In an IRS chief counsel advice memorandum released Sept. 26 (CCA 201439001), the IRS concluded that it generally would not support imposing the simplified production method on restaurants if the taxpayers are willing to develop and implement a reasonable facts-and-circumstances method instead. If those taxpayers use the simplified production method, the IRS also would support allowing them to treat direct production costs as Section 471 costs, rather than as additional Section 263A costs.

Restaurants generally purchase, process and combine ingredients to produce food for sale to customers. Generally, the IRS views this process as production subject to Section 263A. The CCA explains that a number of restaurants under examination have ending inventories that consist mainly of raw materials, specifically ingredients. The restaurants generally capitalize costs related to the kitchen as production costs and treat costs related to the serving area as non-capitalizable under Section 263A. Some restaurants, however, do not capitalize under Section 263A costs that are incurred to produce food, including wages related to preparing and cooking the food (kitchen labor).

The IRS stated in the memorandum that if kitchen labor was treated as additional Section 263A costs under the simplified production method, a significant amount of kitchen labor would be capitalized to the raw materials in ending inventory, even though kitchen labor costs typically relate almost entirely to the production of food that is no longer on hand. If kitchen labor was treated as a Section 471 cost under either the simplified production method or facts-and-circumstances method, those costs would be allocated to the cost of produced food included in the cost of goods sold.

The IRS also noted that if the simplified production method, with kitchen labor treated as an additional Section 263A cost, was imposed on a restaurant, the restaurant could request and would generally receive consent for a change in the method of accounting to treat kitchen labor as a Section 471 cost or to use a facts-and-circumstances method.

Grant Thornton observation: As the IRS notes in the CCA, taxpayers willing to develop and implement a reasonable facts-and-circumstances method, or at least to treat kitchen labor as a Section 471 cost, would be able to allocate kitchen labor almost entirely to cost of goods rather than to the raw material ingredients. Restaurants not currently using such a method should consider filing an application to request to change, which may require advance consent.