stated that “the taxpayer’s method of accounting for inventory for such taxable year shall not be treated as failing to clearly reflect income if such method either 1) treats inventory as non-incidental materials and supplies or 2) conforms to such taxpayer’s method of accounting.

Updated Tax Guidance (Jan 2021)

The IRS published final regulations on the TCJA in January of 2021.

The final regulations clarify in Reg §1.471-1(b)(6)(i) that costs that are generally required to be capitalized to inventory under  IRC §471(a) but that the taxpayer is not capitalizing in its books and records are not required to be capitalized to inventory. The IRS has also determined that, under this method, such costs are not treated as amounts paid to acquire or produce tangible property under Reg §1.263(a)-2 , and therefore, are generally deductible when they are paid or incurred if such costs may be otherwise deducted or recovered, notwithstanding Reg §1.471-1(b)(4) , under another provision of the Code and regulations.[14]

Additionally, the final regulations clarify that costs capitalized for the non-AFS IRC §471(c) inventory method are those costs that are related to the production or resale of the inventory to which they are capitalized in the taxpayer's books and records. Similar clarifications have been made in Reg §1.471-1(b)(5) regarding the AFS IRC §471(c) inventory method.[15]

Hence If you are not valuing your inventory, or in other words, if you are not determining your ending inventory cost balance and they are not reflected in your books and records, then it appears that you can use or continue to use the inventory cash method, which means deducting your inventory when you purchase it, rather than when you sell it.

But if you are keeping track of your overall inventory balance, meaning the total cost of everything you have on hand, or making representations about it, then you’ll need to use the inventory accrual method, meaning that you’ll deduct your inventory when sold.

It’s good practice to use the accrual method for inventory. Accrual accounting provides the best information into how a business is performing.

Notwithstanding the changes made by the TCJA and the ability to deduct costs before the goods are sold, the accrual method is recommended if your business is growing and it’s important to you to have good information about your businesses’ performance.

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[1] The threshold is adjusted for inflation. For 2021 it was $26 million.

[2] Reg. §1.446-1(e)(2)(ii)(a) provides that a material item is any item that concerns the timing of income or deductions. In Revenue Procedures, the IRS has explained that an item concerns timing, and is therefore considered a method of accounting, if “the practice does not permanently affect the taxpayer's lifetime income but does or could change the taxable year in which income is reported. The term “item” is used to indicate any recurring incidence of income or expense. Examples include: real estate taxes, Reg. §1.446-1(e)(2)(iii), Example 2; corporate officers’ bonuses are items, Connors, Inc. v. Comm’r, 71 T.C. 913 (1979); and employees’ vacation pay, Oberman Mfg. Co. v. Comm’r, 47 T.C. 471 (1967), acq., 1967-2 CB 3, See, e.g., TAM 8201015.

[3] Reg. §1.446-1(e)(2)(ii)(a) states that “in most instances,” a method of accounting is not established without a “pattern of consistent treatment” of an item. The “consistency” referred to is consistent treatment of a particular item over time, not consistency between the contemporary treatment of different items.

[4] Reg. §1.446-1(a)(2).

[5] IRC §446(b).

[6] As stated in Reg. §1.446-1(a)(2), “A method of accounting which reflects the consistent application of generally accepted accounting principles in a particular trade or business in accordance with accepted conditions or practices in that trade or business will ordinarily be regarded as clearly reflecting income, provided all items of gross income and expense are treated consistently from year to year.”

[7] IRC §446(a); Reg. §1.446-1(a).

[8] See TAM 9603004 (advising that a method of accounting that was permissible by one taxpayer (using a sliding scale method of depreciation for television film contract rights) was not permissible by another taxpayer because it did not clearly reflect income for the other taxpayer).

[9] Ansley-Sheppard-Burgess Co. v. Comm'r, 104 T.C. 367 (1995). See Sierracin Corp. v. Comm'r, 90 T.C. 341, 368 (1988). That standard was described in Sierracin as follows:

Section 446(b) and sections 1.451-3(e), 1.446-1(a)(2), and 1.446-1(b)(1), Income Tax Regs., vest respondent with broad discretion in determining whether a taxpayer's contracts should be severed so as to clearly reflect income. “Since the Commissioner has “[m]uch latitude for discretion,” his interpretation of the statute's clear reflection standard “should not be interfered with unless clearly unlawful.” Thor Power Tool Co. v. Comm'r, 439 U.S. 522, 532 (1979).

Similarly, under IRC §482, the IRS can distribute, apportion or allocate gross income, deductions, credits, or allowances between two or more businesses under common control to prevent tax evasion or for clear reflection of income.

[10] Reg. §1.446-1(a)(2).

[11] Thor Power Tool Co v. Comm'r, 439 U.S. 522, 79-1 USTC ¶9139 (1979).

[12] 202 F.2d 112, 53-1 USTC ¶9218 (2d Cir. 1953). See also Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781 (11th Cir. 1984), where the court found that the IRS did not abuse its discretion in forcing newspaper corps to change from cash to accrual method. Newspaper was material part of business requiring use of inventories which allowed the IRS to require the newspaper company to use the accrual method. The IRS’s consent to use cash method in earlier year did not bar the IRS from changing to accrual method during subsequent year in which it was apparent that cash method did not clearly reflect income.

[13] The problem, however, is that if taken literally, it would, among other things, virtually preclude the use of the cash method.

[14] Id.

[15] Id. Applicable date. The final regulations are applicable for tax years beginning on or after January 5, 2021.