Editor: Greg A. Fairbanks, J.D., LL.M.
On September 15, 2009, the IRS announced in a field directive (LMSB-040909-035) that it was temporarily suspending the examination of Sec. 263A (UNICAP) issues involving automobile dealerships. The suspension began on September 15, 2009, and will end on December 31, 2010. According to the directive, the IRS suspended the examination in order to allow affected taxpayers the opportunity to comply with legal analysis contained in Technical Advice Memorandum (TAM) 200736026. While the IRS acknowledged that a TAM is not authoritative guidance, it added that the legal reasoning in the TAM may be instructive in connection with automobile dealership examinations.
The TAM addressed a number of issues, including whether the installation of parts on customer-owned vehicles, and on taxpayer-owned (i.e., dealership-owned) vehicles, would constitute “production” for purposes of the UNICAP regulations. The TAM concluded that the installation of parts on the taxpayer-owned vehicles constitutes production, while the installation of parts on customer-owned vehicles does not. The existence of production activities at a retail facility is relevant because it could have a significant effect on a taxpayer’s UNICAP calculation—including whether the taxpayer has a retail sales facility, whether the taxpayer can deduct certain storage and handling costs, and whether the taxpayer can use the simplified resale method.
On April 9, 2009, prior to the publication of the directive, the IRS National Office published Notice 2009-25. The notice requests comments on numerous UNICAP issues related to retailers. The IRS received at least two comment letters in response to the notice. One comment letter, submitted by the National Automobile Dealers Association (NADA), called into question the validity of the reasoning in the TAM and stated that a better definition of “production” was needed. The IRS has placed this issue on its 2009–2010 priority guidance business plan.
In the directive, the LMSB encourages taxpayers to take steps (i.e., file Form 3115, Application for Change in Accounting Method) to comply with the reasoning in the TAM. Presumably, in order to comply with the directive, thousands of affected automobile dealerships will file accounting method change requests with the IRS National Office, notwithstanding that the TAM is nonprecedential and the IRS National Office and Treasury have a pending business plan item that might address some of the technical issues raised by the TAM. In addition to the fact that the TAM is nonprecedential, it does not adequately provide the framework for automobile dealers to know which activities rise to the level of production and which do not.
Regardless of whether publishing the directive furthers sound tax policy, the directive is out there and taxpayers need to be aware of what it means to them. This item describes some of the underlying technical issues raised in the TAM and its potential effects on auto dealers. It also briefly examines the Code and regulation sections that are relevant to this issue. The item then goes on to discuss the TAM and what it means to affected taxpayers.
Rules of Law
Sec. 263A provides that the direct and indirect costs properly allocable to property that is inventory in the hands of the taxpayer must be included in inventory costs. Regs. Sec. 1.263A-1(e)(1) provides that taxpayers subject to Sec. 263A must capitalize all direct costs and certain indirect costs properly allocable to property produced or property acquired for resale. Sec. 263A(g)(1) provides that the term “produce” includes construction, building, installation, manufacturing, development, or improvement of property.
Regs. Sec. 1.263A-3(a)(2) describes capitalization rules relating to resellers with production activities. Regs. Sec. 1.263A-3(a)(2)(B), Example (2), involves a retail grocery store with a bakery department. Based on the existence of the bakery activities, the example describes the taxpayer as a reseller with de minimis production (baking) activities. The issue in the example was whether the taxpayer was subject to UNICAP. In the example, the taxpayer was not required to capitalize additional Sec. 263A costs because the taxpayer’s average annual gross receipts were under $10 million and the taxpayer’s production activities (i.e., baking) were de minimis. This example leaves one to wonder what other activities that occur in a grocery store might constitute “production.” Had the taxpayer’s production activities been more than de minimis, it would have been subject to UNICAP.
Regs. Sec. 1.263A-3(c) provides certain favorable rules in connection with storage and handling costs incurred at a retail sales facility and at an on-site storage facility. A “retail sales facility” is defined as a facility where a taxpayer sells merchandise exclusively to retail customers (final purchasers of the merchandise) in on-site sales. For this purpose, the retail sales facility includes those portions of any specific retail site:
- That are customarily associated with and are an integral part of the operations of that retail site;
- That are generally open each business day exclusively to retail customers;
- On or in which retail customers normally and routinely shop to select specific items of merchandise; and
- That are adjacent to or in immediate proximity to the other portions of the specific retail site.
Regs. Sec. 1.263A-3(c)(5)(ii)(C) provides that a storage facility is an integral part of a retail facility when the storage facility is an essential and indispensible part of the retail sales facility.
