Negative additional Sec. 263A costs

By John Suttora, CPA, Washington, and Dennis St. Martin, CPA, Raleigh, N.C.

Editor: Greg A. Fairbanks, J.D., LL.M.

On Nov. 20, 2018, Treasury and the IRS released final regulations (T.D. 9843) under the uniform capitalization rules (Sec. 263A) that deal with negative additional Sec. 263A costs. These regulations are largely aimed at manufacturers but are likely to affect all taxpayers with inventory. The new regulations: (1) provide rules for the treatment of "negative adjustments" related to certain costs required to be capitalized to property produced or acquired for resale; (2) add a new simplified method of accounting for allocating additional Sec. 263A costs to inventory or other property on hand at year end; and (3) redefine how certain costs are categorized for purposes of the simplified methods. These new regulations are effective for tax years beginning on or after Nov. 20, 2018, but may be applied to the taxpayer's first tax year ending on or after Nov. 20, 2018. The IRS has also issued Rev. Proc. 2018-56, which allows taxpayers to make certain changes automatically to comply with the new regulations.

Background

In general, the uniform capitalization rules under Sec. 263A require taxpayers to capitalize the direct and indirect costs that are allocable to taxpayers' property produced and property acquired for resale. These costs include many of the costs typically capitalized for financial statement purposes. Taxpayers are also required to capitalize additional costs such as purchasing, storage and handling, and an allocable portion of mixed service costs. Further, the uniform capitalization rules require that computations be made on a tax basis, so book-to-tax differences must be taken into account.

To allocate capitalizable Sec. 263A costs, the regulations allow taxpayers to use a variety of facts-and-circumstances methods. These include the specific identification method, burden rate, standard cost method, or another reasonable allocation method. Alternatively, taxpayers may also use one of the simplified methods to allocate costs between ending inventory and cost of goods sold. Many taxpayers use the simplified methods to ease the administrative burden associated with allocating and capitalizing additional Sec. 263A costs and adjusting for book-to-tax differences. The final regulations are aimed at the use of the simplified methods.

Under the simplified methods, taxpayers must determine their Sec. 471 costs (typically those costs capitalized for financial statement purposes) and their "additional section 263A costs." Treasury and the IRS were concerned with taxpayers' using negative adjustments in their additional Sec. 263A costs. "Negative adjustments" generally arise when costs capitalized to inventory for Sec. 471 purposes (typically financial statement costs) are greater than the amount required or permitted to be capitalized for tax purposes under Sec. 263A. For example, research and development costs that are capitalized for financial statement purposes but are not required to be capitalized for tax purposes, and excess book-over-tax depreciation may give rise to a negative adjustment. It is possible for distortions to occur when including "negative adjustments" in a taxpayer's additional Sec. 263A costs. This is because the method used to capitalize the Sec. 471 cost is different from the method used to remove costs from ending inventory.

Treasury and the IRS had previously requested comments in Notice 2007-29 and in proposed regulations issued Sept. 5, 2012, concerning the use of negative adjustments in conjunction with the simplified methods. Treasury and the IRS have received comments and have now released final regulations to address these concerns.

Final regulations

Regs. Sec. 1.263A-1(d)(3) generally prohibits the use of negative adjustments in additional Sec. 263A costs. However, there are several exceptions. The exceptions include:

  • Small taxpayers, which are defined as having average annual gross receipts for the three preceding tax years no greater than $50 million;
  • Taxpayers using the new modified simplified production method described in Regs. Sec. 1.263A-2(c); and
  • Taxpayers using the simplified resale method under Regs. Sec. 1.263A-3(d).

In addition, these new regulations provide that, in limited conditions, certain costs may be treated as negative adjustments to additional Sec. 263A costs. These include direct costs, variances, under- or over-applied burdens, and book-to-tax differences. These rules are discussed in further detail below.

Classification of costs

Under Regs. Sec. 1.263A-1(d)(5), taxpayers with negative adjustments must use the narrower of the classifications of costs described in Regs. Secs. 1.263A-1(e)(2), (3), and (4), whether or not the taxpayer is required to maintain inventories or the classifications of costs used by a taxpayer in its financial statement. If a cost is not described in those regulations sections, the cost is to be classified using the classification of costs used in the taxpayer's financial statement.

