government

One of my businesses is raising goats and making cheese.  Like every other business, at year-end we have to figure out whether we owe taxes.  For a manufacturing business like ours, that’s not always easy.

During the course of a business year, we paid for cow milk,goat feed, cheese making supplies, and so forth.But we don’t get to deduct the full amount of pour purchases, because some of the cheese we made has not yet been sold.  It remains in inventory.    We are required to count the cheese inventory at year-end, which we did.  We had 1,688 pounds of cheese on hand when we counted.

How much is that cheese worth?  Well, last year it cost us more to produce the cheese than its market value, so we chose a method of inventory called “lower of cost or market.”  That means if the cheese is worth less than it cost, we use the market value; if it cost less than it is worth, we use cost.  So we have to figure out how much the cheese would be valued using each method, and use the lower.

To figure out the market value of the cheese, we tally up the total sales for the year and divide it by the number of pounds sold.  To figure the cost of the cheese, we tally up the costs of the purchases we made to make the cheese and divide that by the total amount produced for the year.  That is the total number sold, plus the total number in inventory, less the total number we had in inventory last year (because that cheese was produced in a prior year, not the year in question).

It turns out that we will be valuing our cheese at cost this year.

We need that number because the deductible amount of the purchases, called Cost of Goods Sold or COGS, is calculated by taking the beginning inventory, adding the purchases, and subtracting the ending inventory.

Are you with me so far?

But here’s where it gets really fun: the federal government has determined that a manufacturing industry must determine how much other expense went into the production of our cheese.  This is Section 263A of the tax code, so these expenses are typically referred to as 263A expenses.  In our case, they include labor, supplies, vehicle expense, security (the livestock guardian dog), equipment rental, repairs, and veterinary expenses.  We add all those up to get the “Total Attributable Expenses.”

Now we find the attribution rate, which is the number of pounds of cheese in the ending inventory, divided by the total number of pounds of cheese produced, rounded to 5 decimal places.  Yes, the tax code says how many decimal places to use.

Take the total attributable expense and multiply it by the attribution rate to get the amount of expense that needs to be capitalized– in other words, expense that isn’t deductible in the current year.

But we’re not done yet: last year we had 263A expense that had to be capitalized.  This year, we take that amount as an expense, while removing the current year number from expense.

So our COGS calculation looks something like this:

Beginning Inventory (last year’s ending inventory)

Add: Last Year’s 263A Expense

Add: Purchases

Subtract: Ending Inventory

Subtract: Current Year 263A Expense

————————————————–

Equals: Cost of Goods Sold

Is it simple?  Not at all.  But the actual tax code, as written by Congress, is worse:

In general
        In the case of any property to which this section applies, any
      costs described in paragraph (2) -
          (A) in the case of property which is inventory in the hands
        of the taxpayer, shall be included in inventory costs, and
          (B) in the case of any other property, shall be capitalized.
      (2) Allocable costs
        The costs described in this paragraph with respect to any
      property are -
          (A) the direct costs of such property, and
          (B) such property's proper share of those indirect costs
        (including taxes) part or all of which are allocable to such
        property.
      Any cost which (but for this subsection) could not be taken into
      account in computing taxable income for any taxable year shall
      not be treated as a cost described in this paragraph.

Excuse me?

It goes on like that for about 3 pages.  Then there are pages more of regulations issued by the Treasury Department on how this rule should be applied.

One thing is for sure: tax code like this ensures that accountants, auditors, and tax attorneys stay gainfully employed– at the expense of the businesses that have to hire them to get these calculations right, and then justify their calculations to the IRS.

My other business is preparing tax returns.  The fact that I make my living from the complexity of government regulation is an embarrassment. I would much rather see a simpler tax code and find another line of work!