Year-End Considerations for
Wholesalers and Manufacturers

Year-end tax and financial planning plays a critical role in all businesses. Planning before year end allows a more proactive approach in minimizing tax liabilities and planning for related cash flow requirements, and also in assessing the impact on bank covenants and financial position. This advanced planning provides the opportunity to identify issues while there’s still time left to influence the outcome and avoid unnecessary surprises. In this article, we will highlight the primary planning considerations for wholesalers and manufacturers that should not be overlooked in your year-end planning process.

MANAGE YEAR END SHIPMENTS
In general, revenue recognition is triggered by the shipment or delivery of the merchandise to the customer. Proactive management of year-end shipments provides you with control over the year in which those sales are recognized. Thus, shipping an item on January 3rd rather than December 31st defers the income tax as well as B&O tax and other taxes related to the sale of the item.

EVALUATE UNUSUAL CUSTOMER OR SUPPLIER ARRANGEMENTS
Creative arrangements can sometimes have unexpected consequences for tax or financial statement purposes. Contingent sales, consignment sales, sales with extended rights of return or extended payment arrangements, installment sales – these are just a few examples of the types of arrangements that should be evaluated now to avoid unexpected surprises later. Customer rebate agreements, supplier rebate agreements and co-op advertising plans should also be reviewed to determine the appropriate tax and financial statement recognition period.

REVIEW INVENTORY VALUATION
Inventory valuations should be reviewed for possible tax write-offs and appropriate financial statement valuation. For tax purposes, inventory generally must be valued at cost, and you do not benefit from a tax deduction until the item is sold. There are certain instances, however, when unsold inventory can be valued at less than cost, or even written off completely without being sold.

For taxpayers using the lower of cost or market method of inventory valuation for tax purposes, each inventory item should be valued at cost or “market” – whichever is lower. “Market” generally means the current bid price (i.e. replacement cost). Regulations allow inventory to be valued based on a net realizable value lower than replacement cost if the merchandise was actually offered for sale prior to year end at a price lower than its replacement cost. In this situation, inventory should be valued at the selling price less direct costs of disposition.

“Subnormal goods” should always be valued at net realizable value, regardless of whether the taxpayer uses the cost method or the lower of cost or market method for valuing regular inventory. “Subnormal goods” are any goods that are unsaleable at normal prices or unsaleable in the normal way because of damage, imperfections, shop wear, changes of style, odd or broken lots or other similar causes, including second-hand goods taken in exchange. For subnormal goods, net realizable value is based on bona fide selling prices less direct costs of disposition. This must be based on actual offers to sell the subnormal goods for up to 30 days after year end.

Obsolete or unsaleable inventory does not actually have to be offered for sale at a price lower than cost in order to prove net realizable value, since such merchandise presumably has no value. These items can be valued at the net realizable value, which is often the scrap or salvage value.

CONSIDER DONATING INVENTORY
A C Corporation can donate inventory to a qualified organization and receive a deduction of up to two times the cost basis of the inventory. This deduction is limited to 10% of the C Corporation’s taxable income for the year. To the extent contributions exceed this 10% limit, the excess can be carried forward and deducted for five years.

IRC 263A PLANNING
Internal Revenue Code Section 263A requires that certain overhead costs related to inventory be capitalized into inventory rather than expensed as incurred. These rules apply to all manufacturers and to those resellers with average annual gross receipts for the last three years in excess of $10 million. If you are subject to this provision, look for ways to reduce the impact of the 263A adjustment by reducing the amount of inventory the company is carrying at the end of the year. If you are a reseller who has not yet been subject to 263A because your sales are below the minimum level, review your expected sales for the year. If projected company sales this year will have increased enough to push your three-year average over the $10 million threshold, take a close look at opportunities to defer sales into 2005 if it will keep the company under the $10 million threshold for one more year.

EVALUATE ACCOUNTS RECEIVABLE
Receivables should be reviewed carefully to determine if collection is reasonable. Financial statement users typically discount balances with an aging in excess of 60 or 90 days. Consider increasing collection efforts for such receivables near year end.

