263A:
Taxpayers and Costs Subject
to the UNICAP Rules under
Code Sec. 263A
A CCH Seminar
Presented by
Eric Wallace, CPA
21660
SEMINAR INSTRUCTIONS
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using the presentation materials in this package.
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ABOUT THE SPEAKER
SUMMARY OF EXPERIENCE
ERIC P. WALLACE,
CPA
EWALLACE@CPABR.COM
EDUCATION AND
CERTIFICATIONS



Eric joined Boyer & Ritter in January 2013 as a director for the firm. Eric brings with him
extensive expertise in construction and real estate services and in tangible property tax issues,
depreciation, NOL, and 263A issues and will continue to focus on providing tax, accounting,
auditing and consulting services. Over the last 20 years, Eric ran his own firm, and was a
Partner and head of the Construction & Real Estate Services Team for Carbis Walker LLP, a
regional firm located in Pennsylvania. The focus of his practice was on all aspects of services
to CPA firms, contractors/developers, and the real estate industry. He also provided
specialized professional services, consulting, writing, and training to CPA firms, CPA
organizations, publishing companies, and construction and real estate related industries in
issues on tax, consulting, and accounting and auditing. Eric has been an expert witness in
construction related, accounting malpractice, and other court cases in venues such as
bankruptcy, district, and local courts in various states concerning liability, tax and accounting
issues. He also represented numerous contractor clients before the Internal Revenue Service,
U.S. Department of Labor, and state revenue departments of income, employment, and sales
tax.
PROFESSIONAL AFFILIATIONS

Bachelor of Science
Degree – Public
Accounting, Mesa State

College, Colorado
University of Pittsburgh

Law School
Certified Public

Accountant (CPA)



Member of the American Institute of Certified Public Accountants (AICPA), served on
its Council for several years, currently serves on the AICPA new accounting Framework
Task Force (AICPA FRF for SMEs), and served on the AICPA Financial Reporting for
Private Companies Task Force (2003 to 2006)
Member and past president of the Pennsylvania Institute of Certified Public Accountants
(PICPA)
Member of the Construction Financial Management Association (CFMA), past chairman
of the Tax and Fiscal Affairs Committee
Member of the Association of General Contractors (AGC) and currently serves of the
National Tax and Fiscal Affairs Committee
Member of the Association of Builders and Contractors (ABC)
Member of the Contractors Association of Western PA (CAWP)
Member of the Master Builders Association (MBA)
SPEAKING ENGAGEMENTS
Eric is a frequent lecturer at conferences and continuing education seminars including the
following:
 Numerous group study and conference presentations for the AICPA, various state
societies, non-profit groups, education companies, large companies, and large
international CPA firms. Eric has been an instructor for continuing education courses in
almost all of the states since 1989.
 Speaker for several state CPA societies during 2001-2012 for their annual construction
conferences
PUBLICATIONS
Eric is the author of CCH's two construction books, Construction Guide: Tax and Advisory
Services and Construction-Guide-Accounting-and-KnowledgeBased-AuditsTM. These are
extensive treatises of about 2,000 pages each on accounting, auditing, consulting, and tax for
contractors, homebuilders, and real estate developers. Eric has also written CCH's audit
programs on the construction industry, and its disclosure checklists, currently in its seventh
edition, and a contributor to CCH’s IntelliConnect and ARM on-line resources.
This presentation and these materials are designed to provide accurate and
authoritative information in regard to the subject matter covered. This presentation
and these materials are provided solely as a teaching tool, with the understanding
that the publisher and the instructor are not engaged in rendering legal, accounting,
or other professional service and that they are not offering such advice in this
presentation and these accompanying materials. Practitioners should always
determine and incorporate all of the material facts and circumstances that apply to a
particular situation and conduct the necessary research to determine whether any
new statutory or regulatory requirements are relevant and should be applied. If legal
advice or other expert assistance is required, the service of a competent
professional person should be sought.
© 2014 CCH. All Rights Reserved.
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Chicago, IL 60646-6085
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www.CCHGroup.com
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PRESENTATION
263A
Taxpayers and Costs Subject to the
UNICAP Rules under Code Sec. 263A
Presented by
Eric P. Wallace, CPA
We bring the experts to you
Introduction
Identify the costs capitalized under Sec. 471 additional
costs required to be capitalized under Sec. 263A
Understand the process of allocating costs to expense
or to Sec. 263A ending inventory
Determine which taxpayers are subject to the
Sec. 263A cost capitalization rules and which are not
Get updated on current developments and issues
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263A
10,000-Foot
General Process
263A
A CCH Seminar
Determine If
Subject to 263A, Generally
If producer of tangible
property
If reseller and gross receipts
test > $10M
Self-constructed assets for
use by the taxpayer in its
trade or business
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Classify All Costs into
Their Proper Categories
Direct materials or direct labor
Indirect costs
Determine if
taxpayer is a
producer—if so
 Producers using the
simplified production method will also have to
distinguish between §1.471-11 (a.k.a. full
absorption or book method) costs and additional
§263A costs
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Determine If Taxpayer Is a Reseller
with Gross Receipts Test > $10M
If so
 Must also capitalize into inventory
 Purchasing
 Handling
 Off-site storage
– Not on-site
 Certain G & A costs
 Other costs not subject to 263A
 G & A or other costs
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If Subject to 263A
Does the taxpayer have in place a proper 263A
cost allocation method(s) used to allocate
§263A costs to §263A property?
 If not in compliance—change in method required
If proper, does taxpayer
want to change 263A
method(s), for example, to
adopt a simplified method
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Allocation Methods
Cause Confusion in
263A
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263A
Allocation Methods
Are Used to Allocate
Mixed-service costs
Can be applicable to both
producers or resellers or
exclusively to one
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Cost Allocation Methods
General
Used to allocate direct and indirect costs
 Specific identification or tracing methods
 Burden rate(s) method
 Standard costs
 Any other reasonable allocation method
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Mixed-Service Cost
Allocation Methods
Direct
reallocation
method
Stepallocation
method
Simplified
mixedservice cost
method
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For Producers
Simplified Production Methods
Simplified production method without historic
absorption ratio election
 Is done using a general allocation formula
 Is different for FIFO or LIFO
Simplified production method with historic
absorption ratio election
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263A
For Resellers
Simplified Resale Methods
Simplified resale method without historic
absorption ratio election
 Is done using a general allocation formula
 Is different for FIFO or LIFO
Simplified resale method with historic
absorption ratio election
Variations of the simplified resale method
13
263A
A CCH Seminar
We’re Sorry!
CPE credit is not
available on recorded
programs –
Please disregard the
Attendance Validation
Statement currently being
given
263A
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263A
De minimis and
Other Rules
263A
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De minimis
Producer
Is a producer with total
indirect costs of $200,000
or less
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263A
De minimis
Service Provider
Property has to be
de minimis
 i.e., less than 5% of the
price charged
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De minimis
Service Costs
If 90 percent or more of a mixed-service
department’s costs are deductible service
costs, a taxpayer may elect not to allocate any
portion of the service department’s costs to
property produced or property acquired for
resale
However, if 90 percent or more of a mixedservice department’s costs are capitalizable
service costs, a taxpayer must allocate 100
percent
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De minimis
Production Activities
Property produced by the
reseller is less than 10
percent of the total gross
receipts
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De minimis
Purchasing Activities
Determination of whether personnel are
engaged in purchasing activities
 1/3-2/3 rule for allocating
labor costs
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Other Recent
Rules and Issues
263A
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New 263A Automatic Methods
Method Change Procedures for Reasonable
Allocation Methods described in §1.263A-1(f)(4)
for self-constructed assets
 RP 2014-16 added a new automatic method #194
Method Change Procedures for Real Property
Acquired Through Foreclosure
 RP 2014-16 added a new automatic method #195
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Proposed Regulations on Allocating
263A 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
 This is a new threshold
 Note that the $10M threshold under 263A
is currently for resellers
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Chief Counsel Advice 201302018
Concluded that a sale is considered “on-site”
only when the retail customer is physically
present at the sales facility at some point
during the sales transaction
 The regulations generally permit retailers to deduct
the amount of handling and storage costs that are
attributable to a “retail sales facility” but require
them to capitalize the costs attributable to nonretail sales facilities
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The Final Tangible Property
Regulations on DMSH Amounts
De minimis safe harbor annual election
 Costs of property produced by a taxpayer to which the
taxpayer properly applies the de minimis safe harbor annual
election under §1.263(a)-1(f) can be written off
 Has to comply with the DMSH rules and properly do the annual
election
 However, the cost of property to which a taxpayer properly
applies the DMSH election may be required to be capitalized
to other property as a cost incurred by reason of the
production of the other property that is subject to 263A
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263A
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Court of Appeals
for the Federal Circuit
Invalidated a portion of the 263A regs. 1.263A11(e) regarding the capitalization
of interest
 Dominion, CA-FC, May 31, 2012
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What Issues the IRS Is Seeing
Whether a taxpayer is a “producer” or a
“reseller” under 263A
Whether the taxpayer’s Excel worksheet
calculating either the simplified production
method or the simplified reseller method is in
accordance with the 263A regs
 Are you classifying the costs correctly?
 Are you “tweaking” the formulas to your benefit?
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What Issues the IRS Is Seeing
Missing interest calculations on selfconstructed buildings under 263A(f)
Claiming not subject to 263A—due to the
exceptions—when they are really subject to
263A
 Usually not a good surprise in an IRS audit situation
The IRS is applying 263A to restaurants!
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263A
Taxpayer Must Match DPAD to
263A Cost Allocations
Recall that Section 199 requires the taxpayer
to figure Form W-2 wages that are properly
allocable to DPGR (Domestic Production Gross
Receipts)
A taxpayer must properly allocate of portion of
its wages to COGS in accordance with its 263A
labor costs
The labor allocation processes for 199 and
263A must match (i.e., be able to
reconciled)!
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Scrap Costs
Reg. §1.263A-1(e)(3)(ii)(Q)
Requires that indirect
costs must be capitalized
if they are allocable to
scrap or spoilage
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IRS Technical Advice Memorandum
200437034, April 30, 2004
In determining the factory overhead allocable
to inventory, the manufacturer estimated the
total scrap costs for the tax year and the
revenue it would derive from the sales of
salvageable scrap
 The net scrap materials costs were then allocated
as an indirect cost component of the inventory
costs
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Sales-Based Royalties
Deductible and not capitalized
Robinson Knife Manufacturing Company, Inc.,
CA-2 (nonacq.), 2010-1 USTC
This case overruled the Tax Court where it
found that such costs were “part of the
taxpayer’s production process”
Also refer to TAM 200630019
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Final Regs Issues on Sales-Based
Royalties Jan 13, 2014
Relating to the capitalization and allocation of
royalties that are incurred only upon the sale
of property produced or property acquired for
resale (sales-based royalties)
Final regulations relating to adjusting inventory
costs for a type of an allowance, discount, or
price rebate earned on the sale of merchandise
(sales-based vendor chargebacks) were
included
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Final Regs
Sales-Based Royalties
Regulations modify the simplified production method and the
simplified resale method of allocating capitalized costs between
ending inventory and cost of goods sold

These regulations affect taxpayers that incur capitalizable salesbased royalties or earn sales-based vendor chargebacks
The allocation of sales-based royalties to property sold is optional
rather than mandatory

Therefore, taxpayers can either allocate sales-based royalties
entirely to property sold and include those costs in cost of goods sold
or allocate sales-based royalties between cost of goods sold and
ending inventory using a facts-and-circumstances cost allocation
method
Method change procedures to change a taxpayer’s 263A costing for
this was released in Rev. Proc. 2014-33 in May of 2014
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Field Attorney Advice
20123201F, (Mar. 1, 2013)
Issue
 Whether, and to what extent, a bank’s costs
associated with holding OREO property must be
capitalized under IRC §263A
Conclusion
 Direct costs and an allocable share of indirect costs
associated with OREO property produced or held
primarily for resale must be capitalized to the basis
of such property under IRC §263A
See new auto method change #195
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263A
A CCH Seminar
We’re Sorry!
