On Nov. 20, 2018, the Internal Revenue Service (IRS) published final regulations (the Regulations) under Internal Revenue Code (IRC) Section 263A (or UNICAP) introducing new provisions impacting taxpayers. The Regulations – effective for all tax years beginning on or after Nov. 20, 2018 (the date of publication) – change the way taxpayers identify costs allocable to inventory, restrict the use of negative costs in UNICAP calculations and introduce a new simplified method for UNICAP computations. Accordingly, taxpayers should review their current UNICAP methods for full compliance with the latest Regulations.
What is UNICAP?
The rules under Section 263A and its related Regulations require taxpayers producing or acquiring tangible property for resale to capitalize certain direct and indirect costs to the basis of the property. Those costs include direct costs, allocable indirect costs and possibly costs in excess of what is capitalized for financial reporting purposes. In general, taxpayers whose average annual gross receipts for the three-year period before 2019 exceed $26 million are subject to UNICAP.
Changes in the Definition of Section 471 Costs
The Regulations define Section 471 costs as the types of costs capitalized in a taxpayer's financial statement to inventory produced or acquired for resale in amounts determined under the taxpayer's federal income tax accounting methods.1 In addition, the Regulations now require taxpayers to capitalize all direct costs as Section 471 costs.2
In complying with the Regulations, a taxpayer may now be required to maintain two sets of books – its current set and one maintained for tax purposes – to properly determine its current year and on hand at year-end Section 471 costs (approximating cost of goods sold and ending inventory, respectively) on a federal income tax basis (tax basis).
However, the Regulations also introduce relief to the requirement discussed above requiring Section 471 costs to be capitalized on tax basis. Under the new Alternative Method of determining Section 471 costs, an eligible taxpayer may determine the amount of its Section 471 costs using the financial accounting methods used in its qualifying financial statement. Taxpayers eligible to adopt this Alternative Method include the following taxpayers with qualifying financial statements:
- Taxpayers utilizing the simplified resale method (SRM) as prescribed in Treas. Reg. Section 1.263A-3(d)
- Taxpayers utilizing the simplified production method (SPM) as prescribed in Treas. Reg. Section 1.263A-2(b) whose average gross receipts do not exceed $50 million
- Taxpayers utilizing the modified simplified production method (MSPM) as prescribed in Treas. Reg. Section 1.263A-2(c)
Qualifying financial statements include:
- Financial statements required to be filed with the U.S. Securities and Exchange Commission (SEC) (e.g., Form 10-K)
- Audited financial statements used for any substantial non-tax purpose
- Other financial statements (not including tax returns) required to be filed with any federal or state government or agency, excluding the SEC or IRS
Restrictions on Negative Adjustments within Additional Section 263A Costs
Some taxpayers may find that the costs capitalized to inventory for financial reporting purposes exceed the costs required to be capitalized by UNICAP. In the past, taxpayers have removed these costs from ending tax-basis inventory through the inclusion of negative Section 263A costs in their UNICAP computations. However, the Regulations introduce a broad prohibition on the use of negative Section 263A costs.3
Common examples of costs capitalized for financial statement purposes which may have previously been removed from UNICAP calculations with a negative adjustment include (but are not limited to):
- Research and development expenses under Section 174
- Distribution or selling costs (including outbound freight)
- The excess of book depreciation expense over tax depreciation expense allocable to production or resale property
The prohibition on the inclusion of negative adjustments in additional Section 263A costs does not apply to taxpayers using the SRM or the MSPM. It also does not apply to taxpayers who use the SPM and have average gross receipts less than $50 million.4
Further, negative adjustments in additional Section 263A costs are permitted for any taxpayers required to adjust additional Section 263A costs as a result of adopting the Alternative Method of determining Section 471 costs or one of the de minimis exceptions related to uncapitalized variances described later.
