Accounting methods and periods roundup

Cost recovery, losses and R&D

Historic absorption ratio for UNICAP represents planning opportunity

Aug 08, 2023
Accounting methods Business tax

Recent tax accounting methods guidance may assist with tax planning ideas

With the second quarter in the rearview mirror for calendar-year companies, we enter a period of finalizing 2022 tax compliance and looking ahead to tax planning for the 2023 calendar year.

Neither the courts nor the IRS in the second quarter issued major guidance related to accounting methods, but taxpayers did receive the anticipated annual update to the list of automatic accounting method changes, the obsoletion of a 65-year-old revenue ruling that allowed taxpayers to amend returns for consistency in section 174 cost treatment, and various letter rulings and advice regarding cost recovery and losses.

While not covered in detail here because it is proposed legislation that has not moved to the legislative floor, the House Ways and Means Committee released three proposed bills: the Tax Cuts for Working Families Act, the Small Business Jobs Act, and the Build it in America Act.

The Build it in America Act contains provisions to bring back the ability to expense research and experimentation expenditures for taxable years beginning in 2022 through 2025. It also resets the interest expense limitation calculation to allow the addback of depreciation, depletion and amortization for taxable years beginning in 2022 through 2025. For calendar year 2022 and tax planning into 2023, sections 174 and 163(j) continue to be top of mind for many companies.

Before recapping the recent updates from the IRS and Treasury Department, here’s a tax planning idea for companies subject to capitalization of costs under section 263A. As many companies now have spent three or more years computing section 263A capitalization under the 2018 final regulations, they may be eligible for a more streamlined cost allocation method election called the historic absorption ratio election.

Tax planning opportunity

Inventory and cost allocation planning: UNICAP and the historic absorption ratio election


If I’ve learned anything by talking to people since the release of the 2018 UNICAP regulations, it is that most don’t enjoy the intricacies of inventory accounting, and they enjoy the complicated UNICAP rules even less. I used to feel similarly as I began my career outside of accounting and found the first few UNICAP projects I ever did to be—shall we say—intense.

While I Learned to Stop Worrying and Love UNICAP (apologies to Mr. Kubrick) and spend most of my time thinking about inventory, I doubt all tax professionals will find the same beauty in UNICAP that I do. If you are one of those people who don’t, moving to the historic absorption ratio (HAR) for UNICAP might help you spend a little less time thinking about inventory.

What is the HAR and why now?

The HAR is an optional election for UNICAP that generally reduces the time and effort to calculate UNICAP. Instead of calculating an absorption ratio every year from the entirety of the income statement, the taxpayer applies an average ratio from a three-year test period to ending inventory. The taxpayer must “retest” the ratio by generating a full UNICAP calculation periodically to determine if a new three-year average is necessary.

As described below, a taxpayer needs three prior years on a UNICAP method to compute the HAR ratio. With many taxpayers having adopted the section 263A regulations in 2018, 2019 or 2020, there should now be at least three prior years to pull from to compute the HAR.

How does it work?

In the year of election, the taxpayer takes the prior three years of additional section 263A costs and divides them by the section 471 costs to generate the HAR ratio. This ratio may have other components depending on the inventory methods in place.

The HAR generated from the test period is applied to section 471 costs remaining on hand at year end (generally meaning ending inventory). A taxpayer uses this ratio for five years (the year of election plus the subsequent four years) in the qualifying period. In the sixth year from election (which is the recomputation year), a taxpayer needs to compute a full UNICAP calculation using the method from the original test period.

If the newly computed ratio is within +/- 0.5% of the existing ratio, a taxpayer continues to use the HAR for the sixth year and the next five years. The taxpayer then will need to repeat the recomputation process.

What are potential benefits and detriments to the HAR?

Taxpayers considering the HAR are generally interested in reducing the administrative burden of calculating UNICAP every year, as a full UNICAP calculation is no longer necessary.

As the HAR locks in the absorption ratio, it can lead to either favorable or unfavorable outcomes compared to a full UNICAP computation each year. Taxpayers with lower absorption rates expected to increase soon can enjoy a five-year period at the prior rates. Taxpayers with high absorption ratios would have established those rates for the next five years, regardless of if those rates are expected to decrease.

As an example, taxpayers experiencing elevated levels of uncapitalized tax depreciation related to installation of new equipment for inventory production may have abnormally high ratios that may adjust downward as fewer assets are placed in service and/or bonus depreciation phases out.

Taxpayers with planned or frequent updates to their book or tax methods for inventory may not benefit from the HAR as anticipated. Depending on the inventory changes involved, the taxpayer may have to recompute and apply the test period HAR ratio under the new inventory method. This may represent a substantial administrative burden and may alter the HAR ratio unfavorably.

As an industry consideration, private equity portfolio companies may also benefit from a HAR election. If the general hold period is less than eight years and the exit structure is going to be a taxable asset acquisition (or part-taxable, part-tax-free), then that portfolio company may never encounter its retest period.

Final thoughts

A taxpayer looking to reduce their time on UNICAP compliance may benefit from electing the HAR. It would be wise, however, to consider future acquisitions, ERP upgrades and expected efficiency increases, among other things, before rushing the election in an attempt to simplify compliance.

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