UNICAP Safe Harbors
Since section 263A was enacted by the Tax Reform Act of 1986, taxpayers have been required to capitalize direct and indirect costs to inventory and property produced. Accompanying regulations have been frequently revised to include several special methods and allowances that benefit resellers of inventory, and under the current regulations, taxpayers that sell on site, exclusively to retail customers from inventory stored on site, are not required to capitalize storage and handling costs incurred at the retail sales facility. 1 If some, but not all, sales meet the definition of an on-site retail sale, the facility is considered a dual function facility and only the portion of storage and handling costs incurred at the facility attributable to the non-qualifying sales must be capitalized.2 However, for purposes of determining capitalizable storage costs, if 90 percent or more of the costs of the facility are attributable to the on-site storage function, a dual function facility is deemed to be a retail sales facility. 3
The simplified production method and the simplified resale method allocate additional section 263A costs to inventory by applying an absorption ratio to section 471 costs4 on hand at the end of the year. The absorption ratio is generally calculated by including additional section 263A costs in the numerator and section 471 costs incurred during the year in the denominator. The simplified resale method gives taxpayers a more favorable method of calculating the absorption ratio for storage and handling costs by including beginning inventory in the denominator resulting in a smaller amount to capitalize than under the simplified production method. A reseller with production activities cannot use the simplified resale method unless such production activities are de minimis.5 What qualifies as de minimis is based on all the facts and circumstances, including the volume of production activities in the taxpayer's trade or business.6 Production activities are presumed de minimis if the gross receipts from the sale of property produced by the reseller are less than 10 percent of the total gross receipts of the trade or business, and the labor costs allocable to the trade or business' production activities are less than 10 percent of the reseller's total labor costs allocable to its trade or business.7
An automobile dealership would appear to be a reseller of inventory and not a producer, and accordingly, would be eligible to use the simplified resale method. Under these circumstances, dealerships would be able to avoid capitalizing all or some portion of their storage and handling costs under the rules for retail sales facilities and dual function facilities. Recently, the Service took a closer look at these rules, came to some drastically different conclusions, and then later changed its mind to a more taxpayer favorable position.
Technical Advice Memorandum (TAM) 200736026
Released in Sept. 2007, TAM 200736026 ruled unfavorably on a number of UNICAP issues for automobile dealers.
- First, the IRS concluded that dealer installation activities performed on new and used vehicles owned by the dealer may constitute production activities under section 263A and the regulations, depending on the specific facts. To the extent the installation activities were not production costs, they were handling costs. However, the IRS had insufficient information to determine whether the production activities were de minimis, which would allow the dealership to use the simplified resale method for determining the amount of additional section 263A costs capitalized into inventory.
- Second, the IRS concluded that the costs attributable to repair or installation activities for customer-owned vehicles were handling costs. The IRS compared installation of parts on a customer-owned vehicle to attaching wheels and handlebars to a bicycle acquired for resale. The regulations use the bicycle as an example of “assembling costs,” or costs associated with incidental activities that are necessary in readying property for resale.8 The IRS assumed that the customer has the option of taking the bicycle (and the vehicle for that matter) as assembled or unassembled (as in taking the parts installed or uninstalled), which appears to be inconsistent with the regulation’s definition of “assembling costs,” i.e., readying the property for resale.
- Finally, the IRS stated vehicles sold at wholesale, dealer trades (sales to another dealership at cost), sales structured as leases, and certain wholesale parts sales were not “on-site sales” to retail customers and, as a result, the taxpayer's storage facility was not a retail sales facility. This caused the storage and handling costs to be capitalized to the extent provided in the regulations for dual function facilities.9
Rev. Proc. 2010-44
In Nov. 2010, the IRS issued Rev. Proc. 2010-44 in which it backed away from several of the positions taken in TAM 200736026. As explained below, this revenue procedure provides a decidedly taxpayer-friendly approach in applying the UNICAP rules to inventories of motor vehicle dealerships (MVD). It also expands the application of the following safe harbors to more than just automobile dealerships.
Revenue Procedure 2010-44 provides two safe harbors under section 263A for certain motor vehicle dealerships:
- Retail sales facility safe harbor method. Under this method, an MVD may treat its entire sales facility from which it routinely conducts on-site sales to retail customers-- including any vehicle lot that is an integral part of the sales facility and that is routinely visited by customers-- as a retail sales facility. As a result, the MVD would not be required to capitalize handling and storage costs incurred at the retail sales facility.
- Reseller without production activities safe harbor method. This method allows an MVD to treat itself as a reseller without production activities. Activities performed on dealership-owned and customer-owned vehicles are handling activities, but the costs of these handling activities (other than the cost of vehicle parts) are not required to be capitalized to the extent they are incurred at the MVD’s retail sales facility. In addition, the MVD must capitalize the cost of vehicle parts used on dealer-owned vehicles as an acquisition cost of its vehicles. Further, the MVD may use the simplified resale method.
