Final UNICAP regulations provide long-awaited guidance
TAX ALERT |
Treasury and the IRS (hereafter, the government), on Nov. 19, 2018, issued long-awaited guidance (T.D. 9843) on the treatment of negative additional section 263A costs, as well as the allocation of costs under the UNICAP rules relating to the use of the simplified methods. The government first announced concern about these topics in Notice 2007-29 and issued proposed regulations in 2012. After much delay, debate and review, the government issued final regulations, addressing many of the issues brought up by comments to the proposed regulations.
Of greatest significance, the regulations 1) provide rules for the treatment of negative adjustments to costs required to be capitalized to property produced or acquired for resale, 2) provide a new simplified method, and 3) redefine how certain types of costs are categorized under the simplified methods.
The final regulations define section 471 costs as the costs capitalized to property produced or property acquired for resale in the taxpayer’s financial statement and the taxpayer determines the amount of section 471 costs by using the amount incurred in the tax year for federal income tax purposes. Generally, under this new definition, taxpayers will need to include all direct costs as section 471 costs, regardless of treatment within the financial statements. However, the regulations provide some limited safe harbor relief.
Taxpayers should welcome the new regulations as they offer a clear definition of section 471 costs and provide the ability to remove non-capitalizable costs from financial statement inventory if certain conditions are met. The new definition of section 471 costs is compliance focused, but many taxpayers will find the definition practical. Additionally, the regulations allow taxpayers to treat certain negative amounts as additional section 263A costs when they use the new Modified Simplified Production Method (MSPM), the Simplified Resale Method (SRM), or for taxpayers with average annual gross receipts less than $50 million, the Simplified Production Method (SPM).
Other beneficial additions include an alternative method for calculating section 471 costs, a definitional change of “raw material costs” to “direct material costs,” and other safe harbors for the treatment of certain costs.
In addition, the government released Rev. Proc. 2018-56, which provides the automatic consent procedures to change to certain methods of accounting provided by the final regulations (including a change to the MSPM and a change to comply with the new definition of section 471 costs). The regulations are effective as of November 20, 2018, and apply for taxable years beginning on or after November 20, 2018. However, the IRS will not challenge return positions consistent with the final regulations for taxable years that include November 20, 2018 (practically speaking, these rules will take effect for 2019 returns).
While the regulations present significant planning opportunities, they also signal to exam that inspection of inventory accounting is full steam ahead. Accordingly, taxpayers should consult with their advisors to determine any opportunities and address compliance with respect to the new regulations.
Here is a list of the major changes included in T.D. 9843:
Negative 263A amounts
- The final regulations generally restrict taxpayers from including negative adjustments in additional section 263A costs, unless they use the new MSPM or the SRM. In addition, small taxpayers with average annual gross receipts of $50 million or less for the three previous taxable years may include negative adjustments in additional 263A costs under the SPM (the proposed regulations capped gross receipts at $10 million).
- The regulations require taxpayers that are eligible to include negative adjustments in additional section 263A costs to use that same method for all section 471 costs (the consistency requirement).
- The final regulations provide further clarification that taxpayers cannot remove certain expenses, such as bribes, lobbying expenses, and fines and penalties, from section 471 costs as negative adjustments.
Classification of costs
- The final regulations provide that taxpayers should classify section 471 costs, additional section 263A costs, and adjustments thereto using the narrower of the taxpayer’s financial statement classification or the classification of costs in Treas. Reg. section 1.263A-1(e)(2), (3), or (4).
- To reduce administrative burden, the final regulations use the term “direct material costs” rather than “raw material costs” and provide that taxpayers using the MSPM are not required to track the direct material component of work-in-process and finished goods.
- The regulations provide a de minimis rule for taxpayers using the MSPM to allocate one hundred percent of capitalizable mixed service costs to pre-production or production additional section 263A costs if 90 percent or more of the mixed service costs are allocable to one of those categories.
- The regulations also provide that section 471 costs for, and additional section 263A costs properly allocable to, property produced under a contract and property acquired for resale are included in pre-production section 471 costs, or pre-production additional 263A costs, respectively.
- The regulations clarify that direct material costs include property produced under a contract for a taxpayer when the taxpayer further produces such property.
- For LIFO inventory, the regulations clarify that the combined absorption ratio under the MSPM should be first determined on a non-LIFO basis.
Definition of 471 costs
- The final regulations clarify that section 471 costs are the type of costs capitalized to property produced or property acquired for resale in the taxpayer’s financial statement and the taxpayer determines the amount of section 471 costs by using the amount incurred in the tax year for federal income tax purposes.
- In recognizing that keeping two sets of financial statements is burdensome, the regulations provide an alternative method for determining section 471 costs to taxpayers permitted to include negative adjustments in additional section 263A costs to remove section 471 costs. However, the taxpayer’s financial statement must be required to be filed with the Securities and Exchange Commission, must be a certified audited financial statement, or must be a financial statement required to be provided to the government. An unaudited financial statement used for a non-tax purpose is not eligible.
- This alternative method allows eligible taxpayers to determine the amount of all section 471 costs by using the amount capitalized to property produced or property acquired for resale in the taxpayer’s financial statement, but does not include financial statement write-downs, reserves or other valuation adjustments.
De Minimis exceptions for certain direct costs in section 471 costs
- Although the final regulations retain the requirement that section 471 costs must include all direct costs of property produced and property acquired for resale, they add a de minimis rule that allows taxpayers using one of the simplified methods to include in additional section 263A costs and exclude from section 471 costs certain direct material costs not capitalized for financial statement purposes (e.g., freight-in or trade and cash discounts). The amount of all uncapitalized direct material costs must be less than 5 percent of total direct material costs for the year.
- The final regulations provide a de minimis direct labor cost rule that allows taxpayers using one of the simplified methods to include in additional section 263A costs and exclude from section 471 costs certain direct labor costs not capitalized to property produced or property acquired for resale in the taxpayer’s financial statement. The amount of all uncapitalized direct labor costs must be less than 5 percent of total direct labor costs for the year.
- Special rules exist for taxpayers using the alternative method to determine section 471 costs or a Historic Absorption Ratio (HAR).
Variances and burdens
- The final regulations provide a safe harbor rule for taxpayers using one of the simplified methods to include in additional section 263A costs certain variances and under or over-applied burden costs that are not capitalized to property produced or property acquired for resale in their financial statements. The amount of all uncapitalized variances and under or over-burdened costs must be less than 5 percent of total of section 471 costs for all items that the taxpayer uses a standard cost or burden rate method to allocate costs.
Special rules exist for taxpayers using the alternative method to determine section 471 costs or a HAR.