Tax inventory accounting: Final regulations bring changes
In the shadows of tax reform, the Department of Treasury released final regulations for tax inventory capitalization under Section 263A, commonly known as uniform capitalization (UNICAP). These regulations had been in proposed form since 2012, but the changes provided in the final version are much more complex than the earlier proposal. The good news is that many taxpayers may end up with fewer costs capitalized to inventory for tax purposes when they apply these rules. Taxpayers must comply with these final regulations for any tax year beginning after Nov. 19, 2018 (e.g. 2019 calendar tax year), so now is the right time to familiarize yourself with the changes — and their impact.
The final regulations will impact essentially every taxpayer subject to Sec. 263A. The impact may be favorable or unfavorable depending on how a taxpayer currently accounts for inventoriable costs for both book and tax purposes. Specifically, the final regulations require taxpayers to:
- Perform at least two sets of tax inventory capitalization calculations unless one of several exceptions and/or safe harbors is met.
- Reassess which direct and indirect costs are capitalized on their books, including cost variances, to determine if and how those costs should be capitalized for tax purposes.
- Ensure that book-to-tax differences related to cost of goods sold are capitalized into inventory, if required.
- Remove any negative cost adjustments from their UNICAP calculations unless one of several exceptions is met.
- Evaluate whether the new UNICAP methodology, specifically the modified simplified production method, may provide a more favorable result than the method the taxpayer currently uses.
The final regulations will impact essentially every taxpayer subject to Sec. 263A.
The final regulations will most significantly impact:
- Taxpayers without an audited financial statement.
- Taxpayers with direct costs, variances, or over/underapplied burdens that aren’t capitalized to inventory for book purposes.
- Manufacturers with greater than $50 million average annual gross receipts.
- Taxpayers with fewer inventory turns.
- Taxpayers with large depreciation book-to-tax adjustments.
- Taxpayers identifying inventory on the last-in, first-out method.
- Taxpayers subject to the base erosion and anti-abuse tax.
The IRS has provided automatic consent accounting method changes for taxpayers to comply with the final regulations — meaning that accounting method change filings aren’t due until the 2019 tax return is filed. However, these rules are complex and will take time to implement, so we strongly encourage taxpayers to analyze their current UNICAP methods to determine the likely impact of the final regulations as early as possible.
Section 263A background
In general, Sec. 263A requires taxpayers to capitalize direct and indirect costs that are allocable to a taxpayer’s real and personal property produced or acquired for resale. Sec. 263A applies to any taxpayer with inventory or self-constructed assets. However, small business taxpayers are exempted from Sec. 263A if the average gross receipts from their prior three tax years is less than $26 million. These taxpayers can be exempted from other aspects of inventory accounting as well.
Sec. 263A calculations include three main components:
- Any direct materials, direct labor, or overhead costs not already capitalized for book accounting purposes must be capitalized for tax purposes (e.g. Sec. 471 costs).
- General, administrative, and certain other expenses that may need to be capitalized as indirect costs for income tax purposes must be identified (e.g. additional Sec. 263A costs).
- Additional Sec. 263A costs must be allocated to ending inventory using either a simplified calculation methodology or by following a traditional inventory calculation (e.g. standard costs, burden rate, etc.).
Prior to the final regulations, most taxpayers determined the Sec. 471 costs required to be capitalized for tax purposes simply by following the method of accounting used on their books. Therefore, in most cases, Sec. 471 costs were equal to book cost of goods sold both to type of costs being capitalized and amount of those costs.
For example, manufacturers generally include direct labor, direct material, and overhead costs into book inventory. Resellers, on the other hand, generally include the “landed” or “invoice” cost into book inventory. However, it’s often the case that some costs may not get fully capitalized into inventory for book purposes. These costs may include items such as variances, which the taxpayer has deemed not material for book purposes. These also might include certain costs that fluctuate significantly from year to year, such as bonuses, or costs that are difficult to allocate to specific items of inventory, such as freight in or duties.
The final regulations change the definition of Sec. 471 costs and change the manner in which these types of costs must be capitalized into ending inventory for tax purposes. In many cases, Sec. 471 costs will no longer equal book cost of goods sold and will require taxpayers to maintain a separate tax inventory calculation, even before considering the traditional Sec. 263A calculation. Specifically, taxpayers may be required to recompute their ending inventory using burden rates, standard costs, or other similar inventory costing factors that account for these additional Sec. 471 costs. The taxpayer would then perform the traditional Sec. 263A calculation with respect to all other capitalizable costs (i.e. the additional Sec. 263A costs).
