UNICAP: Changing to the modified simplified production method

Editor: Annette B. Smith, CPA

The IRS in 2018 published uniform capitalization (UNICAP) final regulations under Sec. 263A that, among other things, provide a new simplified method of accounting known as the “modified simplified production method,” or MSPM (T.D. 9843). The new rules affect producers (or resellers) of property that are required to capitalize costs to the property and that elect to allocate costs using a simplified method. The regulations apply for tax years beginning on or after Nov. 20, 2018.

Most large taxpayers currently using the SPM, or simplified production method, include negative adjustments in additional Sec. 263A costs. Under the regulations, however, large producers — those with average annual gross receipts for the three previous tax years greater than $50 million — are prohibited from including such negative adjustments under the SPM but may do so under the MSPM. Therefore, large producers must change from the SPM to the MSPM to continue including negative adjustments in additional Sec. 263A costs (e.g., favorable variances not capitalized to book inventory or book-tax differences related to costs capitalized to book inventory, such as depreciation). This discussion focuses on how to make the switch to the MSPM.

Sec. 481(a) adjustment

A taxpayer changing from the SPM to the MSPM must file a Form 3115, Application for Change in Accounting Method, and take into account the adjustments required by Sec. 481(a) related to revaluations of inventory (Regs. Sec. 1.263A-7(c)(1)). The Sec. 481(a) adjustment related to a change in method of accounting for costs subject to Sec. 263A is the difference between the beginning inventory for the year of change as originally valued using the former method and the beginning inventory as revalued using the new method (Regs. Sec. 1.263A-7(c)(2)(i)).

For a taxpayer changing from the SPM to the MSPM, the Sec. 481(a) adjustment is the difference between the amount of additional Sec. 263A costs capitalized to beginning inventory under the SPM and the amount of additional Sec. 263A costs capitalized to beginning inventory under the MSPM. The taxpayer must compute the amount of additional Sec. 263A costs capitalized to beginning inventory under the MSPM as if the taxpayer had been using the MSPM for all prior years (Regs. Sec. 1.263A-7(c)(2)(i)). For a taxpayer using the last-in, first-out (LIFO) inventory method, this computation might be extremely burdensome.

Fortunately, for taxpayers using the dollar-value LIFO inventory method, the regulations under Sec. 263A provide a simpler method, the three-year average method, for revaluing beginning inventory and computing the Sec. 481(a) adjustment (Regs. Sec. 1.263A-7(c)(2)(v)).

Three-year average method

A taxpayer using the SPM or the MSPM for LIFO inventory multiplies the LIFO increment (layer) stated at current-year cost (i.e., the LIFO value of the layer) by the SPM absorption ratio or the MSPM combined absorption ratio for the year of the layer (Regs. Secs. 1.263A-2(b)(3)(iii) and 1.263A-2(c)(3)(iv)). Thus, the taxpayer maintains additional Sec. 263A layers corresponding to its LIFO layers. Under the three-year average method, a taxpayer using the dollar-value LIFO method revalues beginning inventory by applying a “revaluation factor” to all existing additional Sec. 263A layers in beginning inventory.

Generally, the three-year average method is based on the average percentage change (the three-year revaluation factor) in the current costs of inventory under the present and proposed methods for each LIFO pool based on the three most recent consecutive tax years for which the taxpayer has sufficient information (typically, the three most recent tax years). The revaluation factor is then applied to all layers in beginning inventory in the year of change (Regs. Sec. 1.263A-7(c)(2)(v)(A)).

An example in Regs. Sec. 1.263A-7(c)(2)(v)(C) illustrates how to revalue beginning inventory under the three-year average method — but the taxpayer there is not using a simplified method and is changing to a method of accounting under Sec. 263A for the first time rather than changing from one method to another method under Sec. 263A. However, IRS Technical Advice Memorandum (TAM) 200111014 provides insight on applying the three-year average method when a taxpayer using a simplified method changes its Sec. 263A method.

TAM 200111014

The taxpayer in TAM 200111014 was using a simplified method for dollar-value LIFO inventory when it changed from one method to another method of accounting under Sec. 263A (“old method” and “new method”). The issue was whether the taxpayer properly revalued its beginning inventory to reflect its change in method of accounting. The IRS concluded that the taxpayer had not. The TAM is informative because it reveals the IRS’s application of the three-year average method to dollar-value LIFO inventory.

The IRS concluded that (1) the three-year average method may be used to revalue beginning inventory when changing from one method to another method of accounting under Sec. 263A; (2) the three-year revaluation factor should be applied to the existing Sec. 263A absorption ratios when a simplified method is used to compute the amount of additional Sec. 263A costs capitalized to dollar-value LIFO inventory; and (3) the total current costs (i.e., the FIFO costs) of inventory should be used in the computation of the three-year revaluation factor.

The three-year revaluation factor should equal the additional Sec. 263A costs that would have been capitalized for the prior three years to the FIFO cost of ending inventory under the new method, divided by the additional Sec. 263A costs that would have been capitalized for the prior three years to the FIFO cost of ending inventory under the old method. An example in the TAM includes the FIFO cost of ending inventory for the prior three years in the numerator and denominator of the factor (as opposed to just including the capitalized additional Sec. 263A costs). A question arises whether the factor in the example is improperly weighted with the FIFO cost of ending inventory.

Here is another example that differs from the TAM example but is intended to reflect the same principles:

Example: Company A changes from the SPM to the MSPM for its 2019 tax year and uses the three-year average method to compute the Sec. 481(a) adjustment.

First, Company A uses its FIFO cost, SPM absorption ratio, and MSPM combined absorption ratio to compute the total amount of additional Sec. 263A costs that would have been capitalized to the FIFO cost of ending inventory for 2016, 2017, and 2018, as shown in the table “Sec. 263A Costs That Would Have Been Capitalized to the FIFO Cost of Ending Inventory, 2016-2018” (below). Company A then computes the three-year revaluation factor as shown in the chart “Calculation of 3-Year Revaluation Factor” (also below).

Next, Company A multiplies the three-year revaluation factor by the SPM absorption ratio for each LIFO layer to compute the MSPM combined absorption ratio applicable to each LIFO layer and multiplies the MSPM combined absorption ratio for each layer by the LIFO value of the layer to compute the capitalized additional Sec. 263A costs under the MSPM, as shown in the table “Capitalized Additional Sec. 263A Costs Under the MSPM” (below).

Finally, Company A subtracts the beginning inventory including capitalized additional Sec. 263A costs under the SPM ($59,568,160 + $3,834,509 = $63,402,669) from the beginning inventory, including capitalized additional Sec. 263A costs under the MSPM ($59,568,160 + $3,132,783 = $62,700,943), to compute a Sec. 481(a) adjustment of ($701,726). In this example, the Sec. 481(a) adjustment is a decrease in beginning inventory and taxable income that is taken into account entirely in the year of change under Section 7.03(1) of Rev. Proc. 2015-13.

Note that, if the SPM absorption ratio is negative for any LIFO layer, applying the revaluation factor to the negative SPM absorption ratio will not produce the correct MSPM absorption ratio. There is no IRS guidance on how to adjust a negative absorption ratio when changing from one method to another method under Sec. 263A.

EditorNotes

Annette B. Smith, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, D.C.

For additional information about these items, contact Ms. Smith at 202-414-1048 or annette.smith@pwc.com.

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