CPE credit is not
available on recorded
programs –
Please disregard the
Attendance Validation
Statement currently being
given
263A
A CCH Seminar
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263A
Exceptions to
263A Rules
263A
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Resellers
Personal property acquired
for resale by small resellers
 Taxpayers with average
annual gross receipts for the
three previous tax years of
$10 million or less
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263A
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263A
Producers
Long-term contract
Capitalizable costs allocable under the
simplified production method for producers
who have less than $200,000 of indirect costs
Personal property produced by a small reseller
incident to its resale activities, provided the
production activities are de minimis
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Producers
Any property produced by a taxpayer for use by
the taxpayer other than in a trade or business
Personal property produced for a small reseller
under contract with an unrelated person if the
contract is entered into incident to the resale
activities of the small reseller and the property
is sold to its customers
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263A
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263A
Rules Applicable to
All 263A Taxpayers
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General Concepts
General Rule
 Producers of tangible property (except those
specifically excluded) must include in ending
inventory, and in costs of goods sold, not only
direct costs, but also the indirect costs
§§1.263A-1 to -6 provides guidance to
taxpayers who are required to capitalize
certain costs under §263A
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263A
General Concepts
General scope
 Taxpayers subject to Section 263A must capitalize
all direct costs and certain indirect costs properly
allocable to real and tangible personal property
 Produced by the taxpayer
 Acquired by the taxpayer for resale
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General Concepts
Exception to the rules of 263A
 Small resellers
 Gross receipts averaging less than $10M a year
 Property produced pursuant to a long-term contract
 Certain farming businesses
 Property provided incident to services
 De minimis rule for certain producers with total
indirect costs of $200,000 or less
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263A
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263A
General Operation of 263A
TPs must capitalize their direct costs and a
properly allocable share of their indirect costs
to property produced or property acquired for
resale
 TPs must allocate or apportion costs to various
activities, including production or resale activities
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Direct Costs
Producers
 Producers are required to capitalize “direct
material costs” and “direct labor costs”
Direct costs for resellers
 Resellers are required to capitalize the acquisition
costs of property acquired for resale
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263A
Indirect Costs
All costs other than direct material costs and
direct labor costs (in the case of property
produced) or acquisition costs (in the case of
property acquired for resale)
Taxpayers subject to Section 263A must
capitalize all indirect costs properly allocable
to property produced or property acquired for
resale
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Indirect Costs
Indirect costs are properly allocable to
property produced or property acquired for
resale when the costs directly benefit or are
incurred by reason of the performance of
production or resale activities
Indirect costs may be allocable to both
production and resale activities, as well as to
other activities that are not subject to
Section 263A
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263A
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263A
Indirect Costs
Taxpayers subject to
Section 263A must
make a reasonable
allocation of indirect
costs between
production, resale, and
other activities
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Indirect Costs
For producers
 Indirect costs are defined as all costs other than
direct material costs and direct labor costs
For resellers
 Indirect costs are defined as all costs other than
acquisition costs
Excludable Indirect Costs
 See detailed outline for listing of excludable
indirect costs
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263A
Service Costs
Type of indirect cost that can be identified
specifically with a service department or function
that directly benefits, or costs are incurred by
reason of, a service department or function
 “Service departments” are administrative, service or
support departments that incur service costs
 The facts and circumstances of a producer’s or reseller’s
activities and business organization control whether a
department is a service department
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Service Costs
Service cost categories
 There are three categories of service costs
 Capitalizable
 Deductible
 Mixed-service costs
Capitalizable service costs
 Those service costs that directly benefit or are incurred
by reason of the performance of the production or resale
activities
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263A
Service Costs
Deductible service costs
 Those service costs that do not directly benefit or are
not incurred by reason of the performance of the
production or resale activities
Mixed-service costs
 Those service costs that are partially allocable to
production or resale activities (capitalized mixed-service
costs) and partially allocable to non-production or nonresale activities (deductible mixed-service costs)
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Cost Allocation Methods
Any of several methods may be used under the
UNICAP (uniform capitalization) rules to
allocate direct and indirect inventory costs,
depending on the particular inventory cost
involved
 Specific identification or tracing method
 Burden rates
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263A
Cost Allocation Methods
 Standard Cost
 Is a method whereby costs of goods are initially
determined by reference to a single standard or estimate
 Other Reasonable Allocation Methods
 The 263A rules allow any reasonable method to be used to
allocate costs to particular inventory property
– The total amount of the costs that the taxpayer capitalizes
during the tax year does not differ significantly from the
total amount that would result if all costs had been
capitalized using another permissible method
– The allocation method is applied consistently
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Allocating Categories of Costs
Must be allocated to the property produced or property
acquired for resale by the taxpayer using the
taxpayer's method of accounting
 Specific identification, FIFO, LIFO, or any other reasonable
method
Indirect costs
 Indirect costs are allocated using either
 A specific identification method
 A standard cost method
 A burden rate method
 Any other reasonable allocation method
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263A
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263A
Rules Applicable
to Producers
263A
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Section 263A
Applies to real property and tangible (not
intangible) personal property produced by a
taxpayer for
 Use in its trade or business or
 For sale to its customers, and
 For a taxpayer under a contract with another party
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263A
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263A
Simplified Production Method
Producers can elect a “simplified” method for determining
the additional Section 263A costs properly allocable to
ending inventories of property produced and other eligible
property on hand at the end of the taxable year
 Eligible property
 Must be used for all production and resale activities associated
with any of the following categories of property to which Section
263A applies
– Inventory property
– Non-inventory property held for sale
– Certain self-constructed assets
– Self-constructed tangible personal property produced on a routine
and repetitive basis
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Simplified Production Method without
Historic Absorption Ratio Election
General allocation formula
 The additional Section 263A costs allocable to
eligible property remaining on hand at the close of
the taxable year under the simplified production
method are computed as follows
 Absorption ratio x Section 471 costs remaining on hand at
year end
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263A
Simplified Production Method with
Historic Absorption Ratio Election
Taxpayer may only make a historic absorption ratio
election if it has used the simplified production
method for three or more consecutive taxable years
immediately prior to the year of election and has
capitalized additional Section 263A costs using an
actual absorption ratio for its three most recent
consecutive taxable years
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Rules Applicable to Resellers
Property Acquired for Resale
263A
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263A
Section 263A
Applies to real property and personal tangible and
intangible property acquired for resale by a retailer,
wholesaler, or other taxpayer (reseller)
 However, Section 263A does not apply to personal property for
resale by a reseller whose average annual gross receipts for
the three previous taxable years do not exceed $10,000,000
(small reseller)
 De minimis production activities if:
 Gross receipts from the sale of property produced by the reseller
are less than 10 percent of the total gross receipts of the trade
or business, and
 The labor costs are less than 10% of the reseller’s gross receipts
of the trade or business
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Purchasing, Handling,
and Storage Costs
Resellers must capitalize the acquisition cost of
property acquired for resale, as well as indirect
costs, which are properly allocable to property
acquired for resale
The indirect costs most often incurred by
resellers are purchasing, handling, and storage
costs
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263A
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263A
Simplified Resale Methods
Eligible property
 Generally, the simplified resale
method is only available to a
trade or business exclusively
engaged in resale activities
263A
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Simplified Resale Method without
Historic Absorption Ratio Election
Section 471 costs
Combined
Absorption Ratio
Remaining on
Hand at Year End
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263A
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263A
Permissible Variations of the
Simplified Resale Method
Variations of the simplified
resale method are permitted
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Simplified Resale Method with
Historic Absorption Ratio Election
Permits resellers using the simplified resale
method to elect a historic absorption ratio in
determining additional Section 263A costs
allocable to eligible property remaining on
hand at the close of their taxable years
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263A
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263A
Interest Issues
263A
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Avoided-Cost Method
Interest
One must first understand what “avoided cost”
means
Under 263A, generally all costs that directly
benefit or are incurred because of the
production of property are required to be
capitalized, regardless of whether the costs are
incurred before, during or after the production
period
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263A
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263A
Avoided-Cost Method
Interest
 Interest, however, is required to be capitalized only to the
extent that it is incurred during the production period
 The amount of interest to be capitalized is determined using the
avoided-cost method
 The avoided-cost method operates on the principle that if the
taxpayer had used the amounts expended for the production of
designated property to instead reduce its outstanding debt, it
would have avoided interest costs to the extent that its debt
could have been reduced
 Under the avoided-cost method, the taxpayer must first
capitalize interest incurred on traced debt during each
measurement period and then capitalize interest on
accumulated production expenditures in excess of traced debt
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What to Do When
Sections 460(b) and
263A Both Apply
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263A
What to Do When Sections
460(b) and 263A Both Apply
Court case found that you first apply the costs
to the contract and then only the incremental
costs are allocated to the 263A costs
This is not what the IRS
wanted done
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What to Do When Sections
460(b) and 263A Both Apply
The 263A rules state, more or less, that
allocations within 263A are done proportionally
That is not the rule when dealing with the
interaction of 460 with 263A costs
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263A
We’re Sorry!
CPE credit is not
available on recorded
programs –
Please disregard the
Attendance Validation
Statement currently being
given
263A
A CCH Seminar
We’re Sorry!
The live Question and
Answer Session is not
available for recorded
programs.
263A
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263A
CONCLUSION
263A
A CCH Seminar
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263A
A CCH Seminar
A CCH Seminar
263A
OUTLINE
263A:
Taxpayers and Costs Subject to the
UNICAP Rules under Code Sec. 263A
Eric P. Wallace, CPA
Summary
Understand the Established and Ever Evolving Guidance for Uniform Capitalization
In-depth analysis of Sec. 263A regulations, rulings, and guidance; addresses frequent costcapitalization issues through real life examples; and summarizes best practices.
I.
II.
III.
IV.
V.
VI.
The IRS focuses on Sec. 263A issues in audits of entities where applicable.
a. These rules are applicable to taxpayers that produce property or acquire it for
resale.
In general, taxpayers must capitalize all "allocable" direct and indirect costs.
a. The uncertainty and complexities relate to the definition of "allocable" –
i. Methods for the process to
ii. Costs to be included.
The list of these difficult determinates under Sec. 263A is long, and
a. Decisions about costs related to
i. Royalties,
ii. Research & development,
iii. Pre-production and pre-sale expenses,
iv. Environmental costs, and
v. Other expenses.
Current updates,
Practical examples and best practices for planning and compliance under Sec. 263A.
Questions
Learning Objectives




Identify the costs capitalized under Sec. 471 additional costs required to be capitalized under
Sec. 263A
Understand the process of allocating costs to expense or to Sec. 263A ending inventory
Determine which taxpayers are subject to the Sec. 263A cost capitalization rules and which
are not.
Get updated on current developments and issues
Outline Table of Contents:
10,000 Feet General Process
I.
Determine if subject to 263A, generally
II.
Classify all costs into their proper categories
III.
Determine if TP is a producer
IV.
Determine if TP is a reseller
V.
If subject to 263A
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Allocation Methods are What Causes Confusion in 263A
I.