The modified simplified production method

Regs. Sec. 1.263A-2(c) provides taxpayers with a new simplified method called the modified simplified production method (MSPM). In contrast to the simplified production method (SPM), which uses a single factor to allocate costs, the MSPM uses a two-factor approach. One factor relates to pre-production activities, and the other factor relates to production activities.

As a result, under the MSPM, taxpayers determine a pre-production absorption ratio that is applied to direct material costs, and a production absorption ratio that is applied to production Sec. 471 costs. Production Sec. 471 costs include direct material costs that have entered the production process. In particular, the additional Sec. 263A costs allocable to eligible property remaining on hand at the close of the tax year under the MSPM is computed as follows: (Pre-production absorption ratio × Pre-production Sec. 471 costs remaining on hand at year end) + (Production absorption ratio × Production Sec. 471 costs remaining on hand at year end).

Given the above formula, some definitions are in order. The pre-production absorption ratio equals pre-production additional Sec. 263A costs divided by pre-production Sec. 471 costs. Pre-production additional Sec. 263A costs are those additional Sec. 263A costs that relate to the purchase, storage, and handling costs of direct materials prior to entering the production process. These costs also include the allocable share of mixed service costs. Pre-production Sec. 471 costs are direct material costs incurred for the year for property produced or acquired for resale that a taxpayer includes in its Sec. 471 costs. Direct material costs include items such as trade discounts and any transportation charges incurred to acquire those goods. Direct material costs also include property produced under contract with another party that the taxpayer will use in an additional production process.

The production absorption ratio equals: (Production additional Sec. 263A costs + Residual pre-production additional Sec. 263A costs) ÷ (Production Sec. 471 costs + Direct materials adjustment).

Production additional Sec. 263A costs are defined as those additional Sec. 263A costs incurred during the tax year that are not pre-production additional Sec. 263A costs. Likewise, production Sec. 471 costs are those Sec. 471 costs incurred during the year that are not pre-production Sec. 471 costs.

Residual pre-production additional Sec. 263A costs are the total Sec. 263A costs incurred for the year less the additional Sec. 263A costs that relate to the direct material on hand at year end. This residual element is intended to capture the additional Sec. 263A costs associated with direct materials in production. The direct materials adjustment is equal to the cost of direct materials that have entered into the production process during the year.

Note that the new MSPM is not necessarily simple. There are a number of additional considerations that taxpayers will have to take into account. For example, taxpayers will need to bifurcate warehousing activities between direct materials, and work-in-process and finished goods. Additionally, many taxpayers combine in their "raw materials" both direct materials and work-in-process. For example, a taxpayer may produce an item in Division A and send it to Division B for further processing. Division B may include this item as a "raw material" even though it has already been introduced to the production process. Accordingly, these taxpayers may need to bifurcate their raw materials into the direct material and work-in-process elements.

Allocating mixed service costs under the MSPM

The final regulations require that taxpayers using a facts-and-circumstances approach to allocate mixed service costs must use a reasonable method to allocate those costs between production and pre-production additional Sec. 263A costs. In accordance with Regs. Sec. 1.263A-2(c)(3)(iii), taxpayers using the simplified service cost method may allocate capitalizable mixed service costs between pre-production and production additional Sec. 263A costs using either of the following: (1) the ratio of direct material costs to total Sec. 471 costs incurred for the year, or (2) the ratio of pre-production labor costs to total labor costs that a taxpayer incurs for the year. Total labor costs do not include any mixed service costs.

Regs. Sec. 1.263A-2(c)(3)(iii)(C) provides a de minimis rule that allows taxpayers using the MSPM to allocate 100% of capitalizable mixed service costs to pre-production or production additional Sec. 263A costs if 90% or more of the mixed service costs would otherwise be allocated to that activity. Thus, for example, if 90% of capitalizable mixed service costs are allocated to pre-production additional Sec. 263A costs based on the ratio of labor costs that are pre-production costs to total labor costs incurred in the taxpayer's trade or business during the year, then 100% of capitalizable mixed service costs may be allocated to pre-production additional Sec. 263A costs.