Regs. Sec. 1.263A-3(c)(4)(i) provides that handling costs and storage costs incurred at retail sales facilities need not be capitalized. This rule (i.e., deduction of storage and handling at a retail sales facility) applies to producers that incur storage and handling costs as well as to resellers. Regs. Secs. 1.263A-3(c)(5)(i) and (ii) also contain rules allowing the deduction of storage costs incurred in connection with an on-site storage facility.
Regs. Sec. 1.263A-3(c)(4) states that handling costs are defined as “costs attributable to processing, assembling, repackaging, transporting, and other similar activities with respect to property acquired for resale, providing the activities do not come within the meaning of the term produce as defined in §1.263A-2(a)(1).” Further, Regs. Sec. 1.263A-3(c)(4)(ii) states that processing costs are “the costs a reseller incurs in making minor changes or alterations to the nature or form of a product acquired for resale. Minor changes to a product include, for example, monogramming a sweater, altering a pair of pants, and other similar activities.” Assembling costs are defined as “costs associated with incidental activities that are necessary in readying property for resale (e.g., attaching wheels and handlebars to a bicycle acquired for resale)” (Regs. Sec. 1.263A-3(c)(4)(ii)). Given the definitions of processing, assembling, and production, it is often difficult to determine whether a particular activity is a processing activity or a production activity.
Because the rules relating to retail sales facilities and on-site storage facilities are so favorable, and because the favorable rules apply to storage and handling costs (and not to production costs), knowing the difference between production costs and handling (processing and assembly) costs is critical.
In TAM 200736026, the taxpayer was a franchised automobile dealership that sold new and used vehicles as well as vehicle parts and accessories. The taxpayer repaired customer-owned vehicles and installed parts onto customer-owned and taxpayer-owned vehicles. The TAM ruled on 12 issues, only three of which are discussed here.
One issue was whether the installation of parts (sold by the taxpayer) on either customer-owned vehicles or the taxpayer’s own vehicles constituted production activities for purposes of Sec. 263A. The IRS concluded that the taxpayer engaged in production activities when it installed parts on the taxpayer’s own vehicles but that the taxpayer did not engage in production activities when it installed parts on customer-owned vehicles.
The IRS stated that the installation of parts on customer-owned vehicles is not production because the taxpayer does not own the property that is being produced (which in the IRS’s view was the vehicle). The installation of parts on customer-owned vehicles would be considered handling costs. The IRS stated that production costs include the costs of those items that make the taxpayer’s vehicles saleable or more readily marketable. It noted that while the costs of certain other activities, such as adding fluid to a vehicle, would not be production, those costs would be handling costs.
Another issue addressed in the TAM was how the taxpayer should handle production costs in the simplified resale method absorption ratio, assuming the taxpayer was permitted to use that ratio. The IRS stated that, assuming the taxpayer was permitted to use the simplified resale method, the indirect production costs would be treated as additional Sec. 263A costs and included in either the storage and handling absorption ratio or the purchasing cost absorption ratio.
The IRS also addressed whether a taxpayer could treat purchasing, storage, and handling costs as mixed service costs or whether it should treat such costs as relating directly to resale or production activities. It stated that the purchasing costs and the storage and handling costs directly benefited or were incurred by reason of the production or resale activities. The IRS stated that such costs are not service costs because they cannot be identified with a service department or function.
The TAM and regulations illustrate the importance of the distinction between handling and production for purposes of the UNICAP regulations. If the costs are handling costs, and if those costs are incurred at a retail sales facility, then those costs are deductible. On the other hand, if those costs are production costs, the taxpayer must capitalize them. The distinction is important, not only to the automotive industry but to other industries as well.
Assume that the grocery store described above had a deli department that made sandwiches. Would the IRS view those activities as production? If so, might those activities push the taxpayer’s production activities above the de minimis threshold? Might the IRS use the reasoning in the TAM and apply it to other industries?
Although the TAM is not binding and there is a pending business plan item, the LMSB is now encouraging automobile dealerships to seek accounting method changes. Given the potential scope of this issue and its potential effect on a UNICAP calculation, taxpayers need to consider whether they are treating handling and production activities properly. Automobile dealers are faced with a dilemma. On the one hand, the LMSB directive encourages taxpayers to file Forms 3115 to comply with the TAM. On the other hand, the TAM does not provide the framework needed for a taxpayer to tell precisely which activities constitute production and which do not. Given the existence of a pending guidance plan item, automobile dealerships might also consider whether they want to request permission for a change in accounting method now or wait until the IRS and Treasury issue binding guidance in this area.
Greg Fairbanks is a tax manager with Grant Thornton LLP in Washington, DC.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or firstname.lastname@example.org