Allocation methods are used to allocate mixed service costs
II.
Cost Allocation Methods
III.
Mixed Service Cost Allocation Methods
IV.
For Producers: Simplified Production Methods
V.
For Resellers: Simplified Resale Methods
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De Minimis and other Rules:
I.
De minimis producer
II.
De minimis service provider
III.
De minimis service costs
IV.
De minimis production activities
V.
Determination of whether personnel are engaged in purchasing activities
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Other Recent Rules and Issues:
I.
Method Change Procedures for Reasonable Allocation Methods
II.
Method Change Procedures for Real Property Acquired Through
Foreclosure
III.
Proposed regulation on allocating 263A under the simplified methods
IV.
Chief Counsel Advice (CCA) 201302018
V.
The final regulations on the tangible property costs
VI.
Court of Appeals for the Federal Circuit
VII. IRS is seeing 263A issues
VIII. Chief Counsel Advise Memo (CCA 201220028, Feb. 6, 2012)
IX.
Capitalized interest is not a “preliminary activity”
X.
TP must match its DPAD (section 199) to its 263A cost allocations
XI.
Loan commitment fee is a 263A cost – CCA 201136022
XII. Scrap costs
XIII. IRS Technical Advice Memorandum 200437034, April 30, 2004
XIV. Sales based royalties
XV. Environmental remediation costs
XVI. Field Attorney Advice 20123201F, (Mar. 1, 2013)
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Exceptions to 263A Rules
I.
Resellers: personal property acquired for resale by small rese
II.
Producers
III.
Service Provider
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IV.
More Narrow Situations
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Rules Applicable to All 263A Taxpayers:
I. General Concepts
II. General Operations of 263A
III. Direct Costs
IV. Indirect Costs
V. Service Costs
VI. Cost Allocation Methods
VII. Allocating Categories of Costs
VIII. Allocating Service Costs
IX. Methods for Allocating Mixed Service Costs
X. Costs Provided by a Related Person
XI. Election of 263A Methods
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Rules Applicable to Producers
I. Section 263A applies to real property and tangible (not intangible)
personal property produced by a taxpayer
II. Simplified Production Method
III. Simplified production method without historic absorption ratio election
IV. Simplified production method with historic absorption ratio election
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Rules Applicable to Resellers – Property Acquired for Resale
I. Section 263A applies to real property and personal tangible and intangible
property acquired for resale by a retailer, wholesaler, or other taxpayer
(reseller)
II. Purchasing, handling, and storage costs
III. Simplified Resale Methods
IV. Simplified Resale Method without Historic Absorption Ration Election
V. Permissible Variations of the Simplified Resale Method
VI. Simplified resale method with historic absorption ratio election
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Interest Issues
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I. Avoided Cost Method
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What to do when sections 460(b) and 263A both apply
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Special Rules and Rulings:
I.
Automobile Dealerships
II.
Changes to 263A Costs or Methods
III.
Utilities – Temporary Utility Lines
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Appendixes:
Appendix A - Definitions
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Appendix B – Flowchart
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Inventory: Simplified Production Method: Using the Actual Absorption Ratio
Appendix C –1 (adapted from CCH)
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Simplified Production Method: Using the Actual Absorption Ratio
Example Data Input Sheet-For a FIFO Taxpayer
Appendix C –2
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Simplified Production Method: Using the Actual Absorption Ratio
Actual Absorption Ratio Calculation -For a FIFO Taxpayer
Appendix C –3
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Simplified Production Method: Using the Actual Absorption Ratio
481(a) Adjustment – For a FIFO Taxpayer
Appendix D
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Mixed service costs - Direct reallocation method Example
Appendix E
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Mixed service costs - Step-allocation method - Example
Appendix F
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Mixed service costs - Simplified Mixed Service Cost Method - Example
Appendix G
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Simplified Production Method – Example
Appendix H
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Simplified Production Method without historic absorption ration election – Example
Appendix I
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Simplified Production Method with historic absorption ration election – Example
Appendix J
Various 263A Questions and Answers
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Outline:
10,000 Feet General Process
I.
II.
Determine if subject to 263A, generally
a.
If producer of tangible property
i.
§1.263A-2(b)(3)(iv) has a de minimis rule that treats producers with
total indirect costs of $200,000 or less as having no additional section
263A costs
b.
If reseller (tangible and intangible) and gross receipts test > $10M
c.
Self-constructed assets for use by the TP in its trade or business
Classify all costs into their proper categories
a.
Direct materials or direct labor,
b.
Indirect costs (when the costs directly (not indirect benefit – Wells Fargo v
Comm. 224 F.3d 874 (8th Cir. 2000) benefit or are incurred by reason of the
production activities)
i.
III.
Determine if TP is a producer – if so:
a.
IV.
V.
Mixed service costs (a type of indirect costs that requires further
allocation between activities)
Producers using the simplified production method will also have to distinguish
between §1.471-11 (aka full absorption or book method) costs and additional
§263A costs (see §1.263A-1(d))
Determine if TP is a reseller with gross receipts test > $10M – if so:
a.
Must also capitalize into inventory – purchasing, handling, off-site storage (not
on-site), and certain G & A costs
b.
Other costs not subject to 263A (G & A or other costs)
If subject to 263A
a.
Does the TP have in place a proper 263A cost allocation method(s) used to
allocate §263A costs to §263A property
i.
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If not in compliance -- change in method required.
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b. If proper, does TP want to change 263A method(s), for example, to adopt a
simplified method
Allocation Methods are What Causes Confusion in 263A
I.
Allocation methods are used to allocate:
a. Mixed Service Costs
b. Can be applicable to both producers or resellers or exclusively to one
II.
Cost allocation methods, in general: are used to allocate direct and indirect costs
a. Specific identification or tracing methods
i.
Identified and assigned by cost objective
1. Such as a function, department, activity, or product
2. On the basis of cause and effect or reasonable relationship
b. Burden rate(s) method:
i.
Use of predetermined rates in accordance with GAAP applied
reasonably
c. Standard costs:
i.
Determine costs by reference to a single standard or estimate
ii.
Has to reallocate an appropriate variance
d. Any other reasonable allocation method
i.
Conditions for use?
1. Does not differ significantly from what would have been
capitalized if another method used
2. Consistently applied
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III.
Mixed Service Cost Allocation Methods
a. Direct reallocation method (Appendix D)
i.
The total costs (direct and indirect) of all mixed service departments are
allocated only to departments or cost centers engaged in production or
resale activities and then from those departments to particular activities.
b. Step-allocation method (Appendix E)
i.
Requires that a sequence of allocations is made by the TP.
1. First, the total costs of the mixed service departments that benefit
the greatest number of other departments are allocated to -a. Other mixed service departments;
b. Departments that incur only deductible service costs; and
c. Departments that exclusively engage in production or
resale activities.
2. TP continues allocating mixed service costs until all mixed service
costs are allocated to the types of departments
c. Simplified Mixed Service Cost Method
i.
If elected for any trade or business of the TP, must be used for all
production and resale activities of the trade or business associated with
any of the four categories of property that are subject to section 263A:
1. Inventory property
2. Non-inventory held for sale
3. Self-constructed property
4. Self-constructed tangible personal property produced on a routine
and repetitive basis
IV.
For Producers: Simplified Production Methods: are methods that producers can elect for
determining the additional section 263A costs properly allocable to ending inventories of
property produced and other eligible (i.e. the four categories of property above) property
on hand at the end of the taxable year.
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a. Simplified production method without historic absorption ratio election
i.
Is done using a general allocation formula
ii.
Is different for FIFO or LIFO
b. Simplified production method with historic absorption ratio election
V.
For Resellers: Simplified Resale Methods: are exclusive methods (for resellers) for
determining the additional section 263A costs properly allocable to property acquired for
resale and other eligible (any real or personal) property on hand at the end of the taxable
year. These are added to the taxpayer's ending section 471 costs to determine the section
263A costs that are capitalized.
a. Simplified resale method without historic absorption ratio election
i.
Is done using a general allocation formula
ii.
Is different for FIFO or LIFO
b. Simplified resale method with historic absorption ratio election
c. Variations of the simplified resale method are permitted:
i.
The exclusion of beginning inventories from the denominator in the
storage and handling costs absorption ratio formula; or
ii.
Multiplication of the storage and handling costs absorption ratio by the
total of section 471 costs included in a LIFO taxpayer's ending inventory
(rather than just the increment, if any, experienced by the LIFO taxpayer
during the taxable year) for purposes of determining capitalizable
storage and handling costs.
De minimis and other Rules:
I.
De minimis producer:
a. Is a producer with total indirect costs of $200,000 or less as having no additional
section 263A costs, or
b. Property produced by a small reseller incident to its resale activities
II.
De minimis service provider: property provided incident to the provision of services by
the taxpayer, if the property is not inventory in the hands of the service provider
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a. Property has to be de minimis (i.e. less than 5% of the price charged
III.
De minimis Service Costs:
a. If 90 percent or more of a mixed service department's costs are deductible service
costs, a taxpayer may elect not to allocate any portion of the service department's
costs to property produced or property acquired for resale.
b. However, if 90 percent or more of a mixed service department's costs are
capitalizable service costs, a taxpayer must allocate 100 percent of the
department's costs to the production or resale activity benefitted.
IV.
De minimis Production activities if:
a. Gross receipts from the sale of property produced by the reseller are less than 10
percent of the total gross receipts of the trade or business, and
b. The labor costs are less than 10% of the reseller’s GR of the trade or business
V.
Determination of whether personnel are engaged in purchasing activities. If a person
performs both purchasing and non-purchasing activities, the taxpayer must reasonably
allocate the person's labor costs between these activities. For example, a reasonable
allocation is one based on the amount of time the person spends on each activity.
a. 1/3-2/3 rule for allocating labor costs. A taxpayer may elect the 1/3-2/3 rule for
allocating labor costs of persons performing both purchasing and non-purchasing
activities. If elected, the taxpayer must allocate the labor costs of all such persons
using the 1/3-2/3 rule. Under this rule—
i.
If less than one-third of a person's activities are related to purchasing,
none of that person's labor costs are allocated to purchasing;
ii.
If more than two-thirds of a person's activities are related to purchasing,
all of that person's labor costs are allocated to purchasing
Other Recent Rules and Issues:
I.
Method Change Procedures for Reasonable Allocation Methods described in §1.263A1(f)(4) for self-constructed assets.
a. RP 2014-16 added a new automatic method number #194
b. Applicability: This change applies to a producer (as defined in section
11.01(2)(d) of this APPENDIX) that wants to change to a UNICAP method that
uses a reasonable method, within the meaning of §1.263A-1(f)(4), other than the
methods specifically described in §1.263A-1(f)(2) or (3) to properly allocate
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direct and indirect costs among units of property produced during the taxable
year.
II.
Method Change Procedures for Real Property Acquired Through Foreclosure:
a. RP 2014-16 added a new automatic method number #195
b. Applicability: This change applies to a taxpayer that capitalizes costs under
section 263A(b)(2) and §1.263A-3(a)(1) to real property acquired through
foreclosure, or similar transaction, where the taxpayer wants to change its
method of accounting to an otherwise permissible method of accounting under
which the acquisition and holding costs for real property acquired through
foreclosure, or similar transaction, are not capitalized under section 263A(b)(2)
and §1.263A-3(a)(1). To qualify for this change in method of accounting, a
taxpayer must:
III.
i.
Originate, or acquire and hold for investment, loans that are secured by
real property; and
ii.
Acquire the real property that secures the loans at a foreclosure sale, by
deed in lieu of foreclosure, or in another similar transaction.
