Editor: Alexander J. Brosseau, CPA
On Oct. 1, 2021, the IRS Large Business and International (LB&I) Division issued guidance in the form of a practice unit, Examining a Reseller's 263A Computation, providing examining agents relevant law and audit steps for reviewing a reseller's Sec. 263A computations with respect to inventory held for resale. This is one of a series of LB&I practice units released in 2021 and late 2020 dealing with various aspects of the uniform capitalization rules. This practice unit outlines the general provisions of Sec. 263A, including special rules and exceptions for resellers, and provides insight into elements of a reseller's uniform capitalization calculation that may be areas of focus during an IRS examination.
In general, Sec. 263A and the regulations thereunder require taxpayers that are resellers to capitalize direct costs and an allocable share of indirect costs to property acquired for resale. Regs. Sec. 1.263A-3(a)(1) defines a reseller as a retailer, wholesaler, or other taxpayer that acquires certain property for resale. Regs. Sec. 1.263A-3 describes the costs that a reseller is required to capitalize into inventory under Sec. 263A and provides a simplified resale method for determining additional Sec. 263A costs allocable to ending inventory (see Regs. Sec. 1.263A-3(d)).
In November 2018, the IRS and Treasury issued final regulations under Sec. 263A (T.D. 9843), which were generally effective for tax years beginning on or after Nov. 20, 2018, and generally affect all taxpayers with inventory. Rev. Proc. 2019-43 provides favorable administrative guidance that allows taxpayers to file an accounting method change to comply with the final regulations for the first, second, or third tax year ending on or after Nov. 20, 2018, under the automatic procedures without regard to the five-year scope limitation provided in Section 5.01(1)(f) of Rev. Proc. 2015-13. The LB&I practice unit was released near the end of this three-year period that taxpayers were granted to comply with the final Sec. 263A regulations. LB&I's issuance of a series of practice units concerning the uniform capitalization rules suggests that Sec. 263A computations for resellers (and taxpayers more generally) could become a renewed area of interest for the IRS during examination.
The LB&I practice unit emphasizes key aspects of a reseller's Sec. 263A computation that may be scrutinized during an IRS examination, which include: (1) the reseller's production activities; (2) costs capitalized for financial statement purposes; (3) identification and allocation of additional Sec. 263A costs; and (4) methods of capitalizing Sec. 263A costs to ending inventory. Further, the practice unit brings attention to other considerations, including a taxpayer's requirement to allocate additional Sec. 263A costs to self-constructed assets and related capitalized interest provisions, and certain exceptions from computing additional Sec. 263A costs for resellers.
Resellers with production activities
The practice unit suggests that an examination will likely focus on the extent to which a reseller is engaged in production activities. As described in the practice unit, the volume of production activities performed by resellers affects the methods allowed for capitalizing additional Sec. 263A costs. In accordance with Regs. Sec. 1.263A-3(a)(4)(i), taxpayers engaged in both production and resale activities may generally use the simplified production method or the modified simplified production method but not the simplified resale method to capitalize costs to ending inventory.
For resellers with production activities, the practice unit discusses two exceptions. First, Regs. Sec. 1.263A-3(a)(4)(ii) provides that resellers otherwise permitted to use the simplified resale method may use it if production activities are de minimis. As described in Regs. Sec. 1.263A-3(a)(5)(i), production activities are presumed to be de minimis if: (1) gross receipts from the sale of property produced by the reseller are less than 10% of the total gross receipts of the trade or business; and (2) the labor costs allocable to the trade or business's production activities are less than 10% of the reseller's total labor costs allocable to its trade or business. Additionally, a reseller otherwise permitted to use the simplified resale method may use that method even though it has personal property produced for it under a contract with a third party (e.g., private-label goods), provided the contract manufacturing is incident to its resale activities (see Regs. Sec. 1.263A-3(a)(4)(iii)).
Often, a taxpayer will design a product and have it produced to its specifications. A typical issue that arises is whether the taxpayer has engaged in production activities or is purchasing private-label goods. While the practice unit does not address this issue, guidance may be found in Technical Advice Memorandum (TAM) 200631029. In TAM 200631029, a taxpayer that used contract manufacturers demonstrated a significant amount of control over the supply chain and the manufacturing process (i.e., selected suppliers from which raw materials were sourced and exercised strict oversight over the manufacturing process, etc.) and was therefore found to be a manufacturer of its goods, rather than a reseller of private-label goods, and thus was not entitled to use the simplified resale method. Resellers facing this issue should take note of the degree of control that they exercise over the supply chain, as they will often find that they are not engaged in production activities and are therefore eligible to use the simplified resale method.