In many cases, Sec. 471 costs will no longer equal book cost of goods sold and will require taxpayers to maintain a separate tax inventory calculation.
For income tax purposes, taxpayers may have “negative adjustments” to Sec. 471 costs. These negative adjustments can arise either when (1) a certain cost is capitalized on the books but is not required to be capitalized for income tax purposes or (2) a book expense is larger than the associated tax deduction (e.g. book depreciation exceeds tax depreciation on production equipment). Common costs that aren’t required to be capitalized for income tax purposes include R&D expenses, certain warehousing expenses, and selling expenses. Taxpayers have generally treated these negative adjustments as a reduction to capitalizable costs in their Sec. 263A calculation. The IRS has long challenged this position due to the distortion it causes in Sec. 263A calculations. The final regulations provide very specific guidelines as to when taxpayers are permitted to include negative adjustments as a reduction to capitalizable costs in their Sec. 263A calculation. Many taxpayers may need to maintain a separate inventory calculation to include these negative adjustments as Sec. 471 costs, rather than Sec. 263A costs.
As noted above, Sec. 263A requires the capitalization of certain indirect costs not typically capitalized on a taxpayer’s books. Examples include certain purchasing, storage, and handling costs as well as a portion of IT, accounting, HR, or other costs that have an indirect relationship to inventory production or resale activities. Taxpayers must then determine how much of these “additional Sec. 263A costs” are allocable to ending inventory versus inventory already sold during the year.
Taxpayers enjoy flexibility in choosing how they allocate additional Sec. 263A costs to ending inventory, but the regulations also provide simplifying methods, such as the simplified production method (SPM) and the simplified resale method (SRM). The final regulations didn’t change this portion of Sec. 263A significantly but did provide a new simplified method for manufacturers, the modified simplified production method (MSPM).
Final regulations — our analysis
The final regulations do not change the core logic and approach to Sec. 263A, but they do fundamentally change the definitions of costs and how those costs are allocated to inventory for tax purposes. This will cause many taxpayers to reevaluate their approach to Secs. 471 and 263A. For taxpayers who have historically applied Sec. 263A, the final regulations will likely be favorable and result in lower ending inventory. For taxpayers who may have performed higher-level Sec. 263A calculations, the final regulations could prove to be unfavorable depending on the accuracy of any estimates and assumptions incorporated into the historic Sec. 263A calculation.
The discussion below highlights the significant changes outlined in the final regulations.
Modified simplified production method
One of the most significant changes with the final regulations is the creation of the MSPM. The MSPM is intended to better allocate additional Sec. 263A costs to the inventory item to which the costs relate. Historically, most manufacturers used the SPM, which uses a single absorption ratio to allocate costs to ending inventory. This results in production costs being capitalized to raw materials and purchased goods. While the SPM is simple, it typically results in more costs being capitalized to ending inventory.
The MSPM uses both a pre-production and a production absorption ratio in order to avoid capitalizing production-related costs to raw materials and purchased goods. The SPM only considers total production costs, and the MSPM now provides separate ratios for raw material costs (pre-production such as the purchasing, storage, and handling of raw materials or purchased components) and work in progress and finished goods (production costs).
For taxpayers who have historically applied Sec. 263A, the final regulations will likely be favorable and result in lower ending inventory.
The applicable formulas under the MSPM are shown in the table below. The MSPM will generally result in a reduced Sec. 263A capitalization but will take slightly more effort to compute each absorption ratio separately. However, certain manufacturers must use the MSPM to apply some of the other favorable provisions discussed elsewhere, including the alternative Sec. 471 method.
Taxpayers will be required to use reasonable methods to allocate costs between pre-production and production activities. This means that mixed service costs functions must be allocated properly between the activities that benefit pre-production activities versus production activities. Taxpayers who use the simplified service cost method to allocate mixed service costs are permitted to allocate mixed service costs between pre-production and production costs by using either the ratio of direct material costs compared to Sec. 471 costs or the ratio of pre-production labor costs compared to total labor costs for the tax year. The regulations also provide a de minimis rule that allows the allocation of 100% of capitalizable mixed service costs to either pre-production or production costs if 90% or more of the total is allocable to that category.
Section 471 costs
The final regulations provide a new definition of Sec. 471 costs. Historically, taxpayers have generally followed book capitalization methodologies to identify Sec. 471 costs even though the prior rules didn’t overtly permit this approach. The final regulations simplify the definition by specifying that Sec. 471 costs are the types of costs capitalized for book purposes. However, the regulations make clear that these costs still must be measured on a tax basis. This method is referred to as the “default” method.