Proposed regulations on allocating 263A under the simplified methods
a. Issued in August 2012, would supersede Notice 2007-29 (addressed this issue)
b. Proposed rules would change the TP’s treatment of negative amounts
c. Sec. 263A requires capitalization of certain direct and indirect costs and to
allocate those costs to specific inventory items.
d. 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
i.
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.
e. Under both simplified methods, TP’s 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.
i.
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Additional Sec. 263A costs are costs that were not required to be
capitalized before 263A came into effect but must be capitalized under
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Sec. 263A.
ii.
Sec. 471 costs are costs that the taxpayer capitalized or would have
capitalized prior to 263A.
f. This required cost allocation treatment can result in negative amounts when a
taxpayer capitalizes a 471 cost in an amount that is greater than the amount
required to be capitalized for tax purposes.
g. Using negative amounts in the simplified methods’ formulas can produce
significant distortions in the amount of additional Sec. 263A costs that are
allocated to inventory.
h. The proposed regulations would prohibit the inclusion of negative amounts under
the simplified methods.
i. 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.
j. 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.
k. The proposed regulations introduce a new simplified production method that
would “more precisely allocate” additional 263A costs among raw materials,
work in process, and finished goods inventories.
l. And 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.
IV.
Chief Counsel Advice (CCA) 201302018 concluded that a sale is considered “on-site”
only when the retail customer is physically present at the sales facility at some point
during the sales transaction. The level of on-site sales at a facility determines whether the
facility is treated as a retail sale or dual-function storage facility. The UNICAP rules do
not require taxpayers to capitalize handling and storage costs incurred at retail sales
facilities or at dual-function storage facilities to the extent they are attributable to
property sold in on-site sales. The regulations generally permit retailers to deduct the
amount of handling and storage costs that are attributable to a “retail sales facility” but
require them to capitalize the costs attributable to non-retail sales facilities.
a. In CCA 201302018, the IRS provides examples to clarify the types of
transactions that qualify as on-site sales under Regs. Sec. 1.263A-3(c)(5)(ii)(D).
The examples demonstrate that a retail customer must be physically present at
the sales facility at some point during the sales transaction for the sale to qualify
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as an on-site sale.
b. Situation 1: A retail customer physically visits the sales facility to select,
inspect, and purchase goods. The customer takes possession of the goods at the
time of the sale. This qualifies as an on-site sale because the customer was
physically present at the sales facility for the entire sales transaction.
c. Situation 2: The facts are the same as Situation 1 except that the customer fills
out a purchase order form at the sales facility agreeing to pay for the goods upon
delivery at a later date. This situation qualifies as an on-site sale because the
customer was physically present at the sales facility to select and inspect the
goods and to fill out the purchase order form. The fact that the customer did not
pay for or take possession of the goods at the sales facility does not preclude this
transaction from qualifying as an on-site sale.
d. Situation 3: A retail customer selects and purchases goods from the sales facility
over the internet. The customer physically visits the sales facility to inspect and
take possession of the goods. This situation qualifies as an on-site sale because
the customer was physically present at the sales facility to inspect and take
possession of the goods. The fact that the customer did not select or purchase the
goods at the sales facility does not preclude this transaction from qualifying as an
on-site sale.
e. Situation 4: A retail customer selects and orders goods advertised in a catalog by
mail from the sales facility, and the goods are delivered to the customer. The
customer does not physically visit the sales facility at any time during the sales
transaction. This situation does not qualify as an on-site sale because the
customer was never physically present at the sales facility. Note that this
conclusion is consistent with the example in Regs. Sec. 1.263A-3(c)(5)(ii)(D),
which provides that mail-order and catalog sales are not on-site sales since they
are made to customers not physically present at the sales facility
V.
The final regulations on the tangible property costs – de minimis safe harbor.
a. Costs of property produced by a taxpayer to which the taxpayer properly applies
the de minimis safe harbor election under the TPR. §1.263(a)-1(f) can be written
off.
b. This is an annual election if the taxpayer properly adheres to the qualifications
that enable a taxpayer to elect
c. However, the cost of property to which a taxpayer properly applies the de
minimis safe harbor election may be required to be capitalized to other property
as a cost incurred by reason of the production of the other property that is subject
to 263A
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VI.
Court of Appeals for the Federal Circuit has invalidated a portion of the 263A regs
(1.263A-11(e) regarding the capitalization of interest. (Dominion, CA-FC, May 31, 2012)
a. Reversing the Federal Claims Court, the FC concluded that the associatedproperty regs were not a reasonable interpretation of the avoided-cost rule set out
in Code Sec. 263A and, therefore, were invalid.
b. IRS’s approach in the regs increased the amount of interest expense that a
taxpayer had to capitalize under the avoided-cost rule.
i.
The avoided-cost rule recognizes that if an improvement had not been
made to property, the funds for the improvement could have been used
to pay down the existing debt on the property.
ii.
Because the funds were not used to pay down the debt, interest accrued
on that amount.
c. The court found that the regs pushed this principle too far when it required the
basis of property temporarily taken out of service for the improvement to be
counted as funds otherwise available (the so-called "associated property rule").
VII.
IRS is seeing 263A issues such as the following:
a. Related to whether a TP is a “producer” or a “reseller” under 263A
i.
It does matter – why?
ii.
Due to what allocation or calculation methods of 263A costs are
permitted
iii.
See section on Methods above.
b. Whether the TP’s Excel worksheet calculating either the simplified production
method or the simplified reseller method is in accordance with the 263A regs.
i.
Are you classifying the costs correctly?
ii.
Are you “tweaking” the formulas to your benefit?
c. Missing interest calculations on self-constructed buildings under 263A(f)
d. Claiming not subject to 263A – due to the exceptions – when they are really
subject to 263A
i.
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Not usually a good surprise in an IRS audit situation
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e. Not applying 263A to restaurants.
i.
VIII.
As a producer and a reseller, restaurants are subject to 263A
Chief Counsel Advise Memo (CCA 201220028, Feb. 6, 2012) addressed the subject of
“whether the capitalization of costs to improve leased real property incurred by a lessee
were subject to §263A costing?”
a. Conclusion: Costs (including the portion related to indirect costs) incurred by the
Lessee associated with the construction of the leased property owned by the
Lessor must be capitalized by the Lessee as leasehold improvements under §
263(a) and § 1.162-11(b) and may not be capitalized under § 263A to the basis of
property produced and owned by the Lessee.
b. Why? Section 1.263A-2(a)(1)(ii) clarifies that a taxpayer is not considered to be
producing property unless the taxpayer is considered an owner of the property
produced under federal income tax principles.
IX.
Capitalized interest is not a “preliminary activity” for purposes of the safe harbor rule for
when construction begins for bonus depreciation.
a. Letter ruling 201214003
b. RP 2011-26 is the guidance on when self-constructed property after September 8,
2010 and before January 1, 2012, began before September 9, 2010.
c. A taxpayer may elect to treat any acquired or self-constructed component of that
larger self-constructed property as being eligible for the 100-percent additional
first year depreciation deduction.
d. The issue in this LR was whether the TP’s 263A required interest allocation
counted towards the measurement of whether the TP was deemed to have started
its self-construction – the LR states that it did not
X.
TP must match its DPAD (section 199) to its 263A cost allocations
a. Recall that section 199 requires the TP to figure Form W-2 wages that are
properly allocable to DPGR (domestic production gross receipts)
b. A TP must properly allocate a portion of its wages to COGS in accordance with
its 263A labor costs
c. The labor allocation processes for 199 and 263A must match!!!!!
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XI.
Loan commitment fee is a 263A cost – CCA 201136022
a. A loan commitment fee to obtain construction financing creates an asset that
must be capitalized and included in accumulation production expenditures.
b. IRS Chief Counsel determined that the loan fee was sufficiently related to the
production of units of property that it had to be capitalized and included in the
costs of production.
c. It would then be deducted as property units were sold.
XII.
Scrap costs:
a. Reg. § 1.263A-1(e)(3)(ii)(Q) requires that indirect costs must be capitalized if
they are allocable to scrap or spoilage.
b. Code Sec. 263A only requires an allocation of the cost of waste scrap to the
inventory.
c. The remainder of the scrap cost is allocable to the salvageable scrap and is
properly recovered when the salvageable scrap is sold.
XIII.
IRS Technical Advice Memorandum 200437034, April 30, 2004.
a. A manufacturer used a reasonable method to allocate the costs associated with
scrap disposal to its inventory costs. The manufacturer routinely divided its scrap
into salvageable and waste, and sold its salvageable scrap to scrap dealers. In
determining the factory overhead allocable to inventory, the manufacturer
estimated the total scrap costs for the tax year and the revenue it would derive
from the sales of salvageable scrap. The net scrap materials costs were then
allocated as an indirect cost component of the inventory costs. By reducing the
amount of the overhead costs by the revenue from salvageable scrap sales, such
revenue is never included in the sales revenue used in computing gross income.
XIV.
Sales based royalties:
a. Deductible and not capitalized
b. Robinson Knife Manufacturing Company, Inc., CA-2 (nonacq.), 2010-1 USTC
c. This case overruled the Tax Court where it found that such costs were “part of
the TP’s production process”
d. IRS released final regulations on sales based royalties on January 13, 2014,
relating to the capitalization and allocation of royalties that are incurred only
upon the sale of property produced or property acquired for resale (sales-based
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royalties).
XV.
i.
Also final regulations relating to adjusting inventory costs for a type of
an allowance, discount, or price rebate earned on the sale of merchandise
(sales-based vendor chargebacks) were included
ii.
These regulations modify the simplified production method and the
simplified resale method of allocating capitalized costs between ending
inventory and cost of goods sold. These regulations affect taxpayers that
incur capitalizable sales-based royalties or earn sales-based vendor
chargebacks.
iii.
The final regulations provide that the allocation of sales-based royalties
to property sold is optional rather than mandatory. Therefore, the final
regulations permit taxpayers to either allocate sales-based royalties
entirely to property sold and include those costs in cost of goods sold or
to allocate sales-based royalties between cost of goods sold and ending
inventory using a facts-and-circumstances cost allocation method
iv.
The final regulations also clarify that sales-based royalties that a
taxpayer allocates entirely to inventory property sold are included in cost
of goods sold and may not be included in determining the cost of goods
on hand at the end of the taxable year regardless of the taxpayer's cost
flow assumption.
v.
Method change procedures to change a taxpayer’s 263A costing for this
was released in Rev. Proc. 2014-33 in May of 2014.
Environmental remediation costs:
a. Subject to capitalization, Rev. Rul. 2004-18
b. IRS indicates that these expenses could be characterized as indirect costs of
production under Reg. §1.263A-1(e)(3).
c. Taxpayers that incur otherwise deductible environmental remediation expenses
under Code Sec. 162 may be required to include the costs in inventory under Reg.
§1.263A-1(c)(3).
d. IRS will not challenge the treatment of remediation costs as deductible expenses
rather than amounts properly capitalized to inventory under Code Sec. 263A in
any tax year ending on or before February 6, 2004.
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XVI.
Field Attorney Advice 20123201F, (Mar. 1, 2013):
a. Issue: Whether, and to what extent, a bank's costs associated with holding OREO
property must be capitalized under I.R.C. §263A.
b. Conclusion: Direct costs and an allocable share of indirect costs associated with
OREO property produced or held primarily for resale must be capitalized to the
basis of such property under I.R.C. §263A. However, to the extent certain OREO
properties are held for the production of rental or investment income, as opposed
to being produced or held for resale, rental operating expenses for those properties
would not be subject to capitalization under section 263A.
c. See RP 2014-16 for new 263A automatic methods for bank owned property
method changes.