Also not addressed in the practice unit is the routine purchase order exception. Pursuant to Regs. Sec. 1.263A-2(a)(1)(ii)(B)(2)(ii), a taxpayer that meets the routine purchase order exception is not considered a producer and is therefore eligible to use the simplified resale method.
Identification of Sec. 471 costs
As outlined in the practice unit, examining agents should review the types of costs capitalized for financial statement purposes (Sec. 471 costs) to better determine the additional costs required to be capitalized for tax purposes. Regs. Sec. 1.263A-1(d)(2)(i) defines Sec. 471 costs as the types of costs, other than interest, that a taxpayer capitalizes for financial statement purposes to property produced or property acquired for resale. Generally, the costs that a reseller capitalizes for financial statement purposes include more than just the invoice price of its goods and include trade or other discounts, freight-in, and other necessary charges in acquiring possession of the goods.
Of particular concern for examining agents are vendor rebates. This can be an area of additional scrutiny upon review, as taxpayers reduce the cost of inventory for vendor rebates to the extent they qualify as "trade or other discounts" (see Regs. Sec. 1.471-3(b)). Taxpayers should take note that the term "trade or other discounts" is not limited to discounts based solely upon the purchases of a particular volume of merchandise to which the discount relates but is broader in scope. For example, TAM 200605010 provides that amounts received from vendors pursuant to certain agreements may constitute discounts allowable as a reduction to the cost of inventory, provided the agreements do not require the taxpayer to perform services for the vendor and the vendor is neither entitled to receive, expects to receive, nor has received the performance of services in exchange for the rebate or allowance. Thus, resellers may want to analyze the nature of their vendor rebates in the context of this TAM to determine whether such discounts are considered a "trade or other discount" and therefore treated as a reduction to the cost of inventory.
In addition, with respect to Sec. 471 costs, the final regulations provide a de minimis rule for certain uncapitalized direct material costs under Regs. Sec. 1.263A-1(d)(2)(iv)(C). Under the direct material de minimis rule, resellers are not required to adjust Sec. 471 costs for uncapitalized direct materials (e.g., discounts), provided the absolute value of the uncapitalized direct material costs does not exceed 5% of total direct material costs. Rather, these uncapitalized direct material costs can be included in the numerator of the simplified method absorption ratio computation as an additional Sec. 263A cost. This has proven to be a beneficial provision for resellers with trade or other discounts that are not being capitalized for financial statement purposes and are otherwise treated as a reduction to inventory. Categorizing these discounts as an additional Sec. 263A cost can generate a favorable Sec. 263A adjustment without the administrative burdens associated with adjusting Sec. 471 costs.
Identification and allocation of additional Sec. 263A costs
The LB&I practice unit instructs examining agents to identify and determine the additional Sec. 263A costs allocable to resale activities as part of examining a reseller's Sec. 263A computation. Regs. Sec. 1.263A-1(d)(3) describes additional Sec. 263A costs as costs, other than interest, that are not generally capitalized into inventory for financial statement purposes but that are required to be capitalized under Sec. 263A. As described in the practice unit, these include purchasing costs, handling costs, storage costs, and service costs, including mixed-service costs.
In accordance with Regs. Sec. 1.263A-3(c)(3), resellers are required to capitalize purchasing costs, which include personnel costs (e.g., those of buyers and assistant buyers) related to purchasing activities. Purchasing activities are defined in Regs. Sec. 1.263A-3(c)(3)(i) and include selection of merchandise and placement of purchase orders, for example. As provided in Regs. Sec. 1.263A-3(c)(3)(ii)(A), taxpayers may elect the one-third/two-thirds rule for allocating labor between purchasing and nonpurchasing activities. An audit technique described in the practice unit instructs examining agents to look to the specific functions that an individual performs rather than an individual's job title when determining how to treat costs. This may sometimes benefit the taxpayer. For example, individuals with a title of "buyer" or "merchant" often spend a significant amount of time engaging in marketing and selling activities, the costs of which are not required to be capitalized.
The practice unit indicates resellers must capitalize handling costs and off-site storage and warehousing costs under Sec. 263A. As defined in Regs. Sec. 1.263A-3(c)(4), handling costs are costs attributable to processing, assembling, repackaging, transporting, and other similar activities that do not constitute production with respect to property acquired for resale. Further, Regs. Sec. 1.263A-3(c)(5) provides that storage costs are capitalizable to the extent they are attributable to an off-site storage or warehousing facility.
