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An Unexpected IRS Enforcement Initiative: IRS Adds "Cost of Goods Sold" to Audit Compliance Campaign

By Anthony P. Daddino on August 9, 2023
The IRS is seemingly moving from the exotic back to plain vanilla, announcing a compliance campaign focused on taxpayers that may have inflated their reported cost of goods sold to reduce their taxable income.

The IRS gave no explanation for the new campaign (linked here), nor a description of the campaign’s objective. Some practitioners have claimed that the IRS is ferreting out exaggerated fuel excise tax credits, which are partially impacted by cost of goods sold. My own personal view is that the IRS’ campaign reflects a renewed interest in capitalization methods under IRC Sec. 263A. This would not be the first compliance campaign involving IRC Sec. 263A. In 2018, the IRS announced a compliance campaign focused on interest capitalization for self-constructed assets under IRC Sec. 263A.

In a nutshell, IRC Sec. 263A requires taxpayers that produce property, or acquire property for resale, to capitalize both direct costs as well as an allocable share of their indirect costs. Examples of indirect costs include supervisor and officer salaries, employee benefits cost, shipping, handling and storage costs, depreciation, rent, taxes, utilities, quality control costs, and interest, to name a few. Under IRC Sec. 263A, taxpayers are forced to capture a portion of indirect costs and capitalize them to their ending inventory. The higher the ending inventory, the lower the cost of goods sold.

In terms of this new IRS audit campaign, the IRS may be focusing on taxpayers who are allocating too little of their indirect costs under IRC Sec. 263A, resulting in lower ending inventory figures and a higher (or in IRS-speak, “Inflated”) cost of goods sold. This would certainly explain the increased number of IRS audits involving this issue based on my own personal experiences.

Cookies and cream and mint chocolate chip are exciting options. But plain vanilla is always a great choice – even for the IRS.

If you have any questions about this blog post or any other tax-related topic, please do not hesitate to contact me at adaddino@meadowscollier.com or (214) 749-2464.