Choice of Accounting Method for Manufacturers

The choice of accounting method is an important decision that is sometimes made inadvertently. In general, a taxpayer is permitted to adopt any accounting method, as long as it clearly reflects income (Sec. 446). Available methods include the cash-receipts-and-disbursements method, the accrual method and the long-term contract method. A taxpayer can adopt a method simply by filing two consecutive returns based on the selected method.

Specific accounting methods are statutorily prescribed for certain taxpayers. For example, taxpayers required to use inventories must use the accrual method when reporting sales and purchases (Regs. Sec. 1.446-1(c)(2)(i)). Taxpayers with long-term contracts generally must use the percentage-of-completion method under Sec. 460. Interestingly, even a taxpayer that manufactures personal property may be required to use the long-term contract method, rather than an overall accrual method.

Sec. 460(f) defines a long-term contract as a contract for the manufacture, building, installation or construction of property if it is not completed within the tax year started. Sec. 460(f)(2) contains additional requirements for long-term contract treatment for manufacturing contracts. Specifically, a manufacturing contract not completed in the contracting year is considered a long-term contract and subject to the percentage-of-completion accounting method if manufactured personal property is:

• A unique item not normally carried in finished goods; or
• An item that normally requires more than 12 calendar months to complete.

Prop. Regs. Sec. 1.460-2(b), issued May 5, 1999, further clarifies the definition of a long-term manufacturing contract by addressing the definition of a unique item. A "unique item" is something designed for a specific customer. The factors used to evaluate whether an item is unique include the level of research, development, design and engineering the taxpayer must perform to complete the contract. Also to be considered is whether the same item could be sold to other customers.

Prop. Regs. Sec. 1.460-2 contains three safe harbors concerning contracts to manufacture unique items. If any of the following safe harbors are met, an item is not unique:

• If a taxpayer normally completes the item within 90 days;
• If the item is customized from a taxpayer's existing design, and if the total allocable costs attributable to customizing such item do not exceed 5% of the total costs allocable to the item; or
• A taxpayer carries similar items in finished-goods inventory.

These safe harbors differ significantly from the test used by the Tax Court to determine whether an item was unique (see Sierracin Corp., 90 TC 341 (1988)).

Prop. Regs. Sec. 1.460-2(c) also provides the definition of the normal time to complete an item as the item's reasonably expected production period (as defined in Regs. Sec. 1.263A-12). The regulation further indicates that a production period for an item generally begins on the first day that at least 5% of the estimated accumulated production costs are incurred, including planning and design expenditures. Therefore, a production period may begin before actual physical production has occurred. A production period ends for a unit when such item is ready to be held for sale and all production activities are complete.

Choosing an accounting method may not be much of a choice at all. Taxpayers and their advisers need to be aware of the various requirements that pertain to their business; failure to use the correct accounting method can lead to very unfavorable tax adjustments down the road.

From Shannon Lynch, CPA, MST, Boston, MA