Treatment of Uncapitalized Direct Costs and Uncapitalized Variances
The Regulations now explicitly require taxpayers to include all direct material and direct labor costs as Section 471 costs. Taxpayers must generally recompute Section 471 costs incurred and on-hand to account for uncapitalized direct costs and direct cost variances (including under- and overapplied burdens). Examples of uncapitalized direct costs may include:
- Direct material and labor variances which are expensed directly to the income statement in the period incurred
- Over or underapplied material and labor burden or overhead expensed in the period incurred
- Employee benefits associated with direct labor costs (e.g., vacation or holiday)
- Materials and supplies directly expensed
To ease administrative burden, the Regulations provide a series of de minimis thresholds that may allow for the inclusion of uncapitalized direct costs as additional Section 263A costs rather than as Section 471 costs (which, as previously discussed, would require a recalculation of Section 471 inventory on a tax-basis). The following types of uncapitalized direct costs are considered de minimis for this purpose:
- Direct labor costs – de minimis if the total of all uncapitalized amounts is less than five percent of total direct labor costs incurred
- Direct material costs – de minimis if the total of all uncapitalized amount is less than five percent of total direct material costs incurred
- Uncapitalized variances and over/underapplied burdens – de minimis if the total of all uncapitalized amounts is less than five percent of total Section 471 costs incurred
In determining eligibility for de minimis treatment, each uncapitalized amount is treated as a positive amount – regardless of whether the amount is a negative uncapitalized cost (e.g., cost reduction, overapplied burden, etc.).
New Simplified Method Available to Producers
Historically, the simplified methods available to taxpayers have included the SPM and SRM. The Regulations introduce an additional method available to producers and producer-resellers: the Modified Simplified Production Method.
While the SPM and SRM apply a single absorption ratio to all inventory to compute a UNICAP adjustment, the MSPM uses two separate ratios: a Preproduction ratio and a Production ratio. The Preproduction ratio is applied to raw materials inventory and inventory acquired for resale while the Production ratio is applied to work-in-process and finished goods inventory.5
Despite the added complexities in applying two separate ratios to two distinct pools of inventory, the MSPM may provide a significant tax benefit to producers and producer-resellers whose inventory and purchases include substantial amounts of raw materials and goods acquired for resale (i.e., Preproduction property). The primary driver of this benefit is that raw materials and goods acquired for resale (i.e., inventory which has not yet or will not enter the production process) are not subject to the application of additional Section 263A costs incurred during the production process. This represents a potentially significant advantage over the legacy SPM methodology.
Another benefit of the MPSM is that users with qualifying financial statements are eligible to adopt the Alternative Method of determining Section 471 costs regardless of gross receipts and may include negative additional Section 263A adjustments in their UNICAP computations. These benefits alone may outweigh any additional administrative burden brought about via the MSPM (compared to the SPM).
Accounting Method Changes Available to Taxpayers
Revenue Procedure 2019-43 prescribes a number of automatic method changes available to taxpayers to come into compliance with the final Section 263A regulations. A taxpayer may generally make one or more of the required method changes by filing a single Form 3115 reflecting concurrent changes. These changes are made with a Section 481(a) adjustment.
The eligibility rule under Revenue Procedure 2015-13 is generally waived for a taxpayer's first three taxable years ending on or after Nov. 20, 2018.6 Thus, taxpayers who have recently filed a Form 3115 for a different change in method under Section 263A are not restricted from making another change to adopt the Regulations.
Taxpayers should comprehensively review their current UNICAP methods for tax years 2019 and 2020 since the impacts of the Regulations are broad and multifaceted. With the new rules introduced by the Regulations, it is possible that a taxpayer's present UNICAP methods are not permissible under the revised guidance and, therefore, may require one or more accounting method changes to become compliant.
However, the MSPM also introduces a key opportunity for producers and manufacturers to improve their UNICAP methods with a potentially tax favorable change from the SPM. A favorable adjustment can be used to reduce taxable income in the year of change – which presents a significant opportunity for taxpayers to realize cash tax savings in a turbulent and uncertain economy.
- Treas. Reg. Section 1.263A-1(d)(2)(i)
- Treas. Reg. Section 1.263A-1(d)(2)(ii)
- Treas. Reg. Section 1.263A-1(d)(3)(ii)
- Treas. Reg. Section 1.263A-1(d)(3)(ii)(B)
- Treas. Reg. Section 1.263A-2(c)(3)
- Rev. Proc. 2019-43, Sections 12.01(2)(b) and 12.02(4)