Under the “default” method, any difference between book and tax costs must be capitalized to inventory in a manner similar to the book inventory capitalization methodology, and these amounts cannot be included in a traditional Sec. 263A calculation. Therefore, a separate Sec. 471 calculation will have to be performed for these costs prior to performing the calculations to capitalize additional Sec. 263A costs.
This definitional change will therefore have additional compliance requirements and will require a thorough understanding of book costing methods. However, for taxpayers who previously included these excess costs in their Sec. 263A calculation, the total capitalization of these costs will likely decrease.
The regulations do permit certain taxpayers to include these costs in their Sec. 263A calculations. Under the “alternative” method, taxpayers can rely on the types and amounts of costs capitalized for financial statement purposes. Any differences in amounts would be treated as an additional Sec. 263A cost. That said, in order to use this method, the taxpayer must meet two requirements:
- The taxpayer has a financial statement filed with the SEC, an audited financial statement, or a financial statement provided to a state or federal government agency.
- The taxpayer must use the simplified resale method, modified simplified production method, or have less than $50 million average in gross receipts for the three previous tax years and use the simplified production method.
Taxpayers with greater than $50 million of average annual gross receipts cannot use the “alternative” method if they also use the simplified production method. If taxpayers prefer to use the “alternative” method to avoid performing a separate Sec. 471 inventory calculation, they may have to adopt the MSPM in order to be eligible. While the rules attempt to provide relief to certain smaller taxpayers with gross receipts less than $50 million, these taxpayers are also less likely to have the requisite financial statements, leaving them with only the “default” option.
While the “default” method may be a more complex calculation, it may result in fewer costs being capitalized and thereby reduce taxable income.
It’s important to consider that while the “default” method may be a more complex calculation, it may result in fewer costs being capitalized and thereby reduce taxable income.
Example 1: A manufacturer with $40 million of average annual gross receipts has reviewed financial statements and has historically used the SPM for its Sec. 263A calculation. The company purchased $500,000 of production equipment that it fully expensed under the bonus depreciation rules, but the book depreciation expense was only $50,000. The $450,000 of excess tax depreciation must be capitalized to inventory for income tax purposes. The company doesn’t qualify for the “alternative” Sec. 471 method because it doesn’t have audited financial statements. Therefore, it must capitalize the excess $450,000 of depreciation expense as a Sec. 471 cost by determining how this additional expense would have impacted its book inventory capitalization if it were actually included on its book. In other words, how would it have increased the overhead burden rates applied or the standard costs absorbed? This taxpayer must file a Form 3115 to adopt the “default” Sec. 471 method for its 2019 tax year.
Example 2: Same as Example 1, except the company has audited financial statements. The company has the option of following the path in Example 1 or adopting the “alternative” Sec. 471 method. If it adopts the “alternative” method, it’s then able to include the $450,000 of excess tax depreciation in its Sec. 263A calculation and is not required to recompute its book inventory capitalization. This taxpayer must file a Form 3115 to adopt the “alternative” method for its 2019 tax year.
Note that if the company exceeds $50 million in average annual gross receipts in the future, it must also adopt the MSPM or else it’ll be required to use the “default” method as in Example 1. Another Form 3115 would be required to be filed in that year either to adopt the MSPM or to change to the “default” method.
Direct costs and the de minimis rule
The final regulations provide that all direct costs — both direct labor and direct material — must be included in a taxpayer’s Sec. 471 costs regardless of whether the taxpayer uses the “default” or “alternative” method for identifying those costs. The costs cannot be included in the Sec. 263A calculation as additional Sec. 263A costs. Common costs include freight-in that is expensed on the books because it’s difficult to trace to specific items of inventory, bonuses not factored in to labor burden rates because they aren’t determined until the end of the year, or direct warehousing costs that aren’t included in burden rates. Taxpayers must recompute their book inventories as if these costs were included to determine the resulting excess capitalization that must occur for income tax purposes.
The final regulations provide a de minimis rule in order to prevent some taxpayers from having to perform this more burdensome calculation. Under this rule, any taxpayer using one of the simplified allocation methods can treat the uncapitalized direct costs as an additional Sec. 263A cost if the amount of uncapitalized costs are less than 5% of the total direct costs. The de minimis threshold is computed separately for direct materials and direct labor.
