IRS Launches Compliance Campaign Aimed at Inflated Cost of Goods Sold

The IRS Large Business & International Division (LB&I) has announced a compliance campaign aimed at taxpayers that may have reduced their taxable income by improperly inflating their reported cost of goods sold (COGS). LB&I is responsible for tax administration activities for domestic and foreign businesses with a U.S. tax reporting obligation having assets of at least $10 million, as well as certain high net worth individuals.

COGS reflects the “above the line” costs that a manufacturer or retailer incurs to produce or acquire inventory sold to customers during the tax year. Costs required to be included in inventory costs – and recovered as COGS for a given year – generally are identified by the taxpayer’s inventory method of accounting under Section 471 (such as either the last-in, first-out (LIFO) or first-in, first-out (FIFO) inventory method) as well as by the uniform capitalization rules of Section 263A.

IRS Campaign Aimed at COGS

When first published on the LB&I webpage on August 8, 2023, the description of the new COGS campaign lacked any indication of its scope or purpose. The description said only that “This campaign focuses on LB&I taxpayers that have indications of inflated Cost of Goods Sold to reduce taxable income.” The ambiguity left taxpayers and their advisors to speculate on the intent and scope of the new compliance campaign.

Subsequently, LB&I Commissioner Holly Paz committed to clarifying the scope of the campaign. She stated, “[The campaign] really is about looking at taxpayers and industries that are overstating their cost of goods sold, whether that is through inventory manipulation or valuation, overstatement of costs, [or] improper deduction of nondeductible items.” She also stated that the campaign is not focused on transfer pricing. “LB&I Will Clarify Its Campaign on Inflated Cost of Goods Sold,” 180 Tax Notes Federal 2141 (Sept. 18, 2023). The campaign description on the LB&I website has been updated to reflect these three considerations, without further detail.

It is worth noting that the campaign likely will rely heavily upon data analytics and perhaps the IRS’s artificial intelligence capabilities to identify LB&I taxpayers that have potentially inflated COGS improperly. Rather than being led by a specific LB&I practice area as is typical for compliance campaigns, this effort will be led by LB&I’s Office of Compliance Planning & Analytics.

Insights

Several variables affect a company’s COGS calculation. These include inventory counts and valuations as well as determinations regarding whether a specific cost must be (or can be) capitalized as an inventory cost and recovered through COGS rather than treated as an ordinary business expense and deducted in the year incurred. At this time, it is unclear which of the many variables in computing COGS may be of interest to LB&I.