§ 1.471-1. Need for inventories.

¶(i) In general. A taxpayer, other than a tax shelter prohibited from using the cash method under section 448(a)(3), meets the gross receipts test of this paragraph (b)(2) if it meets the gross receipts test of section 448(c) and § 1.448-2(c). This gross receipts test applies even if the taxpayer is not otherwise subject to section 448(a).

¶(ii) Application of the gross receipts test—

¶(i) Using a method that treats its inventory as non-incidental materials and supplies (section 471(c) NIMS inventory method), as described in paragraph (b)(4) of this section; or

¶(ii) Using the method for each item that is reflected in the taxpayer's applicable financial statement (AFS) (AFS section 471(c) inventory method); or, if the taxpayer does not have an AFS for the taxable year, the books and records of the taxpayer prepared in accordance with the taxpayer's accounting procedures, as defined in paragraph (b)(6)(ii) of this section (non-AFS section 471(c) inventory method).

¶(i) In general. The costs of inventory treated as non-incidental materials and supplies are recovered through cost of goods sold only in the taxable year in which the inventory is used or consumed in the taxpayer's business, or in the taxable year in which the taxpayer pays for or incurs the cost of the inventory, whichever is later. Inventory treated as non-incidental materials and supplies is used or consumed in the taxpayer's business in the taxable year in which the taxpayer provides the inventory to its customer. The costs of inventory are treated as non-incidental materials and supplies under this paragraph (b)(4) are not eligible for the de minimis safe harbor election under § 1.263(a)-1(f)(2).

¶(ii) Identification and valuation of inventory treated as non-incidental materials and supplies. A taxpayer may determine the amount of the costs of its inventory treated as non-incidental materials and supplies that are recoverable through costs of goods sold by using either a specific identification method, a first-in, first-out (FIFO) method, or an average cost method, provided that method is used consistently. See § 1.471-2(d). A taxpayer that uses the section 471(c) NIMS inventory method may not use any other method described in the regulations under section 471, or the last-in, first-out (LIFO) method described in section 472 and the accompanying regulations, to either identify inventory treated as non-incidental materials and supplies, or to value that inventory treated as non-incidental materials and supplies. The inventory costs includible in the section 471(c) NIMS inventory method are the direct material costs of the property produced or the costs of property acquired for resale. However, an inventory cost does not include a cost for which a deduction would be disallowed, or that is not otherwise recoverable but for paragraph (b)(4) of this section, in whole or in part, under a provision of the Internal Revenue Code.

¶(iii) Allocation methods. A taxpayer treating its inventory as non-incidental materials and supplies under this paragraph (b)(4) may allocate the costs of such inventory by using specific identification or any other reasonable method.

¶(iv) Example. Taxpayer D is a baker that reports its baking trade or business on Schedule C, Profit or Loss From Business, of the Form 1040, Individual Tax Return, and D's baking business has average annual gross receipts for the 3-taxable years prior to 2019 of less than $100,000. D meets the gross receipts test of section 448(c) and is not prohibited from using the cash method under section 448(a)(3) in 2019. Therefore, D qualifies as a small business taxpayer under paragraph (b)(2) of this section. D uses the overall cash method, and the section 471(c) NIMS inventory method. D purchases $50 of peanut butter in November 2019. In December 2019, D uses all of the peanut butter to bake cookies available for immediate sale. D sells those peanut butter cookies to customers in January 2020. The peanut butter cookies are used or consumed under paragraph (b)(4)(i) of this section in January 2020 when the cookies are sold to customers, and D may recover the cost of the peanut butter in 2020.

¶(i) In general. A taxpayer that meets the gross receipts test described in paragraph (b)(2) of this section and that has an AFS for such taxable year may use the AFS section 471(c) inventory method described in this paragraph to account for its inventory costs for the taxable year. For purposes of the AFS section 471(c) inventory method, an inventory cost is a cost of production or resale that a taxpayer capitalizes to inventory property produced or property acquired for resale in its AFS. For purposes of the AFS section 471(c) inventory method, costs that are generally required to be capitalized to inventory under section 471(a) but that the taxpayer does not capitalize to inventory on its AFS are not required to be capitalized to inventory. However, an inventory cost does not include a cost that is neither deductible nor otherwise recoverable but for paragraph (b)(5) of this section, in whole or in part, under a provision of the Internal Revenue Code (for example, section 162(c), (e), (f), (g), or 274). In lieu of the inventory method described in section 471(a), a taxpayer using the AFS section 471(c) inventory method recovers its inventory costs in accordance with the inventory method used in its AFS.

¶(ii) Definition of Applicable Financial Statement (AFS). The term applicable financial statement (AFS) is defined in section 451(b)(3) and the accompanying regulations. See § 1.451-3(a)(5). The rules relating to additional AFS issues provided in § 1.451-3(h) apply to the AFS section 471(c) inventory method. In the case of a taxpayer with a financial accounting year that differs from the taxpayer's taxable year, the taxpayer must consistently use the same method of accounting described in § 1.451-3(h)(4)(i)(A) through (C) that is used for section 451(b) purposes to also determine its inventory for the taxable year under this paragraph (b)(5)(ii). A taxpayer has an AFS for the taxable year if all of the taxpayer's taxable year is covered by an AFS.