Exceptions to 263A Rules:
I.
II.
III.
Resellers: personal property acquired for resale by small resellers (taxpayers with average
annual gross receipts for the three previous tax years of $10 million or less)
Producers:
a.
Property produced by the taxpayer pursuant to a long-term contract, including
home construction contracts, unless that contract will be completed within two
years of the contract commencement date and the taxpayer's average annual gross
receipts for the three preceding tax years do not exceed $10 million
b.
Capitalizable costs allocable under the simplified production method for
producers who have less than $200,000 of indirect costs;
c.
Personal property produced by a small reseller incident to its resale activities,
provided the production activities are de minimis;
d.
Any property produced by a taxpayer for use by the taxpayer other than in a trade
or business or an activity conducted for profit (other than property produced by an
exempt organization in connection with its unrelated trade or business activities);
e.
Personal property produced for a small reseller under contract with an unrelated
person if the contract is entered into incident to the resale activities of the small
reseller and the property is sold to its customers
Service Provider: de minimis amounts of property provided incident to the provision of
services by the taxpayer, if the property is not inventory in the hands of the service
provider
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IV.
More narrow situations:
a.
Certain property produced in farming businesses
b.
Raising, harvesting, or growing trees, other than trees bearing fruit, nuts, or other
crops, or ornamental trees
c.
Qualified creative expenses paid or incurred by certain freelance authors,
photographers, and artists
d.
Various specified costs, such as deductible research and experimental
expenditures, bidding expenses for contracts not awarded to the taxpayer,
marketing and selling expenses, income taxes and other items
e.
The origination of loans (however, the acquisition of pre-existing loans from other
persons for resale is considered property acquired for resale);
f.
Intangible drilling and development costs, mining development expenditures, and
mining exploration expenditures and
g.
Costs relating to natural gas acquired for resale to the extent such costs would
otherwise be allocable to cushion gas.
Rules Applicable to All 263A Taxpayers:
I. General Concepts:
a. General Rule = producers of tangible property (except those specifically
excluded) must include in its ending inventory, and in its costs of goods sold, not
only its direct costs, but also the indirect costs.
b. §§1.263A-1 to -6 provides guidance to taxpayers that are required to capitalize
certain costs under section 263A.
i.
Generally apply to all costs required to be capitalized under section
263A except for interest that must be capitalized under section 263A(f).
ii.
Statutory or regulatory exceptions may provide that section 263A does
not apply to certain activities or costs
c. General scope: TPs subject to section 263A must capitalize all direct costs and
certain indirect costs properly allocable to real and tangible personal property-i.
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Produced by the taxpayer; and
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1. Regardless of whether the property is sold or used in the TP’s
business
ii.
Acquired by the taxpayer for resale: must capitalize the direct costs of
acquiring the property and the allocable share of indirect
1. There are exceptions for resale by a small reseller.
iii.
Farmers must capitalize certain costs
iv. TPs involved in production and resale of creative property must do 263A
d. Exception to the rules of 263A
i.
Small resellers: gross receipts averaging less than $10M a year
ii.
Property produced pursuant to a long-term contract
iii.
Certain farming businesses
iv.
Costs incurred in raising, harvesting or growing timber
v.
Certain free-lance authors, photographers and artists
vi.
Certain not-for-profit activities
vii.
Intangible drilling and development costs
viii.
Natural gas acquired for resale
ix.
Research and experimental expenditure allowable as a deduction under
section 174 or the regulations thereunder. Additionally, section 263A
does not apply to any amount allowable as a deduction under section
59(e) with respect to qualified expenditures under section 174.
x.
Property provided incident to services (health, law, engineering,
architecture, accounting, actuarial science, performing arts, or
consulting.)
1. Property has to be de minimis (i.e. less than 5% of the price
charged)
xi.
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De minimis rule for certain producers with total indirect costs of
$200,000 or less.
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1. §1.263A-2(b)(3)(iv) has a de minimis rule that treats producers
with total indirect costs of $200,000 or less as having no additional
section 263A costs
xii.
Origination of loans is not considered the acquisition of intangible
property for resale. (But 263A(b)(2)(A) does include the acquisition by a
taxpayer of pre-existing loans from other persons for resale.)
II. General Operation of 263A
a. TPs must capitalize their direct costs and a properly allocable share of their
indirect costs to property produced or property acquired for resale.
i.
TPs must allocate or apportion costs to various activities, including
production or resale activities.
ii.
After section 263A costs are allocated to the appropriate production or
resale activities, these costs are generally allocated to the items of
property produced or property acquired for resale during the taxable year
and capitalized to the items that remain on hand at the end of the taxable
year.
1. Exceptions: Simplified production method and the Simplified
resale method
b. Arises in its application: how to property allocate the additional indirect and
mixed service costs required to be capitalized under Section 263A in a reasonable
and consistent manner.
III. Direct costs
a. Direct Costs:
i.
Producers. Producers are required to capitalize "direct material costs"
and "direct labor costs."
1. Direct material costs include the costs of those materials that
become an integral part of specific property produced and those
materials that are consumed in the ordinary course of production
and that can be identified or associated with particular units or
groups of units of property produced.
2. Direct labor costs include the costs of labor that can be identified
or associated with particular units or groups of units of specific
property produced.
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a. Labor encompasses full-time and part-time employees, as
well as contract employees and independent contractors.
b. Direct labor costs include all elements of compensation
other than employee benefit costs.
c. Elements of direct labor costs include basic compensation,
overtime pay, vacation pay, holiday pay, sick leave pay
(other than payments pursuant to a wage continuation plan
under Code Sec. 105(d) as it existed prior to its repeal in
1983), shift differential, payroll taxes, and payments to a
supplemental unemployment benefit plan
ii.
Direct costs for resellers. Resellers are required to capitalize the
acquisition costs of property acquired for resale.
1. In the case of inventory, the acquisition cost generally provides
that "costs" means the invoice price less trade or other discounts,
except strictly cash discounts approximating a fair interest rate,
which may or may not be deducted at the option of the taxpayer,
provided a consistent course is followed in the case of merchandise
purchased since the beginning of the tax year.
2. To the net invoice price, transportation or other necessary charges
incurred in acquiring possession of the goods are added.
IV. Indirect Costs = all costs other than direct material costs and direct labor costs (in the
case of property produced) or acquisition costs (in the case of property acquired for
resale). Taxpayers subject to section 263A must capitalize all indirect costs properly
allocable to property produced or property acquired for resale. Indirect costs are properly
allocable to property produced or property acquired for resale when the costs directly
benefit or are incurred by reason of the performance of production or resale activities.
Indirect costs may be allocable to both production and resale activities, as well as to other
activities that are not subject to section 263A. Taxpayers subject to section 263A must
make a reasonable allocation of indirect costs between production, resale, and other
activities.
a. Examples:
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i.
Indirect labor costs;
ii.
Officers' compensation;
iii.
Pension and other related costs
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iv.
Employee benefit expenses;
v.
Indirect material costs;
vi.
Purchasing costs; handling costs; storage costs;
vii.
Cost recovery and depletion;
viii.
Rent;
ix.
Taxes;
x.
Insurance;
xi.
Utilities;
xii.
Repairs and maintenance;
xiii.
Engineering and design costs;
xiv.
Spoilage; tools and equipment;
xv.
Quality control;
xvi.
Post-production costs
xvii.
Pre-production costs
xviii.
Bidding costs;
xix.
Licensing and franchise costs;
xx.
Interest; and
xxi.
Capitalizable service costs ( Reg. §1.263A-1(e)(3)(ii); Temporary Reg.
§1.263A-1T(e)(3)(ii)(E), adopted by T.D. 9564, effective for amounts
paid or incurred (to acquire or produce property) in tax years beginning
on or after January 1, 2012).
b. For producers: indirect costs are defined as all costs other than direct material
costs and direct labor costs.
c. For resellers: indirect costs are defined as all costs other than acquisition costs.
d. Excludable Indirect Costs:
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i.
Exempt deductible expenses.
1. Marketing, selling, advertising, and distribution expenses;
2. Unsuccessful bidding expenses
3. Costs of expensed assets;
4. Strike costs
5. Research and experimental expenses
6. Section 179 costs,
7. Section 165 losses,
8. Income taxes
9. Warranty and product liability costs
10. On-site storage costs
11. Deductible service costs, and
12. Depreciation, amortization and cost recovery allowances on
equipment and facilities that are taken out of service for a finite
period but not merely during nonworking hours
ii.
Interest expenses incurred on specified resale property
iii.
Costs incurred for natural gas acquired for resale are if they are
attributable to cushion gas.
iv.
De minimis rule for producers with total indirect costs of $200,000 or
less:
1. If a producer incurs $200,000 or less of total indirect costs in a tax
year, the additional Code Sec. 263A costs allocable to eligible
property remaining on hand at the close of that tax year are deemed
to be zero
V.
Service Costs: type of indirect cost that can be identified specifically with a service
department or function that directly benefits or costs are incurred by reason of a service
department or function.
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a. "Service departments" are administrative, service or support departments that
incur service costs.
b. The facts and circumstances of a producer's or reseller's activities and business
organization control whether a department is a service department.
i.
For example, XYZ Manufacturing may include in service departments
its HR or personnel, accounting, data processing, security, legal and
other similar departments.
c. Service cost categories. There are three categories of service costs:
i.
Capitalizable
ii.
Deductible, and
iii.
Mixed service costs
d. Capitalizable service costs: those service costs that directly benefit or are incurred
by reason of the performance of the production or resale activities.
i.
Such costs are required to be capitalized
ii.
Service departments or functions that incur these capitalizable service
costs which are generally allocated among production or resale activities
include:
1. The administration and coordination of production or resale
activities (wherever performed in the producer's or reseller's
business organization);
2. HR or personnel operations (including the cost of recruiting,
hiring, relocating, assigning, and maintaining personnel records or
employees);
3. Purchasing operations (including purchasing materials and
equipment, scheduling and coordinating delivery of materials and
equipment to or from factories or job sites and expediting and
follow-up);
4. Materials handling and warehousing and storage operations;
5. Accounting and data services operations (including cost
accounting, accounts payable, disbursements and payroll functions,
but excluding accounts receivable and customer billing functions);
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6. Data processing;
7. Security services; and
8. Legal services
e. Deductible service costs: those service costs that do not directly benefit or are not
incurred by reason of the performance of the production or resale activities of a
producer or reseller.
i.
Costs are not required to be capitalized
ii.
Deductible service costs generally include costs incurred by reason of a
producer's or reseller's overall management or policy guidance
functions, costs incurred by reason of marketing, selling, and advertising
and distribution activities.
iii.
Departments or functions that incur deductible service costs include:
1. Departments or functions responsible for overall management or
for setting overall policy for activities or trades or businesses such
as the board of directors (including their immediate staff), and the
chief executive, financial, accounting, and legal officers (also
including their immediate staff) provided that no substantial part of
the cost of the departments or functions benefits a particular
production or resale activity;
2. Strategic business planning;
3. General financial accounting;
4. General financial planning (including general budgeting) and
financial management (including bank relations and cash
management);
5. Personnel policy such as establishing and managing personnel
policy in general; developing wage, salary, and benefit policies;
developing employee training programs unrelated to particular
activities; negotiating with labor unions; and maintaining relations
with retirees;
6. Quality control and safety engineering policy;
7. Insurance risk management policy, but not including bid or
performance bonds or insurance related to activities;
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8. Environmental management policy, except to the extent that the
costs of any system or procedure benefits a particular activity;
9. General economic analysis and forecasting;
10. Internal audit;
11. Shareholder, public and industrial relations;
12. Tax services; and
13. Marketing, selling or advertising ( Reg. §1.263A-1(e)(4)(ii)(B) and
Reg. §1.263A-1(e)(4)(iv)
f. Mixed service costs: those service costs that are partially allocable to production
or resale activities (capitalized mixed service costs) and partially allocable to nonproduction or non-resale activities (deductible mixed service costs).
i.