Close attention should also be paid to potentially uncollectible receivables. Have all collection efforts been exhausted to the extent necessary to support a bad debt deduction for tax purposes?

MONITOR CASH
Plan transactions at the close of the year to ensure a positive cash balance.

MAXIMIZE TAX DEPRECIATION
Qualifying assets placed in service on or before December 31, 2004 are eligible for the 50% bonus depreciation. This is a temporary tax incentive that expires at the end of the year. To qualify, the asset must be new (i.e. original use) tangible property. Certain leasehold improvements may also qualify. Take advantage of this expiring provision while you can – review your capital budget to see if asset purchases planned for 2005 should be accelerated into 2004.

A business can also elect to “expense” the cost of up to $102,000 of qualifying property purchased and placed in service before the end of the year under IRC Section 179. This election is subject to taxable income limits, and the dollar amount available for the election is also reduced dollar-for-dollar for annual purchases in excess of $410,000.

The bonus depreciation and high Section 179 provisions in recent years have allowed many businesses to significantly accelerate tax depreciation deductions. This will eventually result in a timing reversal, with financial statement depreciation exceeding tax depreciation. Review book-to-tax depreciation differences carefully to avoid surprises.

EVALUATE RELATED PARTY ACCRUALS
Review amounts that are due to/from a related party at year end. Most commonly these items are wages, interest expense and rent. The tax deduction for expenses owed to related parties is generally postponed until the year paid, even though these amounts are expensed on the company’s financial statement when incurred. It may be advantageous to pay these items before year end in order to trigger the tax deduction.

MAXIMIZE TAX BENEFITS OF LOSSES
If you are anticipating a significant loss for the year, there are several special tax issues to consider in year-end planning. If a net operating loss is generated, you will be able to carry the loss back to prior years. There are many limitations, however, that may prevent current recognition of losses – basis limitations, at-risk limitations, passive loss limitations, capital loss limitations and the wash sale rules, just to name a few. Additionally, the benefit of itemized deductions may be lost entirely in a loss year. The interaction of these rules requires careful consideration to determine the best course of action to follow in implementing a year-end planning strategy.

EVALUATE RELATED ENTITY OPERATIONS
Don’t assume that a loss passed through from one entity will automatically offset income passed through from another. Losses may be limited by any number of rules that are applied at the entity or activity level. If this is addressed before year end, it may be possible to shift income to avoid this problem.

REVIEW 401(K)/PROFIT-SHARING PLANS
Recent changes in the retirement plan rules have made qualified plans even more attractive. Maximum deductible contributions have been increased to 25% of compensation for defined contribution plans. Current law also allows flexibility in allocating contributions to employees whereby different groups of employees may receive different rates of contributions. This allows companies the opportunity to make significant retirement contributions for the benefit of owners and key employees while not requiring those same contribution levels for everyone. Plans should be reviewed now so that any advantageous plan changes can be adopted before year end.

REVIEW STATE OPERATIONS
If your company has operations in multiple states, now is the time to review your inventory levels in each state. Business income is generally apportioned based on a three-factor formula which includes revenues, payroll and property. Property includes all leased or owned property based on rent expense, fixed assets and inventory kept in that state. Evaluate expected year-end inventory levels and manage year-end transfers to your advantage. Postponing a transfer from a Washington warehouse to a location in a state with an income tax could reduce your state tax obligations.

This is also a good time to review any expansion into new states and evaluate any additional licensing and reporting requirements.
Additionally, if company operations have ceased in a particular state, review the steps necessary to terminate state filing and reporting requirements.

THE REAL ‘BOTTOM LINE’
As you reflect on year-end planning for your business and your personal finances, we encourage you to keep your strategic plan in mind. Tax minimization, while certainly important, needs to be considered in conjunction with the company’s and your personal overall goals. Likewise, the economic impact of decisions on the company’s financial position needs to be considered in conjunction with the impact on banking requirements, shareholder expectations and future plans. We look forward to working with you in identifying, clarifying and achieving your goals as part of your year-end planning process.

Kim Gregoris, CPA, MS (Tax)
Principal