Legislative Update: “Green Book” Details Tax Accounting Method Proposals
The release May 11 of the Treasury’s “Green Book”—General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals—details legislative proposals concerning tax accounting methods and related topics. This edition of
TaxNewsFlash summarizes those proposals.
Repeal the Last-In, First-Out (LIFO) Method of Accounting for Inventories
Under current law, certain taxpayers are permitted to determine inventory values using the LIFO method, which treats the most recently acquired or manufactured goods as having been sold during the year. To use LIFO, a taxpayer also must use LIFO for financial reporting.
For a taxpayer facing rising inventory prices, the LIFO method can provide a tax benefit through lower ending inventories, leading to higher cost of goods sold deductions and lower taxable income. To the extent prices rise and the taxpayer acquires or manufactures more goods than it sells during the year, the taxpayer accumulates incremental layers of goods valued at current-year costs, providing for the deferral of income tax to the extent such costs increase.
The proposal would repeal the use of the LIFO method for tax years beginning after December 31, 2011. Taxpayers would be required to write up their beginning LIFO inventory to First-In, First-Out (FIFO) value. The corresponding increase in gross income would be taken into account ratably over eight tax years.
If use of International Financial Reporting Standards (IFRS) becomes mandatory, companies would be forced to discontinue LIFO under current law.
Repeal the Lower-of-Cost-or-Market (LCM) Method of Accounting for Inventories
Under current law, certain taxpayers are permitted to use the LCM method, under which the taxpayer may write down the carrying values of eligible inventories to replacement or reproduction cost. A taxpayer may also write down the cost of subnormal (i.e., damaged) goods to reflect their decline in value. Additionally, taxpayers using the retail method for tax purposes are not required to use the same method for financial reporting purposes.
The proposal would repeal the use of the LCM and subnormal goods methods for tax years beginning after 12 months from the date of enactment. Wash sale rules would be included to prevent taxpayers from circumventing the prohibition. In addition, the retail method would be allowed only if the taxpayer also employed the method for financial reporting purposes. Compliance would be treated as a change in method of accounting for inventories, and any resulting section 481(a) adjustment would be included in income ratably over a four-year period beginning with the year of change.
Repeal of LCM and subnormal goods writedowns would leave inventory (for tax purposes) at cost, including adjustments necessary under the uniform capitalization rules. Presumably retailers could still use the retail method under a cost rather than an LCM approach, although the Green Book does not explicitly address the point.
Make the Research & Experimentation Tax Credit Permanent
The research credit expires December 31, 2009. The credit is 20% of qualified research expenses (QREs) over a base amount. The base amount is the product of the taxpayer’s average gross receipts for the four preceding tax years and the ratio of 1984-to-1988 QREs over the 1984-to-1988 gross receipts. A taxpayer also may elect the alternative simplified credit, which is equal to 14% of qualified research expenses that exceed 50% of the average qualified research expenses for the three preceding tax years.
The proposal would make the research credit permanent.
Expand NOL Carryback
A net operating loss (NOL) generally is the amount by which a taxpayer’s business deductions exceed its gross income. For taxpayers—other than certain eligible small businesses—an NOL may be carried back two years and forward 20 years to offset taxable income in such years. The
American Recovery and Reinvestment Act of 2009 extended the carryback period for applicable 2008 NOLs to up to five years by certain eligible small businesses whose average annual gross receipts do not exceed $15 million.
The Green Book proposes that the administration negotiate with Congress to broaden the NOL provision to more taxpayers, but it does not explain particulars.
Provide Tax Incentives for Transportation Infrastructure
In 2002, Congress provided tax incentives for areas of New York City damaged or affected by the September 11 terrorist attacks. New York Liberty Zone incentives include:
- Expansion of the work opportunity tax credit for Liberty Zone business employees
- Special depreciation allowance for qualified Liberty Zone property
- Five-year recovery period for depreciation of qualified Liberty Zone leasehold improvement property
- $8 billion of tax-exempt private activity bond financing for certain nonresidential real property, residential rental property, and public utility property
- $9 billion of additional tax-exempt, advance refunding bonds
- Increased section 179 expensing; and extension of the replacement period for nonrecognition of gain for certain involuntary conversions
Under the proposal, the special depreciation allowance for qualified Liberty Zone property that is either nonresidential real property or residential rental property would be terminated as of the date of enactment. Property placed in service after the date of enactment would be ineligible for the incentive unless a binding written contract were in effect on the date of enactment and the property were placed in service before the original sunset dates.
The proposal would sunset certain Liberty Zone benefits, replacing them with tax credits to New York State and New York City for expenditures relating to the construction or improvement of transportation infrastructure in or connecting to the Liberty Zone.
Deny Deductions for Punitive Damages
Under current law, a taxpayer may not deduct a fine or penalty paid to the government for the violation of any law. If a taxpayer is convicted of a violation of the antitrust laws, or a taxpayer’s plea of guilty or
nolo contendere to a violation is entered or accepted in a criminal proceeding, no deduction is allowed for two-thirds of any amount paid or incurred on a judgment or settlement of certain antitrust civil suits. When neither provision applies, a deduction is allowed for damages paid or incurred as ordinary and necessary expenses in carrying on a trade or business, regardless of whether such damages are compensatory or punitive.
The proposal would prohibit any deduction for punitive damages paid or incurred by the taxpayer, whether upon a judgment or settlement of a claim. If the liability for punitive damages were covered by insurance, the damages paid or incurred by the insurer would be included in the gross income of the insured person. The insurer would be required to report payments to the insured person and to the IRS. The proposal would apply to damages paid or incurred after December 31, 2010.