Qualifying MVDs may obtain automatic consent to change to either or both safe harbor methods.
The first safe harbor appears to give a better result than under the regulations for dealerships with any off-site or wholesale sales. Instead of having to determine the amount of non-retail or off-site sales as a percentage of the total, an MVD can exclude all storage and handling costs attributable to any lot that is an integral part of the sales facility and routinely visited by customers. There may still be some issues regarding what constitutes routine visits, particularly for lots not directly connected to the sales facility, however, this safe harbor will eliminate the requirement to capitalize most, and in some cases all, storage and handling costs for many dealerships.
The second safe harbor, by not requiring consideration of production activities, allows most dealerships to continue to avail themselves of the advantageous provisions in the regulations, including the simplified resale method. As mentioned above, the simplified resale method results in a lower absorption ratio for capitalizing storage and handling costs than does the simplified production method, assuming there are any such costs to capitalize after applying the first safe harbor. There may also be an opportunity for some dealerships to reduce the amount they currently capitalize for activities performed on dealer-owned vehicles. In order to properly allocate income between departments, many dealerships capitalize the cost of labor performed by its own service department on dealer-owned vehicles. Under the safe harbor, only the cost of parts must be capitalized.
Revenue Procedure 2010-44 defines the term motor vehicle dealership to encompass more than just typical automobile dealers. A dealership that primarily purchases and resells to retail customers one or more of the following categories of new or used motor vehicles, is a motor vehicle dealership:
- Light-duty trucks
- Medium-duty trucks
- Heavy-duty trucks
- Recreational vehicles
- Farm machinery and equipment
- Construction machinery and equipment
As stated above, qualifying MVDs may obtain automatic consent to change to either or both safe harbor methods pursuant to App. Sec. 11.07 of Rev Proc 2011-14. A change to use the retail sales facility safe harbor method is designated automatic accounting method change number 150, and a change to use the reseller without production activities safe harbor method is designated automatic accounting method change number 151. In addition, the following scope limitations of Rev. Proc. 2011-14 are temporarily waived for an MVD’s first or second tax year ending after Nov. 9, 2010:
- Under examination, including a consolidated group member or partnership or S corporation with an owner under examination
- Section 381(a) transaction
- Prior five-year item change
However, an MVD that currently removes section 471 costs from ending inventory by treating them as negative amounts in the numerator of the simplified resale/production method may not use either safe harbor method, unless it changes from such section 471 method.
An MVD will receive audit protection upon filing a Form 3115 to use a method consistent with the safe harbors provided in Rev. Proc. 2010-44. In addition, if an MVD used a method consistent with those safe harbors on a tax return filed before Nov. 10, 2010, the IRS will not assert that the methods are improper for such year(s).
Rev. Proc. 2010-44 provides favorable guidance under section 263A for more than just automobile dealerships, and appears to address some of the concerns raised by commentators after the release of TAM 200736026 with respect to production activities and storage and handling costs. Taxpayers affected by Rev. Proc. 2010-44 should take time now to review their section 263A methods and determine the benefit of automatically changing to either the retail sales facility safe harbor method or the reseller without production activities safe harbor method, or both. Taxpayers already using section 263A methods consistent with either or both safe harbors should be reassured with the provision of audit protection for the use of such methods in prior years.
1 Treas. Reg. sections 1.263A-3(c)(4) and (5).
3 Treas. Reg. section 1.263A-3(c)(5)(iii)(C).
4 For section 263A purposes, a taxpayer’s section 471 costs are generally, the costs, other than interest, capitalized under its method of accounting immediately prior to the effective date of section 263A. See Treas. Reg. section 1.263A-1(d)(2).
5 Treas. Reg. section 1.263A-3(a)(4)(ii).
6 Treas. Reg. section 1.263A-3(a)(2)(iii).
7 Treas. Reg. sections 1.263A-3(a)(2)(iii)(A)(1).
8 See Treas. Reg. section 1.263A-3(c)(4)(iii).
9 As a result of the TAM, automobile dealership section 263A methods became a Tier III issue. Subsequently, the IRS issued Notice 2009-25, inviting public comments by July 13, 2009, on how certain business practices in the retail industry have changed since the promulgation of the UNICAP regulations under section 263A, and whether certain definitions, under the regulations, should be modified in light of current business practices such as sales by fax or the internet. In LMSB-4-0909-035, the IRS announced that it would suspend the examination of automobile dealership section 263A issues from Sept. 15, 2009 through Dec. 31, 2010. Prior to the expiration of the moratorium, the IRS issued a second directive (LMSB-04-0810-021), on Aug. 9, 2010, continuing the suspension of UNICAP examinations of automobile dealerships until the release of further guidance. On Nov. 9, 2010, the IRS released the much anticipated guidance in the form of a revenue procedure – Rev. Proc. 2010-44.