Small Business Questions & Answers


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Ask About Business Classification Codes

by Baffled in Buffalo | May 24, 2012

Subject :Other News

Dear Toolkit,

I barely figured out the "SIC" code that was required when filling out our annual federal tax returns and now, when I filed this year's return, I found out that there's a whole new coding system called "Nakes." What's going on with our classification-happy government and what do they use this stuff for anyway?


Baffled in Buffalo

Dear Baffled in Buffalo,

"Nakes" is just a nickname for NAICS (North American Industrial Classification System), which was adopted in 1997 for use by the plethora of statistical agencies Uncle Sam employs. It was designed to replace the 1987 version of the "SIC" (Standard Industrial Classification) code, originally developed in the 1930s. The government, state agencies, trade associations, researchers and other statistical organizations use the data submitted under these codes to predict future economic trends and analyze historical patterns.

NAICS is based on the consistent economic concept of process/production. Businesses (they call them establishments) that use similar processes to produce goods or services are grouped together. The SIC was partially based on production and partially on demand, so it was inconsistent by definition. NAICS, unlike SIC, recognizes the emergence of service-based and high technology businesses into our economy. While SIC had 1004 industry classifications, 416 of which were service-based, NAICS includes 1170 industries of which 565 are serviced-based. Some of the types of businesses NAICS includes that SIC did not are as diverse as casinos, satellite communications, diet centers and software publishers.

According to the U. S. Census Bureau, "NAICS industries are identified by a 6-digit code, in contrast to the 4-digit SIC code. The longer code accommodates the larger number of sectors and allows more flexibility in designating subsectors. It also provides for additional detail not necessarily appropriate for all three NAICS countries (Canada, Mexico and the U.S.). The international NAICS agreement fixes only the first five digits of the code. The sixth digit, where used, identifies subdivisions of NAICS industries that accommodate user needs in individual countries. Thus, 6-digit U.S. codes may differ from counterparts in Canada or Mexico, but at the 5-digit level they are standardized." Stimulating reading, right?

Illinois State University has a good, clear example of the differences between SIC and NAICS digital codes, using the potato chip as the product manufactured.

20 Food and Kindred Products
209 Miscellaneous Food Preparations and Kindred Products
2096 Potato Chips, Corn Chips, and Similar Snacks

31 Manufacturing
311 Food Manufacturing
3119 Other Food Manufacturing
31191 Snack Food Manufacturing
311919 Other Snack Food Manufacturing

So if you make potato chips, your old SIC code was 2096 but your new NAICS code is 311919.

The IRS uses these codes to screen your tax return against others with the same code classification. This will tell them if your income and expenses are in line with industry norms. If they're not, you can expect to be invited in for an audit.

If you'd prefer to avoid the gracious hospitality of the IRS audit folks, you'd do well to select your NAICS code very carefully and accurately. A detailed list of the codes you have to choose from comes with each and every type of federal tax return you'd be likely to use for your business and further details can be found on the Census Bureau's web site. But if you truly can't find a classification that fully describes what you do (such as making chocolate buggy whips or whatever) then you can fall back on that old standby "miscellaneous" category—999999.

So, if you're still thirsting for more knowledge about the latest hot trends in statistical tabulation, more than you ever wanted to know about NAICS can be found here.