Although many Restaurants have not been audited for failure to capitalize costs under Internal Revenue code 263A, the IRS still has the authority to assess taxes!

One of the surprises is that although it is very clear that restaurants need to capitalize costs under Code Section 263A, the IRS has not assessed income taxes.

In a “nutshell” the Code Section 263A takes a percentage of those costs that are required to be incurred so the food menu items can be prepared.  Code Section 263A takes a percentages of costs including administrative labor, rent and other costs required to produce the menu item and increases the ending inventory amount.   The result is that cost of goods sold decreases while taxable income increases resulting in higher personal income taxes for the partners or shareholders.

The impact on taxable income is normally just in the first year that the Code Section 263A “Unicap” simplified method is applied. If the costs are similar in future years, there isn’t an impact on taxable income in future years.

Those restaurants who apply the Code Section 263A rules use the simplified production method. This method is used to capitalize some of the expenses that go into producing the menu items

Under the simplified method, indirect labor is allocated based on the ratio of direct kitchen labor to total direct labor. Other indirect costs are also allocated to production activities. An allocation ratio is then computed. The ending inventory is then multiplied by the allocation ratio to determine the additional costs that should be added to the ending inventory.

Let us use an example of what the IRS states should be done to correctly reduce expenses for menu items.

Jack and Jill have a restaurant called Jill’s Bistro.

For example, let us assume that a calculation was performed and direct kitchen labor amounted to almost 40% total direct labor.

The salary and related expenses of the general manager are considered indirect expenses and are not allocated between dining room and kitchen activities. This is referred to in IRC Sec. 263A as a mixed service cost.

It is also possible to include labor expenses related to the general manager as a component of direct expenses.

However, in most cases, any saving from reduced additional Section 263A expenses is not justified when compared to the additional costs of tracking and allocating the manager’s time.

I am enclosing a calculation from one of tax booklets how Section 471 (pre-UNICAP) expenses are applied as follows:

Summary income information:

Sales     $ 641,000
Cost of food:
Beginning inventory $ 9,000
Purchases  220,000
Less: ending inventory (10,000)  without Unicap simplified inventory method dollars included. See below for with Unicap calcualtion

Cost of food sold  (219,000)
Gross profit     422,000
Less: labor and fringe benefits     (199,000)
Less: general and administrative expenses (see following list)     (210,000)
Operating income $ 13,000

General and administrative expenses:
Rent     $ 42,300
Utilities     19,800
Advertising 17,800
Depreciation 14,700
Repairs     11,100
Expendable replacement 10,500
Insurance     10,500
Laundry    9,000
Accounting and legal 8,200
Business tax and licenses 9,200
Interest     8,000
Janitorial and cleaning     7,800
Supplies    7,800
Credit card discount 4,800
Travel     6,000
Music and entertainment    3,500
Automobile    5,000
Menus    3,000
Telephone    4,000
Business meals    2,000
Cash (over) short    1,800
Miscellaneous    2,500
Office supplies    700
Total general and administrative expenses    $ 210,000

The December 31 inventory valuation for tax return purposes is calculated as follows:

Additional Section 263A costs:

Indirect labor (assume allocation of management and administration labor expenses is based on ratio of direct kitchen labor to total direct labor) (i.e., $43,000 × 54%): $ 23,220
Allocated indirect expenses
Total additional Section 263A costs related to inventory: $ 119,640
Allocation ratio: [ratio of additional Section 263A costs to current year Section 471 (pre-UNICAP) expenses ($119,640 ÷ $376,000)]: 31.8%
Section 471 (pre-UNICAP) expenses included in ending inventory (i.e., ending physical inventory valuation): $ 10,000
Multiplied by allocation ratio: ×.318
Additional Section 263A expenses allocated to ending inventory ($10,000 × 31.8%): $ 3,180
Ending inventory balance: $ 10,000
Ending tax return inventory valuation: $ 13,180

Please let me know if you have any questions. Thank you very much! Jeff

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About Jeffrey Brooks

Jeffrey Brooks, CPA, CFP, MBA since 1976 has specialized in helping clients save significant taxes, help businesses increase their cash flow, revenues and profits while increasing their control and satisfaction. Jeff and his accounting firm sincerely cares about the happiness of his clients.

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