¶(iii) Timing of inventory costs. Notwithstanding the timing rules used in the taxpayer's AFS, the amount of any inventoriable cost may not be capitalized or otherwise taken into account for Federal income tax purposes any earlier than the taxable year during which the amount is paid or incurred under the taxpayer's overall method of accounting, as described in § 1.446-1(c)(1). For example, in the case of an accrual method taxpayer, inventoriable costs must satisfy the all events test, including economic performance, of section 461. See § 1.446-1(c)(1)(ii) and section 461 and the accompanying regulations.

¶(iv) Example. H is a calendar year C corporation that is engaged in the trade or business of selling office supplies and providing copier repair services. H meets the gross receipts test of section 448(c) and is not prohibited from using the cash method under section 448(a)(3) for 2019 or 2020. For Federal income tax purposes, H chooses to account for purchases and sales of inventory using an accrual method of accounting and for all other items using the cash method. For AFS purposes, H uses an overall accrual method of accounting. H uses the AFS section 471(c) inventory method of accounting. In H's 2019 AFS, H incurred $2 million in purchases of office supplies held for resale and recovered the $2 million as cost of goods sold. On January 5, 2020, H makes payment on $1.5 million of these office supplies. For purposes of the AFS section 471(c) inventory method of accounting, H can recover the $2 million of office supplies in 2019 because the amount has been included in cost of goods sold in its AFS inventory method and section 461 has been satisfied.

¶(i) In general. A taxpayer that meets the gross receipts test described in paragraph (b)(2) of this section for a taxable year and that does not have an AFS, as defined in paragraph (b)(5)(ii) of this section, for such taxable year may use the non-AFS section 471(c) inventory method to account for its inventories for the taxable year in accordance with this paragraph (b)(6). The non-AFS section 471(c) inventory method is the method of accounting used for inventory in the taxpayer's books and records that properly reflect its business activities for non-tax purposes and are prepared in accordance with the taxpayer's accounting procedures. For purposes of the non-AFS section 471(c) inventory method, an inventory cost is a cost of production or resale that the taxpayer capitalizes to inventory property produced or property acquired for resale in its books and records, except as provided in paragraph (b)(6)(ii) of this section. Costs that are generally required to be capitalized to inventory under section 471(a), but that the taxpayer does not capitalize in its books and records are not required to be capitalized to inventory. However, an inventory cost does not include a cost that is neither deductible nor otherwise recoverable but for paragraph (b)(5) of this section, in whole or in part, under a provision of the Internal Revenue Code (for example, section 162(c), (e), (f), (g), or 274). In lieu of the inventory method described in section 471(a), a taxpayer using the non-AFS section 471(c) inventory method recovers its applicable costs through its book inventory method of accounting. A taxpayer that has an AFS for such taxable year may not use the non-AFS section 471(c) inventory method.

¶(ii) Timing and amounts of costs. Notwithstanding the timing of costs reflected in the taxpayer's books and records, a taxpayer may not recover any costs that have not been paid or incurred under the taxpayer's overall method of accounting, as described in § 1.446-1(c)(1). For example, in the case of an accrual method taxpayer or a taxpayer using an accrual method for purchases and sales, inventory costs must satisfy the all events test, including economic performance, under section 461(h). See § 1.446-1(c)(1)(ii), and section 461 and the accompanying regulations.

¶(iii) Examples. The following examples illustrate the rules of paragraph (b)(6) of this section.

¶(i) In general. A change in the method of treating inventory under this paragraph (b) is a change in method of accounting under sections 446 and 481 and the accompanying regulations. A taxpayer changing its method of accounting under paragraph (b) of this section may do so only with the consent of the Commissioner as required under section 446(e) and § 1.446-1. For example, a taxpayer using the AFS section 471(c) inventory method or non-AFS section 471(c) inventory method that wants to change its method of accounting for inventory in its AFS, or its books and records, respectively, is required to secure the consent of the Commissioner before using this new method for Federal income tax purposes. However, a change from having an AFS to not having an AFS, or vice versa, without a change in the underlying method for inventory for financial reporting purposes that affects Federal income tax is not a change in method of accounting for such inventory under section 446(e). In the case of any taxpayer required by this section to change its method of accounting for any taxable year, the change shall be treated as a change initiated by the taxpayer. For rules relating to the clear reflection of income and the pattern of consistent treatment of an item, see section 446 and § 1.446-1. The amount of the net section 481(a) adjustment and the adjustment period necessary to implement a change in method of accounting required under this section are determined under § 1.446-1(e) and the applicable administrative procedures to obtain the Commissioner's consent to change a method of accounting as published in the Internal Revenue Bulletin (see Revenue Procedure 2015-13 (2015-5 IRB 419) (or successor) (see also § 601.601(d)(2) of this chapter).

¶(ii) Automatic consent for certain method changes. Certain changes in method of accounting made under paragraph (b) of this section may be made under the procedures to obtain the automatic consent of the Commissioner to change a method of accounting. See Revenue Procedure 2015-13 (2015-5 IRB 419) (or successor) (see § 601.601(d)(2) of this chapter)). In certain situations, special terms and conditions may apply.