Interestingly, the practice unit does not discuss pick-and-pack costs, which resellers may generally deduct in accordance with Regs. Sec. 1.263A-3(c)(4)(vi)(C). Resellers commonly generate a significant benefit by properly analyzing handling and off-site storage costs to identify pick-and-pack costs. While many resellers perform a pick-and-pack analysis for labor and labor-related costs, the ability to include nonlabor costs in the pick-and-pack analysis is often overlooked. For example, depreciation on machinery and equipment dedicated to the pick-and-pack function may qualify as a deductible pick-and-pack cost.
Service costs are another area of concern in the practice unit. Service costs are indirect costs associated with a service department or function that are generally required to be capitalized to the extent allocable to resale or production activities in accordance with Regs. Sec. 1.263A-1(e)(4). As defined in Regs. Sec. 1.263A-1(e)(4)(ii)(C), mixed-service costs are service costs that are partially allocable to capitalizable functions and partially allocable to deductible functions. The practice unit refers to TAM 200446024 to highlight that purchasing and storage and handling costs are not eligible to be included in mixed-service costs, as they are not service costs but direct costs of resellers.
A more favorable reading of the TAM suggests this guidance can be beneficial for resellers with merchandising and other departments that perform discrete functions. Merchandising departments for resellers often include several distinct functions that can be analyzed separately from one another. For example, a merchandising department may include: (1) buyers that are responsible for the capitalizable purchasing function; (2) personnel responsible for visual display and other deductible marketing and selling functions; and (3) mixed-service functions such as administration of the entire merchandising department.
Similarly, a reseller's warehousing department often includes nonhandling functions such as human resources, logistics management, and other administrative support functions. Analyzing departments at the functional level is likely to generate a more favorable result for the taxpayer. Additionally, this approach is consistent with the general audit techniques described in the practice unit, which suggests examining agents review functions of a taxpayer's departments.
Capitalization of Sec. 263A costs to ending inventory and other considerations
A reseller may use any of several methods to allocate Sec. 263A costs to ending inventory. These include the simplified resale method or a burden-rate method under Regs. Sec. 1.263A-1(f)(3)(i). Interestingly, the practice unit references TAM 200437035, in which a taxpayer's burden-rate method did not clearly reflect income because it used direct labor as a base for developing standard costs to allocate storage and handling costs. Resellers that wish to use a burden-rate method may instead consider developing burden rates based on unit information, as this approach generally meets the same degree-of-specificity requirements outlined in TAM 9821001 and TAM 9717002. Resellers wishing to avoid such administrative burdens may nevertheless find the available simplified methods such as the simplified resale method to be cost-beneficial approaches to valuing inventories.
An additional area of consideration for resellers that is referenced in the practice unit — but is often overlooked by resellers — is self-constructed assets. As discussed in more detail in two other LB&I practice units, Interest Capitalization for Self-Constructed Assets and Section 263A Costs for Self-Constructed Assets, both released earlier, Sec. 263A and the regulations thereunder are generally applicable to self-constructed real property. For example, many resellers incur costs to construct real property (e.g., retail stores), including costs associated with leasehold improvements on real property. Resellers should understand the extent to which such activities related to self-constructed assets are performed and which costs (if any) are capitalized for financial statement purposes. Further, Sec. 263A(f) provides rules for capitalizing interest to self-constructed assets, and resellers must also evaluate the extent to which such rules apply. Often, resellers with activities related to self-constructed assets capitalize more costs for financial statement purposes than are required for tax purposes and may benefit from a proper analysis of applicable costs.
Lastly, resellers should be aware of certain exceptions to Sec. 263A in Regs. Sec. 1.263A-1(b). Common exceptions highlighted in the LB&I practice unit on resellers include the exception for small resellers (which is generally effective for tax years beginning on or before Dec. 31, 2017), the exception for property provided incident to services, and the exception for small business taxpayers (which is generally effective for tax years beginning after Dec. 31, 2017). Such exceptions may allow resellers to avoid performing a Sec. 263A computation. However, resellers should be aware that a change in method of accounting may be required to properly implement such exceptions.
For calendar-year taxpayers, the three-year period granted to comply with the final Sec. 263A regulations closed with the tax year ended Dec. 31, 2020. The release of the LB&I practice unit providing guidance to examining agents when reviewing Sec. 263A computations for resellers could signify that Sec. 263A computations will soon become an area of focus for the IRS during exam. Nonetheless, the guidance provided in the LB&I practice unit can be observed by taxpayers as an outline of key aspects to a reseller's Sec. 263A computation that may be scrutinized upon IRS exam.
Alexander J. Brosseau, CPA, is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office.
For additional information about these items, contact Mr. Brosseau at 202-661-4532 or firstname.lastname@example.org.
Contributors are associated with Deloitte Tax LLP unless otherwise noted.
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