For example, an HR department may incur costs to recruit factory
workers, the costs of which are allocable to production activities, and it
may also incur costs to develop wage, salary, and benefit policies, the
costs of which are allocable to non-production activities.
ii.
General allocation rule: De minimis rule: A taxpayer may elect not to
allocate any portion of the service department's costs to property
produced or property acquired for resale, provided 90 percent or more of
a mixed service department's costs are deductible service costs not
required to be capitalized.
1. If the taxpayer makes the election, the taxpayer must also allocate
all mixed service department costs if 90 percent of the department
costs are capitalizable under 263A.
2. Changes in methods of accounting must follow other IRS rules
VI. Cost Allocation Methods: Any of several methods may be used under the UNICAP
(uniform capitalization) rules to allocate direct and indirect inventory costs, depending on
the particular inventory cost involved:
a. Specific identification or tracing Method: each separate cost, whether direct or
indirect, is identified and assigned by cost objective, such as a function,
department, activity or product on the basis of a cause and effect or other
reasonable relationship between the costs and the cost objective.
b. Burden Rates: method of allocating indirect costs to inventory property through
the use of predetermined rates that approximate the actual amount of indirect
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costs incurred.
i.
To use the burden rates method, the taxpayer must develop burden rates
in accordance with generally accepted accounting principles and apply
those rates in a reasonable manner.
ii.
The taxpayer must also maintain adequate records and working papers to
support the burden rate calculations.
iii.
Different burden rates may be used for different indirect costs.
1. For example, the taxpayer may use one burden rate for allocating
the cost of utilities and another for allocating the cost of rent.
iv.
In developing burden rates, the taxpayer should consider:
1. The level of activity and time period that reflect operating
conditions for the unit costs for which the burden rate is being
determined;
2. The appropriate statistical base (such as direct labor hours, direct
labor dollars, or machine hours, or a combination thereof) for
applying the overhead rate to determine costs; and
3. The appropriate method of budgeting, classifying and analyzing
expenses (such as an analysis of fixed and variable costs).
v.
Any net negative or net positive difference between the total
predetermined amount of costs allocated to inventory property and the
total amount of indirect costs actually incurred and required to be
allocated to that property must be treated as an adjustment to the
taxpayer's ending inventory or capital account in the tax year in which
the difference arises.
1. If the adjustment is not significant in relation to the taxpayer's
indirect costs incurred for inventory property for the year, it need
be made only if it is made in the taxpayer's financial reports.
2. The taxpayer must treat both positive and negative adjustments
consistently.
3. Any such periodic adjustment to burden rates to reflect current
operating conditions is not a change of accounting method. A
change in the concept under which burden rates are developed,
however, does constitute a change of method, and the consent of
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the IRS ordinarily is required
c. Standard Cost: is a method whereby costs of goods are initially determined by
reference to a single standard or estimate.
i.
This method may be used only if the taxpayer reallocates to property a
pro rata portion of any net negative or net positive overhead variances
and any net negative or net positive direct cost variances.
1. A net positive overhead variance is the excess of total standard
indirect costs over total actual indirect costs.
2. A net negative overhead variance is the excess of total actual
indirect costs over total standard indirect costs.
3. The variances must be apportioned to property to which the costs
are allocable.
ii.
If the variances are not significant in amount in relation to the taxpayer's
total indirect costs incurred for inventory property for the year, however,
the allocation of the variances needs to be made only if the allocation is
made in the taxpayer's financial reports.
iii.
The taxpayer must treat both positive and negative variances
consistently.
d. Other Reasonable Allocation Methods: The 263A rules allow any reasonable
method to be used to allocate costs to particular inventory property. An allocation
method is reasonable if, for the taxpayer's inventory property taken as a whole,
the following conditions are met:
1. The total amount of the costs that the taxpayer capitalizes during
the tax year does not differ significantly from the total amount that
would result if all costs had been capitalized using another
permissible method, including the simplified methods, with
appropriate consideration given to the volume and value of the
taxpayer's production or resale activities, the availability of costing
information, the time and cost of using various allocation methods
and the accuracy of the allocation method chosen as compared
with other allocation methods;
2. The allocation method is applied consistently by the taxpayer;
3.
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And the allocation method is not used to circumvent the
requirements of the simplified methods or the UNICAP rules.
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4. Examples of other reasonable allocation methods:
a. Security services. The costs of security or protection
services must be allocated to each physical area that
receives the services using any reasonable method applied
consistently (such as the size of the physical area, the
number of employees in the area, or the relative fair market
value of assets located in the area).
b. Legal services. The costs of legal services are generally
allocable to a particular production or resale activity on the
basis of the approximate number of hours of legal service
performed in connection with the activity, including
research, bidding, negotiating, drafting, reviewing a
contract, obtaining necessary licenses and permits, and
resolving disputes. Different hourly rates may be
appropriate for different services. In determining the
number of hours allocable to any activity, estimates are
appropriate, detailed time records are not required to be
kept. Insubstantial amounts of services provided to an
activity by senior legal staff, such as administrators or
reviewers, may be ignored. Legal costs may also be
allocated to a particular production or resale activity based
on the ratio of the total direct costs incurred for the activity
to the total direct costs incurred with respect to all
production or resale activities. The taxpayer must also
allocate directly to an activity the cost incurred for any
outside legal services. Legal costs relating to general
corporate functions are not required to be allocated to a
particular production or resale activity.
c. Centralized payroll services. The costs of a centralized
payroll department or activity are generally allocated to the
departments or activities benefited on the basis of the gross
dollar amount of payroll processed.
d. Centralized data processing services. The costs of a
centralized data processing department are generally
allocated to all departments or activities benefited using
any reasonable basis, such as total direct data processing
costs or the number of data processing hours supplied. The
costs of data processing systems or applications developed
for a particular activity are directly allocated to that
activity.
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e. Engineering and design services. The costs of an
engineering or a design department are generally directly
allocable to the departments or activities benefited based on
the ratio of the approximate number of hours of work
performed for the particular activity to the total number of
hours of engineering or design work performed for all
activities. Different services may be allocated at different
hourly rates.
f. Safety engineering services. The costs of safety engineering
departments or activities generally benefit all of the
taxpayer's activities and, thus, should be allocated using a
reasonable basis, such as the approximate number of safety
inspections made in connection with a particular activity as
a fraction of total inspections, the number of employees
assigned to an activity as a fraction of total employees, or
the total labor hours worked in connection with an activity
as a fraction of total hours. However, in determining the
allocable costs of a safety engineering department, costs
attributable to providing a safety program relating only to a
particular activity must be directly assigned to such
activity. Additionally, the cost of a safety engineering
department only responsible for setting safety policy and
establishing safety procedures to be used in all of the
taxpayer's activities is not required to be allocated.
VII. Allocating Categories of Costs
a. Direct materials and labor: these costs, incurred during the taxable year, must be
allocated to the property produced or property acquired for resale by the taxpayer
using the taxpayer's method of accounting (specific identification, FIFO, LIFO, or
any other reasonable method)
b. Indirect costs: generally allocated to intermediate cost objectives such as
departments or activities prior to the allocation of such costs to property produced
or property acquired for resale. Indirect costs are allocated using either:
i.
A specific identification method,
ii.
A standard cost method,
iii.
A burden rate method, or
c. Any other reasonable allocation method
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VIII.
Service costs = a type of indirect costs that may be allocated using the same allocation
methods available for allocating other indirect costs described above.
a. TPs that use a specific identification method or another reasonable allocation
method must allocate service costs to particular departments or activities based on
a factor or relationship that reasonably relates the service costs to the benefits
received from the service departments or activities.
i.
Using reasonable factors or relationships, a taxpayer must allocate
mixed service costs under:
1. A direct reallocation method
2. A step-allocation method
3. Or any other reasonable allocation method
b. De minimis rule.
i.
If 90 percent or more of a mixed service department's costs are
deductible service costs, a taxpayer may elect not to allocate any portion
of the service department's costs to property produced or property
acquired for resale.
ii.
However, if 90 percent or more of a mixed service department's costs
are capitalizable service costs, a taxpayer must allocate 100 percent of
the department's costs to the production or resale activity benefitted.
iii.
For example, if 90 percent of the costs of an electing taxpayer's
accounting department benefit the taxpayer's manufacturing activity, the
taxpayer must allocate 100 percent of the costs of the accounting
department to the manufacturing activity.
iv.
This election applies to all of a TP’s mixed service departments and
constitutes the adoption of a (or a change in) method of accounting
IX. Methods for allocating mixed service costs
a. Direct reallocation method.
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i.
The total costs (direct and indirect) of all mixed service departments are
allocated only to departments or cost centers engaged in production or
resale activities and then from those departments to particular activities.
ii.
This direct reallocation method ignores benefits provided by one mixed
service department to other mixed service departments, and also
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excludes other mixed service departments from the base used to make
the allocation.
iii.
Example: See Appendix D
b. Step-allocation method
i.
A sequence of allocations is made by the TP.
1. First, the total costs of the mixed service departments that benefit
the greatest number of other departments are allocated to -a. Other mixed service departments;
b. Departments that incur only deductible service costs; and
c. Departments that exclusively engage in production or
resale activities.
2. TP continues allocating mixed service costs until all mixed service
costs are allocated to the types of departments
3. A step-allocation method recognizes the benefits provided by one
mixed service department to another mixed service department and
also includes mixed service departments that have not yet been
allocated in the base used to make the allocation.
ii.
Example: See Appendix E
c. Simplified Mixed Service Cost Method:
i. Eligible property
1. In general. --the simplified service cost method, if elected for any
trade or business of the taxpayer, must be used for all production
and resale activities of the trade or business associated with any of
the following categories of property that are subject to section
263A:
a. Inventory property. --Stock in trade or other property
properly includible in the inventory of the taxpayer.
b. Non-inventory property held for sale. --Non-inventory
property held by a taxpayer primarily for sale to customers
in the ordinary course of the taxpayer's trade or business.
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c. Certain self-constructed assets. --Self-constructed assets
substantially identical in nature to, and produced in the
same manner as, inventory property produced by the
taxpayer or other property produced by the taxpayer and
held primarily for sale to customers in the ordinary course
of the taxpayer's trade or business.
d. Self-constructed tangible personal property produced on a
routine and repetitive basis
2.
i.
When units of tangible personal property are
mass-produced, that is, numerous substantially
identical assets are manufactured within a taxable
year using standardized designs and assembly line
techniques, and either the applicable recovery
period of the property is no longer than 3 years or
the property is a material or supply that will be
used and consumed within 3 years of being
produced.
ii.
The applicable recovery period of the assets will
be determined at the end of the taxable year in
which the assets are placed in service
iii.
TP can elect to exclude this category from the
simplified mixed service cost method
Examples. – See Appendix F
3. General allocation formula: allocation ratio x total mixed service
cost
a. Producer may elect one of two allocation ratios:
i.
The labor-based allocation ratio or
ii.
The production cost allocation ratio.