Example 3: A reseller of inventory purchases $40 million of goods and incurs $1 million of inbound freight. The company doesn’t capitalize this freight because it’s complex to allocate it back to each item that may be included in any particular shipment. Because this is a direct material cost, it’s required to be capitalized as a Sec. 471 cost. However, because the uncapitalized direct material costs are only 2.5% of the total direct materials costs, the company has the option to include this $1 million of costs as an additional Sec. 263A cost and capitalize it through the SRM. This taxpayer must file a Form 3115 to both adopt the de minimis rule and to begin capitalizing these costs for its 2019 tax year if it was not capitalizing them already.
Example 4: Same as Example 3 except that the inbound freight is $3 million. Because the uncapitalized direct material cost is 7.5%, the de minimis exception is not satisfied and the $3 million must be capitalized under Sec. 471. Therefore, the company must determine how much of the freight incurred relates to items still included in ending inventory. This determination may require a process similar to the one the company was trying to avoid by expensing the inbound freight on its books to begin with. This taxpayer must file a Form 3115 to capitalize these direct materials costs for its 2019 tax year.
Variance and burden safe harbor rule
The final regulations require that variances and under/overapplied burdens also must be treated as Sec. 471 costs. Taxpayers using a standard cost or burden rate method for book inventory costing often record variances and over/underapplied burden directly to cost of goods sold and do not capitalize these costs to ending inventory. In these circumstances, taxpayers must recompute their book inventories as if these costs were included in book capitalization to determine the resulting capitalization that must occur for income tax purposes. The previous regulations generally permitted these costs to be expensed, as long as they weren’t material.
However, like the direct cost de minimis rule above, a safe harbor permits these costs to be included as additional Sec. 263A costs, if the taxpayer is using a simplified allocation method and if the uncapitalized variances/burdens are less than 5% of the total Sec. 471 costs. The safe harbor requires taxpayers to treat negative amounts as positives in the numerator of the 5% ratio.
Negative Sec. 263A costs can arise when the book costs capitalized into inventory are greater than the amount required or allowed to be capitalized under Sec. 263A. Negative costs commonly arise either when (1) a certain cost is capitalized on the books but is not required to be capitalized for income tax purposes (e.g. R&D expenses, certain warehousing expenses, and sales expenses) or (2) a book expense is larger than the associated tax deduction (e.g. book depreciation exceeds tax depreciation on production equipment).
The option to continue to treat negative costs as additional Sec. 263A costs is taxpayer favorable.
Prior to the final regulations, taxpayers would generally treat these items as negative additional Sec. 263A costs. That is, these items would reduce the total pool of costs otherwise required to be capitalized under Sec. 263A for income tax purposes. Under the final regulations, taxpayers can only continue to treat negative costs as additional Sec. 263A costs if:
- The taxpayer uses the “alternative” method for Sec. 471 costs (taxpayer must have an applicable financial statement under this method).
- The taxpayer uses the SRM, MSPM, or the taxpayer has less than $50 million of average annual gross receipts and uses the SPM.
All taxpayers will have negative costs at some point. For example, book depreciation will exceed tax depreciation eventually because of accelerated tax depreciation rules. The option to continue to treat negative costs as additional Sec. 263A costs is taxpayer favorable. As such, taxpayers should consider whether their current methods allow them to include the benefit of negative costs. Certain taxpayers may also consider scrubbing their inventory costs to determine if additional negative costs may exist that weren’t previously removed from tax inventory capitalization.
Example 5: A manufacturer with $100 million of gross receipts uses the SPM. It capitalizes book depreciation of $2 million but only has $600,000 of tax depreciation. It has historically treated negative costs as additional Sec. 263A costs and reduces its additional Sec. 263A cost capitalization pool by the $1.4 million depreciation difference. In its 2019 tax year, it’s no longer permitted to reduce its additional Sec. 263A costs by this $1.4 million. Therefore, it must file a Form 3115 to change its method of accounting to either (1) adopt the MSPM in order to continue to include the $1.4 million negative costs as an additional Sec. 263A cost or (2) to stop reducing its additional Sec. 263A costs by this amount and perform a separate calculation to determine how its book inventory capitalization would have changed had this excess $1.4 million of costs not been included in its burden rates or standard costs.
The final regulations will impact essentially every taxpayer subject to Sec. 263A. This impact may be favorable or unfavorable depending on how a taxpayer currently accounts for inventoriable costs for both book and tax purposes. The IRS has provided automatic consent accounting method changes for taxpayers to comply with the final regulations — meaning that accounting method change filings aren’t due until the 2019 tax return is filed.
As you can see, the rules are complex and will not be quick to implement. We recommend taxpayers start analyzing their current UNICAP methods now to determine the likely impact of the final regulations as early as possible.
As always, if you have any questions about the final regulations, their implementation, or their impact, please give us a call.