Note that this approach operates similarly to the allocation of mixed service costs under the simplified resale method (SRM) in that a two-factor approach is used to allocate mixed service costs. In addition, these simplified methods tend to skew the allocation of mixed service costs toward the production factor. Therefore, taxpayers should analyze their methods of allocating mixed service costs to determine the most cost-beneficial result.

LIFO taxpayers

Similar to the SPM, Regs. Sec. 1.263A-2(c)(3)(iv) requires that LIFO taxpayers using the MSPM calculate a particular year's index without regard to their additional Sec. 263A costs. These taxpayers adjust current-year costs by applicable indexes to determine whether there has been an inventory increment or decrement in the current year. Taxpayers with increments multiply the increment by a combined absorption ratio to determine the amount of additional Sec. 263A costs associated with that increment. The combined absorption ratio is the additional Sec. 263A costs allocable to eligible property remaining on hand at the close of the tax year (determined on a current cost basis) divided by the pre-production and production Sec. 471 costs remaining on hand at year end (determined on a current cost basis). Also, similar to the SPM, LIFO taxpayers with decrements will relieve costs associated with each layer to the extent that layer has been invaded.

MSPM with historic absorption ratio

Regs. Sec. 1.263A-2(c)(4) provides that taxpayers may also use the historic absorption ratio in conjunction with the MSPM. The method is similar to the SPM with a historic absorption ratio in that a taxpayer may only make a historic absorption ratio election if it has used the MSPM for three or more consecutive tax years immediately prior to the year of election. There is also a three-year test period. However, FIFO taxpayers using this method compute the pre-production absorption ratio during the test period and a separate production absorption ratio during the test period. LIFO taxpayers compute a combined absorption ratio during the test period.

To extend the qualifying period, under Regs. Sec. 1.263A-2(c)(4)(iv), taxpayers recompute these ratios using actual data in the tax year following the close of the qualifying period (e.g., the sixth year following the test period). FIFO taxpayers may extend their qualifying period if both the pre-production absorption ratio and the production absorption ratio are within one-half of one percentage point of the corresponding ratios used during the qualifying period. LIFO taxpayers must have their combined absorption ratio be within one-half of one percentage point of the combined absorption ratio used during the qualifying period in order to extend the qualifying period.

Definition of Sec. 471 costs and special rules

The final regulations provide that a taxpayer's Sec. 471 costs are the types of costs that a taxpayer capitalizes to its property produced or acquired for resale for financial statement purposes. However, the regulations clarify that these costs must be determined on a tax basis. In particular, the taxpayer determines these costs based on the amount incurred during the tax year for federal income tax purposes.

In addition, the final regulations generally require that Sec. 471 costs include all direct costs of property produced and property acquired for resale. These costs include all direct material and direct labor costs, variances and over- and under-applied burden, and the related book-to-tax adjustments. However, as discussed below, several special rules allow these costs to be treated as additional Sec. 263A costs if certain conditions are met.

Alternative method for determining Sec. 471 costs

Taxpayers adhering to the strict general rule described above would be required to maintain two separate cost accounting systems — one for financial statement purposes and another for tax purposes. Given this administrative burden, Regs. Sec. 1.263A-1(d)(2)(iii) provides an alternative method for determining Sec. 471 costs. This alternative method allows taxpayers with qualifying financial statements to determine their Sec. 471 costs by using the amounts of costs capitalized to property produced or property acquired for resale in those financial statements. Taxpayers using this alternative method remove costs that are not required or permitted to be capitalized by including them as negative adjustments in their additional Sec. 263A costs, but only if they are permitted to do so by reason of one of the exceptions described above.

The alternative rule is limited to taxpayers that have a financial statement that is (1) a financial statement required to be filed with the SEC; (2) a certified audited financial statement used for a substantial nontax purpose; or (3) a financial statement (other than a tax return) required to be provided to the government. A taxpayer using the alternative method may not include any write-downs, reserves, or other valuation adjustments used for financial statements in determining Sec. 471 costs. Note that lower-of-cost-or-market taxpayers may still be afforded a write-down of inventory, but they must use the tax rules prescribed in Regs. Secs. 1.471-2(c) and 1.471-4.

De minimis rule for direct labor costs

As discussed above, the final regulations generally require that Sec. 471 costs include all direct costs of property produced or acquired for resale. However, some taxpayers do not capitalize all of their direct labor costs. For example, items such as holiday pay, sick leave pay, shift differential, or payroll taxes may be deducted currently as a period cost. Accordingly, Regs. Sec. 1.263A-1(d)(2)(iv)(B) provides a de minimis rule for certain direct labor costs.