4. A reseller may elect the simplified service cost method, but must
use a labor-based allocation ratio.
a. Labor-based allocation ratio formula:
Section 263A labor costs / total labor costs
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5. Production cost allocation ratio formula:
Section 263A production costs / Total costs
d. Mixed Service Costs allocable to more than one business. --To the extent mixed
service costs, labor costs, or other costs are incurred in more than one trade or
business, the taxpayer must determine the amounts allocable to the particular
trade or business for which the simplified service cost method is being applied by
using any reasonable allocation method
X.
Costs provided by a related person
a. must capitalize an arm's-length charge for any section 263A incurred by a related
person that are properly allocable to the property produced or property acquired
for resale
b. Both the TP and the related person must account for the transaction as if an arm'slength charge had been incurred by the taxpayer with respect to its property
produced or property acquired for resale.
c. Arm’s-length charge means the arm's-length charge (or other appropriate charge
where permitted and applicable) under the principles of section 482.
d. There are certain exceptions.
XI.
Election of 263A Methods: Notwithstanding the references generally to “TP” in 263A
regulations, the methods of accounting provided under section 263A are to be elected
and applied independently for each separate and distinct trade or business of the
taxpayer
Rules Applicable to Producers
I.
Section 263A applies to real property and tangible (not intangible) personal property
produced by a taxpayer for:
a. Use in its trade or business or
b. For sale to its customers, and
c. For a taxpayer under a contract with another party
i.
There is an exception for home construction contracts if revenues are
less than $10M
d. If a TP produces and resales, TP may elect the SPM but cannot elect the
simplified resale method.
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i.
II.
If SPM is elected, the TP must apply the SPM to property produced and
property acquired for resale
Simplified Production Method – Producers can elect a “simplified” method for
determining the additional section 263A costs properly allocable to ending inventories of
property produced and other eligible property on hand at the end of the taxable year.
a. Eligible property
i.
Must be used for all production and resale activities associated with any
of the following categories of property to which section 263A applies:
1. Inventory property. --Stock in trade or other property properly
includible in the inventory of the taxpayer.
2. Non-inventory property held for sale. --Non-inventory property
held by a taxpayer primarily for sale to customers in the ordinary
course of the taxpayer's trade or business.
3. Certain self-constructed assets. --Self-constructed assets
substantially identical in nature to, and produced in the same
manner as, inventory property produced by the taxpayer or other
property produced by the taxpayer and held primarily for sale to
customers in the ordinary course of the taxpayer's trade or
business.
4. Self-constructed tangible personal property produced on a routine
and repetitive basis
a. Is produced by the taxpayer on a routine and repetitive
basis in the ordinary course of the taxpayer's trade or
business when units of tangible personal property are massproduced, that is, numerous substantially identical assets
are manufactured within a taxable year using standardized
designs and assembly line techniques, and either the
recovery period of the property is no longer than 3 years or
the property is a material or supply that will be used and
consumed within 3 years of being produced.
b. TP can elect to exclude this category from the simplified
mixed service cost method
ii.
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Examples. – See Appendix G:
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III.
Simplified production method without historic absorption ratio election
a. General allocation formula:
1. The additional section 263A costs allocable to eligible property
remaining on hand at the close of the taxable year under the
simplified production method are computed as follows:
a. Absorption ratio x Section 471 costs remaining on hand at
YE
b. Effect of allocation. --The absorption ratio generally is multiplied by the section
471 costs remaining in ending inventory or otherwise on hand at the end of each
taxable year in which the simplified production method is applied.
c. The resulting product is the additional section 263A costs that are added to the
taxpayer's ending section 471 costs to determine the section 263A costs that are
capitalized.
d. There are special rules applicable to LIFO taxpayers.
e.
Additional section 263A costs that are allocated to inventories on hand at the
close of the taxable year under the simplified production method are treated as
inventory costs
f. LIFO taxpayers electing the simplified production method
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i.
A taxpayer using a LIFO method must calculate a particular year's index
(e.g., under §1.472-8(e)) without regard to its additional section 263A
costs. Similarly, a taxpayer that adjusts current-year costs by applicable
indexes to determine whether there has been an inventory increment or
decrement in the current year for a particular LIFO pool must disregard
the additional section 263A costs in making that determination.
ii.
LIFO increment. --If the taxpayer determines there has been an
inventory increment, the taxpayer must state the amount of the
increment in current-year dollars (stated in terms of section 471 costs).
The taxpayer then multiplies this amount by the absorption ratio. The
resulting product is the additional section 263A costs that must be added
to the taxpayer's increment for the year stated in terms of section 471
costs.
iii.
LIFO decrement. --If the taxpayer determines there has been an
inventory decrement, the taxpayer must state the amount of the
decrement in dollars applicable to the particular year for which the LIFO
layer has been invaded. The additional section 263A costs incurred in
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prior years that are applicable to the decrement are charged to cost of
goods sold. The additional section 263A costs that are applicable to the
decrement are determined by multiplying the additional section 263A
costs allocated to the layer of the pool in which the decrement occurred
by the ratio of the decrement (excluding additional section 263A costs)
to the section 471 costs in the layer of that pool.
g. Example – Appendix H
IV.
Simplified production method with historic absorption ratio election
a. 263A generally permits producers using the simplified production method to elect
a historic absorption ratio in determining additional section 263A costs allocable
to eligible property remaining on hand at the close of their taxable years – but
only for tax years in the early 1990’s
b. TP may only make a historic absorption ratio election if it has used the simplified
production method for three or more consecutive taxable years immediately prior
to the year of election and has capitalized additional section 263A costs using an
actual absorption ratio for its three most recent consecutive taxable years.
c. This method is not available to a taxpayer that is deemed to have zero additional
section 263A costs.
d. The historic absorption ratio is used in lieu of an actual absorption ratio and is
based on costs capitalized by a taxpayer during its test period.
e. If elected, the historic absorption ratio must be used for each taxable year within
the qualifying period
f. Operating rules and definitions
i.
Historic absorption ratio
1. The historic absorption ratio is equal to the following ratio:
Add'l section 263A costs incurred during the test period
__________________________________________________________
Section 471 costs incurred during the test period.
ii.
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Additional section 263A costs incurred during the test period are defined
as the additional section 263A costs that the taxpayer incurs during the
test period
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iii.
Section 471 costs incurred during the test period mean the section 471
costs that the taxpayer incurs during the test period
iv.
Test period
1. In general. --The test period is generally the three taxable-year
period immediately prior to the taxable year that the historic
absorption ratio is elected.
2. Updated test period. --The test period begins again with the
beginning of the first taxable year after the close of a qualifying
period. This new test period, the updated test period, is the three
taxable-year period beginning with the first taxable year after the
close of the qualifying period
v.
Qualifying period
1. In general. --A qualifying period includes each of the first five
taxable years beginning with the first taxable year after a test
period (or an updated test period).
2. Extension of qualifying period. --In the first taxable year following
the close of each qualifying period, (e.g., the sixth taxable year
following the test period), the taxpayer must compute the actual
absorption ratio under the simplified production method.
3. If the actual absorption ratio computed for this taxable year (the
recomputation year) is within one-half of one percentage point
(plus or minus) of the historic absorption ratio used in determining
capitalizable costs for the qualifying period (i.e., the previous five
taxable years), the qualifying period is extended to include the
recomputation year and the following five taxable years, and the
taxpayer must continue to use the historic absorption ratio
throughout the extended qualifying period.
4. If, however, the actual absorption ratio computed for the
recomputation year is not within one-half of one percentage point
(plus or minus) of the historic absorption ratio, the taxpayer must
use actual absorption ratios beginning with the recomputation year
under the simplified production method and throughout the
updated test period. The taxpayer must resume using the historic
absorption ratio (determined with reference to the updated test
period) in the third taxable year following the recomputation year.
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g. Method of accounting
i.
Adoption and use. --The election to use the historic absorption ratio is a
method of accounting.
ii.
A taxpayer using the simplified production method may elect the
historic absorption ratio in any taxable year provided the taxpayer has
not obtained the Commissioner's consent to revoke the historic
absorption ratio election within its prior six taxable years.
iii.
The election is to be effected on a cut-off basis, and thus, no adjustment
under section 481(a) is required or permitted.
iv.
The use of a historic absorption ratio has no effect on other methods of
accounting adopted by the taxpayer and used in conjunction with the
simplified production method in determining its section 263A costs.
v.
The taxpayer must use the same methods of accounting used in
computing its historic absorption ratio during its most recent test period
unless the taxpayer obtains the consent of the Commissioner.
vi.
The recomputation of the historic absorption ratio during an updated test
period and the change from a historic absorption ratio to an actual
absorption ratio by reason of the requirements of this paragraph (b)(4)
are not considered changes in methods of accounting under section
446(e) and, thus, do not require the consent of the Commissioner or any
adjustments under section 481(a).
h. Revocation of election. --A taxpayer may only revoke its election to use the
historic absorption ratio with the consent of the Commissioner in a manner
prescribed under section 446(e) and the regulations thereunder. Consent to the
change for any taxable year that is included in the qualifying period (or an
extended qualifying period) will be granted only upon a showing of unusual
circumstances.
i. Reporting and recordkeeping requirements
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i.
Reporting. --A taxpayer making this election must attach a statement to
its federal income tax return for the taxable year in which the election is
made showing the actual absorption ratios determined under the
simplified production method during its first test period.
ii.
This statement must disclose the historic absorption ratio to be used by
the taxpayer during its qualifying period.
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iii.
A similar statement must be attached to the federal income tax return for
the first taxable year within any subsequent qualifying period (i.e., after
an updated test period).
j. Recordkeeping. --A taxpayer must maintain all appropriate records and details
supporting the historic absorption ratio until the expiration of the statute of
limitations for the last year for which the taxpayer applied the particular historic
absorption ratio in determining additional section 263A costs capitalized to
eligible property.
k. Transition rules. --Taxpayers will be permitted to elect a historic absorption ratio
in their first, second, or third taxable year beginning after December 31, 1993,
under such terms and conditions as may be prescribed by the Commissioner.
Taxpayers are eligible to make an election under these transition rules whether or
not they previously used the simplified production method.
i.
A taxpayer making such an election must recompute (or compute) its
additional section 263A costs, and thus, its historic absorption ratio for
its first test period as if the rules prescribed in this section and
§§1.263A-1 and 1.263A-3 had applied throughout the test period.
Rules Applicable to Resellers – Property Acquired for Resale
I.
Section 263A applies to real property and personal tangible and intangible property
acquired for resale by a retailer, wholesaler, or other taxpayer (reseller).
a. However, section 263A does not apply to personal property for resale by a reseller
whose average annual gross receipts for the three previous taxable years do not
exceed $10,000,000 (small reseller).
i.
However, if the TP acquires real property for resale – the TP is subject
to 263A regardless of their gross receipts
b. Property acquired for resale includes stock in trade of the taxpayer or other
property which is includible in the taxpayer's inventory if on hand at the close of
the taxable year, and property held by the taxpayer primarily for sale to customers
in the ordinary course of the taxpayer's trade or business
c. De minimis production activities if:
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i.
Gross receipts from the sale of property produced by the reseller are less
than 10 percent of the total gross receipts of the trade or business, and
ii.
The labor costs are less than 10% of the reseller’s GR of the trade or
business
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II.
Purchasing, handling, and storage costs—
a. Resellers must capitalize the acquisition cost of property acquired for resale, as
well as indirect costs, which are properly allocable to property acquired for resale.
b. The indirect costs most often incurred by resellers are purchasing, handling, and
storage costs.
i.
