In November 2018, amid the aftermath of tax reform, the U.S. Treasury and IRS issued new UNICAP regulations, providing companies with an updated method for capitalizing inventory costs. The revised method is one of several that companies can consider when capitalizing costs to inventory and it could bring simplicity, compliance and tax efficiency to your organization. Manufacturers should consider the new regulations and their potential to provide tax-savings.
Inventory is often one of the largest assets on a manufacturer’s balance sheet, and UNICAP has the potential to result in the capitalization of additional costs to inventory for tax purposes; now more than ever, manufacturers must evaluate the impact of these new rules. To aid that evaluation, we explore the common myths around UNICAP and provide manufacturers with some practical insights. Through RSM’s process of applying the new UNICAP methods, companies will potentially capitalize fewer costs and be able to deduct more.
Myth 1: The new UNICAP rules apply to any company with inventory.
Reality: Previously, UNICAP applied to most producers, regardless of size, and to resellers (retailers, wholesalers, distributors, etc.) with average annual gross receipts of $10 million or more. Under the new rules however, UNICAP applies to producers and resellers alike with average annual gross receipts for the prior three tax years of $25 million or more (adjusted for inflation). The final UNICAP regulations are generally effective for 2019 but are generally elective for 2018. Although the new rules are generally not effective until 2019, companies with gross receipts over $25 million, producers in particular, should consider reviewing the application of the new UNICAP rules now to determine if early adoption in 2018 is advantageous.
Myth 2: New UNICAP rules are burdensome with regard to both time and cost.
Reality: While the new regulations require a deeper understanding of costs related to operations, they introduce a new modified simplified production method (MSPM) that allows better allocation of costs between inventory and cost of goods sold (COGS). The MSPM will generally result in fewer costs capitalized to inventory than the existing simplified production method (SPM). In addition, the MSPM may approximate the generally more taxpayer-favorable results of a facts and circumstances method, but with less complexity and customization. Paired with our analysis, the new simplified methods should ease the burdens of the complexity introduced by the new rules. Relative to other capitalization methods, the new simplified methods are simpler and often result in tax savings.
Myth 3: UNICAP often requires the capitalization of costs that seem unrelated to items of inventory.
Reality: The MSPM tends to draw a stronger connection between the costs capitalized and the item of inventory. For example, a manufacturer of a widget might have raw materials, work in process (WIP) and finished goods in ending inventory. If the manufacturer must capitalize some indirect production labor cost under UNICAP, the MSPM would only require the capitalization of that cost to WIP and finished goods, not to raw materials. Compare that to the SPM under the old rules, which might have required the capitalization of that labor cost, in addition to WIP and finished goods, to raw materials that have not yet entered production. The new simplified methods result in outcomes that are more realistic and better correlate costs that can be capitalized to types of inventory. As the foregoing example illustrates, this better correlation is especially evident for manufacturers. The new UNICAP methods will often result in the capitalization of fewer costs and therefore provide potential tax savings, particularly for manufacturers with significant raw materials inventory balances.
Myth 4: UNICAP is a timing difference so manufacturers don’t need to worry about it.
Reality: As with all methods of accounting, in theory UNICAP is not permanent because it does not affect lifetime income; eventually UNICAP costs will enter COGS. However, if a company is a going concern and anticipates having inventory balances—or perhaps even larger inventory balances—in the future, the additional taxable income resulting from UNICAP effectively becomes permanent due to the time value of money. As long as a company maintains an inventory balance, the company must continue to capitalize UNICAP costs until it disposes the last of its inventory (typically upon sale of business). This essentially results in permanent tax on UNICAP by accelerating the tax burden currently and delaying the reversal into the indefinite future, thus reducing current cash flow for the company. For example, if a company has $1 million of inventory for books, $1.5 million for tax and an effective tax rate of 25%, the company will pay an additional $125,000 of tax now [($1.5 million - $1 million) x 25%], which will reverse only as the company reduces its inventory balance to zero. As the company reduces the amount capitalized for tax, it frees up additional cash flow for other use.
Myth 5: I don’t need to review UNICAP because the IRS has audited my tax return before without raising an issue about UNICAP.
Reality: The results of one IRS exam do not bind an agent on future IRS exams. Layer in the increased IRS focus on UNICAP following the release of the long-awaited regulations and the urgency is greater now for companies to review their UNICAP methodologies before the IRS does.
Myth 6: UNICAP should not apply to me since I already capitalize many costs for financial statement purposes.
Reality: Most companies are unlikely to follow tax rules for generally accepted accounting principles (GAAP) and should therefore have book-tax differences for UNICAP, such as depreciation. UNICAP costs generally layer on top of the costs already capitalized for financial statement purposes. Thus, the theory is the more costs capitalized for financial statement purposes the fewer additional UNICAP costs to layer on top. However, because the UNICAP rules are generally more encompassing than GAAP, additional UNICAP costs are usually required in addition to the costs already capitalized for financial statement purposes. For example, UNICAP generally requires the capitalization of certain general and administrative expenses, such as HR, IT and accounting—costs not normally capitalized for financial statement purposes. In addition, UNICAP requires the use of the tax amount of costs. Financial statements do not reflect tax amounts when book-tax differences exist. One notable aspect of the new UNICAP rules is that if UNICAP does not require the capitalization of costs already capitalized for financial statement purposes, it may be possible to remove these costs via the UNICAP calculation—a simplification not previously permitted by the IRS.
Next steps for UNICAP
Manufacturers should consider the new regulations and their potential to provide tax-savings. Through RSM’s process for applying the new UNICAP methods, companies will potentially capitalize fewer costs and be able to deduct more.