Under this de minimis rule, a taxpayer using the SRM, SPM, or MSPM includes in its additional Sec. 263A costs, and excludes from its Sec. 471 costs, the total amount of all uncapitalized direct labor costs that are incurred in that tax year. The rule applies if the total amount of those costs is less than 5% of total direct labor costs incurred in the tax year (whether or not capitalized for financial statement purposes). Taxpayers may not use this de minimis rule to include in additional Sec. 263A costs basic compensation or overtime.

De minimis rule for direct material costs

As noted above, cash and trade discounts and other freight charges to acquire goods are treated as adjustments to the underlying Sec. 471 costs. Thus, they may not be included as negative adjustments in additional Sec. 263A costs. However, Regs. Sec. 1.263A-1(d)(2)(iv)(C) provides a rule to allow taxpayers using the SRM, SPM, or MSPM to include in their additional Sec. 263A costs and exclude from their Sec. 471 costs a de minimis amount of direct material costs not capitalized in their financial statements. This rule applies if the total amount of all uncapitalized direct material costs is less than 5% of total direct material costs (whether or not capitalized).

For the purposes of the 5% rule, positive and negative adjustments may not be netted together. For example, a taxpayer with a 3% positive adjustment for freight-in and a 4% negative adjustment for cash and trade discounts would be considered to have a total of 7% and, therefore, be in excess of the 5% limitation. Alternatively, if the same taxpayer had only a 1% negative adjustment for cash and trade discounts, the taxpayer would have a total of 4% and therefore meet the 5% limitation. In this example, the taxpayer would be able to treat both the positive and negative adjustments as additional Sec. 263A costs.

Treatment of variances and under- or over-applied burdens

As discussed above, variances and under- or over-applied burden amounts related to direct and indirect costs are adjustments to the underlying Sec. 471 costs. However, many taxpayers treat some or all of these amounts as period costs in their financial statements. Accordingly, Regs. Sec. 1.263A-1(d)(2)(v) provides a de minimis rule for taxpayers using the SRM, SPM, or MSPM to treat these period costs as additional Sec. 263A costs rather than Sec. 471 costs. This rule applies if the amount of uncapitalized variances and under- or over-applied burdens for the tax year is less than 5% of the taxpayer's total direct and indirect costs incurred for the year that are allocated using a standard cost or burden rate method. As such, the total direct and indirect costs incurred for the year include any of the variances and under- or over-applied burden taken as period costs. Similar to the rule for direct material costs, the positive and negative adjustments may not be netted together in determining if the 5% limitation is met.

Book-to-tax adjustments

Regs. Sec. 1.263A-1(d)(2)(iii)(B) provides that a taxpayer that uses the alternative method for determining Sec. 471 costs described above must include all positive and negative book-to-tax adjustments as additional Sec. 263A costs. This is regardless of whether these book-to-tax differences are associated with Sec. 471 costs or additional Sec. 263A costs. In contrast to the other special rules discussed above, there is no 5% limitation associated with the treatment of book-to-tax adjustments as additional Sec. 263A costs.

Implications

The final regulations may affect all taxpayers with inventory because of the way Sec. 471 costs are defined. In addition, many taxpayers may find the new MSPM cumbersome to use but perhaps more tax beneficial. In contrast to the SPM, the MSPM does a better job of allocating additional costs to the inventory that incurred those costs. Thus, many taxpayers may benefit from the use of the MSPM. Regardless, all taxpayers should review their current uniform capitalization methods to determine the impact of these final regulations and to determine any additional information requirements to comply with the new guidance.

EditorNotes

Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington..

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.

Newsletter Articles

TAX REFORM

Traps for the unwary: Tax Cuts and Jobs Act changes

By now many of us are familiar with the various provisions of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. Here is a list of changes together with (perhaps) unexpected nuances.

DEDUCTIONS

Qualified business income deduction regs. and other guidance issued

The package includes final regulations, guidance on how to calculate W-2 wages, a safe-harbor rule for rental real estate businesses, and new proposed rules on the treatment of previously suspended losses.