The IRS and Treasury released final uniform capitalization (UNICAP) regulations in November 2018. The regulations provide a number of changes for the type and manner in which costs are capitalized to inventory for tax purposes. The regulations notably introduce a new modified simplified production method (MSPM) that allows better matching of types of costs to types of inventory and cost of goods sold. Unlike the simplified production method (SPM), which in a practical sense is limited to producers with average gross receipts under $50 million, the MSPM is available to producers of any size. Government contractors should pay close attention to these rules if they enter into contracts for the provision or production of goods.
The regulations define section 471 costs as the types of costs capitalized to property produced or property acquired for resale in the taxpayer’s financial statements (i.e., generally accepted accounting principles) but according to the amounts per tax rather than GAAP. Practically, this means taxpayers would need to keep two sets of financial statements, one with amounts determined under GAAP and one determined by tax. Since keeping two sets of financial statements would be burdensome, the regulations provide an alternative method for taxpayers to determine section 471 costs, allowing eligible taxpayers to determine the amount of all section 471 costs by using both the type and amount capitalized to property produced or property acquired for resale in the taxpayer’s financial statements, excluding write-downs, reserves or other valuation adjustments. The alternative definition is only available for taxpayers eligible to use the SPM with no more than $50 million in average annual gross receipts, the MSPM, or the simplified resale method (SRM).
The regulations also provide some relief for taxpayers capitalizing costs for book purposes that are noncapitalizable for tax purposes—so-called negative adjustments. Taxpayers using the new definition of section 471 costs may include negative adjustments in additional section 263A costs, but must maintain consistent treatment across all section 471 costs. Certain nondeductible costs (such as bribes, lobbying, fines and penalties) are not eligible for removal as negative adjustments. Rev. Proc. 2018-56 provides for automatic change procedures in order to switch to the MSPM or recharacterize section 471 costs to additional 263A costs (and vice versa). This allows taxpayers flexibility in becoming compliant with the new regulations.
The regulations affect resellers and producers by requiring the capitalization of all direct costs, such as direct materials, direct labor, inbound freight and vendor discounts, as section 471 costs. Before the new regulations, many taxpayers included uncapitalized direct costs as additional section 263A costs. This led to inconsistency across companies and industries and factored into the government’s decision to propose these new rules. Under the new rules, uncapitalized direct costs may be treated as additional section 263A costs only in limited instances pursuant to de minimis rules or safe harbor treatment.
Of great significance to producers, the regulations introduced a new simplified method, the MSPM, which surprisingly can yield beneficial results for many producers. The MSPM provides better matching of costs to ending inventory. It requires taxpayers to allocate costs to inventory based on the relationship to pre-production inventory (i.e., raw materials) or production inventory (i.e., WIP and finished goods). By allocating pre-production costs (e.g., freight-in, purchasing labor) to raw materials inventory only, the taxpayer avoids allocating such costs to work in progress (WIP) and finished goods. By contrast, the SPM can result in the allocation of pre-production costs to WIP and finished goods (or of production costs to raw materials) despite the lack of relationship between such costs and type of inventory. For example, under the SPM, direct labor might be allocated to raw materials even though the raw materials have not yet obtained the benefit of production labor. Accordingly, taxpayers with a larger amount of raw materials in ending inventory relative to WIP and finished goods should see a benefit by switching to the MSPM.
A government contractor must consider whether a contract is for the provision of services, of goods, or to manufacture, build, install, or construct property where such contract is not completed within the taxable year it is entered into. If the contract is to manufacture, build, install or construct property where such contract is not completed within the taxable year it is entered into, the contract is likely subject to the percentage of completion method (PCM) under section 460; UNICAP does not apply. If the contract is for the provision of goods—whether produced or acquired for resale—and is not considered a long-term contract under section 460, then UNICAP applies. If the contract is for the provision of services, neither UNICAP nor PCM applies. Instead, the normal rules for deductions under section 461 apply. Therefore, government contractors must first determine the nature of their contracts. Moreover, with the recently released Financial Accounting Standards Board guidance under ASC 606, as well as changes to revenue recognition under section 451 as part of tax reform, government contractors should also evaluate the treatment of revenue from such contracts (a topic outside the scope of this article).
Determining the treatment of contracts is often difficult because contracts may be for a mix of services and goods or for a mix of activities that could be construed as maintenance or construction (or something similar). Furthermore, because there can be different types of contracts with different streams of revenue, the determinations may vary from contract to contract. Therefore, government contractors must carefully evaluate all of their contracts to determine the appropriate treatment for each. Such factors to consider are the significance of property provided to customers relative to services, the extent to which the work performed represents manufacturing or construction, the duration of the contract, the passage of title to property, and the allocation of shared costs among contracts if more than one set of rules applies.
Method changes relating to long-term contracts under section 460 require advance consent from the IRS through non-automatic procedures. Such changes are effected on a cut-off basis (meaning no retrospective section 481a adjustment), require a user fee payable to the IRS (currently $10,800 plus $230 for each additional applicant), and must be filed within the year of change (meaning requests are due by the last day of the tax year). Taxpayers may not implement changes in accounting method without the IRS consent. Alternatively, many changes required by the new UNICAP regulations can be implemented under the automatic method change procedures, which do not require a user fee, nor advance consent from the IRS, and may be filed with a timely filed tax return including extensions. The List of Automatic Changes can be found in Rev. Proc. 2018-31 (or its successor). Method changes are made on a cut-off basis or with a section 481(a) adjustment. If the method change is on a cut-off basis, the change in treatment is prospective only, while changes requiring a section 481a adjustment are retrospective.
Government contracts typically involve contracts that require special methods of accounting and use of the Federal Acquisition Register (FAR) that dictate timing of income and expense recognition. Additionally, there are new revenue recognition standards for financial accounting under ASC 606. The new revenue recognition guidance brings monumental changes to how many middle-market companies account for revenue and disclose revenue-related information. The new guidance is effective as of Jan. 1, 2018, for public entities with calendar year ends. For all nonpublic entities with calendar year-ends, the new guidance is effective in the year ending Dec. 31, 2019. To have a better understanding of how the new revenue recognition rules and long-term contracts under section 461 may affect government contractors, please read our Insight Article, Accounting methods: What government contractors should know.