Proposed Regs. Issued on Allocating Sec. 263A Costs Under Simplified Methods

The IRS issued proposed regulations that affect taxpayers who produce or resell property and allocate costs under the simplified production method or simplified resale method (REG-126770-06). The proposed rules would govern the taxpayers’ treatment of negative additional costs under those methods.

Sec. 263A requires taxpayers to capitalize certain direct and indirect costs and allocate those costs to specific inventory items. The two simplified allocation methods available under Regs. Secs. 1.263A-2(b) and 1.263A-3(d) (the simplified production method and simplified resale method, respectively) are exceptions to this rule because they allocate a pool of capitalizable costs between ending inventory and cost of goods sold using a ratio rather than allocating them to specific inventory items.

 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 

Under both methods, taxpayers allocate “additional Sec. 263A costs” to property on hand at the end of the tax year based on the ratio of these costs during the year to the taxpayer’s total “Sec. 471 costs” during the year. Additional Sec. 263A costs are costs that were not required to be capitalized before Sec. 263A came into effect but must be capitalized under Sec. 263A. Sec. 471 costs are generally costs that the taxpayer capitalized or would have capitalized prior to the effective date of Sec. 263A.

This treatment can result in negative amounts when a taxpayer capitalizes a cost as a Sec. 471 cost in an amount that is greater than the amount required to be capitalized for tax purposes. Using negative amounts in the simplified methods’ formulas can produce significant distortions in the amount of additional Sec. 263A costs that is allocated to inventory.

The proposed regulations would prohibit the inclusion of negative amounts under the simplified methods. There would be a safe harbor for producers with average annual gross receipts of $10 million or less, who could continue to include negative amounts under the simplified production method.

Taxpayers who use the simplified resale method would be allowed to remove Sec. 471 costs that are not required to be capitalized for tax purposes from ending inventory by treating them as negative additional Sec. 263A costs.

The proposed regulations would also introduce a new simplified production method that would more precisely allocate additional Sec. 263A costs among raw materials, work in process, and finished goods inventories.

Finally, the proposed regulations would adopt a single definition of Sec. 471 costs that would apply to taxpayers that were in existence before Sec. 263A was enacted and to newer taxpayers.

The regulations are proposed to apply to tax years ending on or after the date they are published as final in the Federal Register.