This issue also applies to producers incurring purchasing, handling, and
storage costs.
c. Costs attributable to purchasing, handling, and storage. The costs attributable to
purchasing, handling, and storage activities generally consist of direct and indirect
labor costs (including the costs of pension plans and other fringe benefits);
occupancy expenses including rent, depreciation, insurance, security, taxes,
utilities and maintenance; materials and supplies; rent, maintenance, depreciation,
and insurance of vehicles and equipment; tools; telephone; travel; and the general
and administrative costs that directly benefit or are incurred by reason of the
taxpayer's activities.
i.
Purchasing costs: costs associated with operating a purchasing
department or office within a trade or business, including personnel
costs (e.g., of buyers, assistant buyers, and clerical workers), relating
to—
1. The selection of merchandise;
2. The maintenance of stock assortment and volume;
3. The placement of purchase orders;
4. The establishment and maintenance of vendor contacts; and
5. The comparison and testing of merchandise.
ii.
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Determination of whether personnel are engaged in purchasing activities.
The determination of whether a person is engaged in purchasing activities
is based upon the activities performed by that person and not upon the
person's title or job classification. Thus, for example, although an
employee's job function may be described in such a way as to indicate
activities outside the area of purchasing (e.g., a marketing representative),
such activities must be analyzed on the basis of the activities performed by
that employee. If a person performs both purchasing and non-purchasing
activities, the taxpayer must reasonably allocate the person's labor costs
between these activities. For example, a reasonable allocation is one based
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on the amount of time the person spends on each activity.
1. 1/3-2/3 rule for allocating labor costs. A taxpayer may elect the
1/3-2/3 rule for allocating labor costs of persons performing both
purchasing and non-purchasing activities. If elected, the taxpayer
must allocate the labor costs of all such persons using the 1/3-2/3
rule. Under this rule—
a. If less than one-third of a person's activities are related to
purchasing, none of that person's labor costs are allocated
to purchasing;
b. If more than two-thirds of a person's activities are related to
purchasing, all of that person's labor costs are allocated to
purchasing; and
c. In all other cases, the taxpayer must reasonably allocate
labor costs between purchasing and non-purchasing
activities.
iii.
Handling costs--(i) In general. Handling costs include costs attributable
to processing, assembling, repackaging, transporting, and other similar
activities with respect to property acquired for resale, provided the
activities do not come within the meaning of the term produce as defined
in §1.263A-2(a)(1). Handling costs are generally required to be
capitalized under section 263A. Under this paragraph (c)(4)(i), however,
handling costs incurred at a retail sales facility (as defined in paragraph
(c)(5)(ii)(B) of this section) with respect to property sold to retail
customers at the facility are not required to be capitalized.
iv.
Processing costs
v.
Assembling costs
vi.
Repackaging costs
vii.
Transportation costs
viii.
Pick and pack costs
ix.
III.
Storage costs
Simplified resale methods: simplified method for determining the additional section
263A costs properly allocable to property acquired for resale and other eligible
property on hand at the end of the taxable year.
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a. Eligible property. Generally, the simplified resale method is only available to a
trade or business exclusively engaged in resale activities.
IV.
i.
Certain resellers with property produced as a result of de minimis
production activities or property produced under contract may elect the
simplified resale method,
ii.
Eligible property - includes any real or personal that is acquired for
resale and any eligible
Simplified resale method without historic absorption ratio election: allocation
formula
i.
The additional section 263A costs allocable to eligible property
remaining on hand at the close of the taxable year are computed as
follows:
Section 471 costs
Combined absorption ratio x
remaining on hand at year end.
b. Effect of allocation: The resulting product under the general allocation formula is
the additional section 263A costs that are added to the taxpayer's ending section
471 costs to determine the section 263A costs that are capitalized.
c. Definitions -- combined absorption ratio = is defined as the sum of the storage
and handling costs absorption ratio and the purchasing costs absorption ratio
d. Section 471 costs remaining on hand at year end = mean the section 471 costs,
that the taxpayer incurs during its current taxable year, which remain in its ending
inventory or are otherwise on hand at year end.
i.
For LIFO inventories of a taxpayer, the section 471 costs remaining on
hand at year end means the increment, if any, for the current year stated
in terms of section 471 costs.
ii.
Additional section 263A costs that are allocated to inventories on hand
at the close of the taxable year under the simplified resale method of this
paragraph (d) are treated as inventory costs
e. Storage and handling costs absorption ratio- this absorption ratio is determined as
follows:
Current year's storage and handling costs
----------------------------------------Beginning inventory plus current year's purchases.
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i.
Current year's storage and handling costs are defined as the total storage
costs plus the total handling costs incurred during the taxable year that
relate to the taxpayer's property acquired for resale and other eligible
property.
ii.
Beginning inventory in the denominator of the storage and handling
costs absorption ratio refers to the section 471 costs of any property
acquired for resale or other eligible property held by the taxpayer as of
the beginning of the taxable year.
iii.
Current year's purchases generally mean the taxpayer's section 471 costs
incurred with respect to purchases of property acquired for resale during
the current taxable year.
iv.
For LIFO - in computing the denominator of the storage and handling
costs absorption ratio, a taxpayer using a dollar-value LIFO method of
accounting, must state beginning inventory amounts using the LIFO
carrying value of the inventory and not current-year dollars.
f. Purchasing costs absorption ratio - this absorption ratio is determined as follows
Current year's purchasing costs
------------------------------Current year's purchases.
i.
Current year's purchasing costs are defined as the total purchasing costs
incurred during the taxable year that relate to the taxpayer's property
acquired for resale and eligible property.
ii.
Current year's purchases generally mean the taxpayer's section 471 costs
incurred with respect to purchases of property acquired for resale during
the current taxable year.
g. Allocable mixed service costs.
i. If a taxpayer allocates its mixed service costs to purchasing costs, storage
costs, and handling costs the taxpayer is not required to determine its
allocable mixed service costs under this section.
ii. However, if the taxpayer uses the simplified service cost method, the
amount of mixed service costs allocated to and included in purchasing
costs, storage costs, and handling costs in the absorption ratios in of this
section is determined as follows:
Labor costs allocable to activity
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--------------------------------- x Total mixed
Total labor costs
service costs.
iii.
Labor costs allocable to activity are defined as the total labor costs
allocable to each particular activity (i.e., purchasing, handling, and
storage), excluding labor costs included in mixed service costs.
iv.
Total labor costs are defined as the total labor costs (excluding labor
costs included in mixed service costs) that are incurred in the taxpayer's
trade or business during the taxable year.
v.
For LIFO TPs electing simplified resale method - must calculate a
particular year's index (e.g., under §1.472-8(e)) without regard to its
additional section 263A costs.
1. Similarly, a taxpayer that adjusts current-year costs by applicable
indexes to determine whether there has been an inventory
increment or decrement in the current year for a particular LIFO
pool must disregard the additional section 263A costs in making
that determination.
2. LIFO increment. If the taxpayer determines there has been an
inventory increment, the taxpayer must state the amount of the
increment in current-year dollars (stated in terms of section 471
costs). The taxpayer then multiplies this amount by the combined
absorption ratio. The resulting product is the additional section
263A costs that must be added to the taxpayer's increment for the
year stated in terms of section 471 costs.
3. LIFO decrement. If the taxpayer determines there has been an
inventory decrement, the taxpayer must state the amount of the
decrement in dollars applicable to the particular year for which the
LIFO layer has been invaded. The additional section 263A costs
incurred in prior years that are applicable to the decrement are
charged to cost of goods sold. The additional section 263A costs
that are applicable to the decrement are determined by multiplying
the additional section 263A costs allocated to the layer of the pool
in which the decrement occurred by the ratio of the decrement
(excluding additional section 263A costs) to the section 471 costs
in the layer of that pool.
V.
Permissible variations of the simplified resale method. The following variations of
the simplified resale method are permitted:
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i.
The exclusion of beginning inventories from the denominator in the
storage and handling costs absorption ratio formula; or
ii.
Multiplication of the storage and handling costs absorption ratio by the
total of section 471 costs included in a LIFO taxpayer's ending inventory
(rather than just the increment, if any, experienced by the LIFO taxpayer
during the taxable year) for purposes of determining capitalizable
storage and handling costs.
b. Examples – See Appendix H
VI.
Simplified resale method with historic absorption ratio election- This method
permits resellers using the simplified resale method to elect a historic absorption ratio
in determining additional section 263A costs allocable to eligible property remaining
on hand at the close of their taxable years.
i.
A taxpayer may only make a historic absorption ratio election if it has
used the simplified resale method for three or more consecutive taxable
years immediately prior to the year of election.
ii.
The historic absorption ratio is used in lieu of an actual combined
absorption ratio and is based on costs capitalized by a taxpayer during its
test period.
iii.
if elected, the historic absorption ratio must be used for the qualifying
period
iv.
Operating rules and definitions—
1. Historic absorption ratio. is equal to the following ratio:
Add'l section 263A costs incurred during the test period
-------------------------------------------------------Section 471 costs incurred during the test period.
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v.
Additional section 263A costs incurred during the test period are defined
as the sum of the products of the combined absorption ratios multiplied
by a taxpayer's section 471 costs incurred with respect to purchases, for
each taxable year of the test period.
vi.
Section 471 costs incurred during the test period mean the section 471
costs described in §1.263A-1(d)(2) that a taxpayer incurs generally with
respect to its purchases during the test period described in paragraph
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(d)(4)(ii)(B) of this section.
vii.
Test period – is generally the three taxable-year period immediately
prior to the taxable year that the historic absorption ratio is elected.
viii.
Updated test period. The test period begins again with the beginning of
the first taxable year after the close of a qualifying period
ix.
This new test period, the updated test period, is the three taxable-year
period beginning with the first taxable year after the close of the
qualifying period.
x.
Qualifying period - includes each of the first five taxable years
beginning with the first taxable year after a test period (or updated test
period).
1. Extension of qualifying period. In the first taxable year following
the close of each qualifying period (e.g., the sixth taxable year
following the test period), the taxpayer must compute the actual
combined absorption ratio under the simplified resale method. If
the actual combined absorption ratio computed for this taxable
year (the recomputation year) is within one-half of one percentage
point (plus or minus) of the historic absorption ratio used in
determining capitalizable costs for the qualifying period (i.e., the
previous five taxable years), the qualifying period must be
extended to include the recomputation year and the following five
taxable years, and the taxpayer must continue to use the historic
absorption ratio throughout the extended qualifying period.
2. If, however, the actual combined absorption ratio computed for the
recomputation year is not within one-half of one percentage point
(plus or minus) of the historic absorption ratio, the taxpayer must
use actual combined absorption ratios beginning with the
recomputation year under the simplified resale method and
throughout the updated test period. The taxpayer must resume
using the historic absorption ratio (determined with reference to
the updated test period) in the third taxable year following the
recomputation year.
xi.
Method of accounting--(A) Adoption and use. The election to use the
historic absorption ratio is a method of accounting.
1. A taxpayer using the simplified resale method may elect the
historic absorption ratio in any taxable year provided the taxpayer
has not obtained the Commissioner's consent to revoke the historic
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absorption ratio election within its prior six taxable years.
2. The election is to be effected on a cut-off basis, and thus, no
adjustment under section 481(a) is required or permitted.
3. The use of a historic absorption ratio has no effect on other
methods of accounting adopted by the taxpayer and used in
conjunction with the simplified resale method in determining its
section 263A costs.
4. Accordingly, in computing its actual combined absorption ratios,
the taxpayer must use the same methods of accounting used in
computing its historic absorption ratio during its most recent test
period unless the taxpayer obtains the consent of the
Commissioner.
xii.
Finally, the recomputation of the historic absorption ratio during an
updated test period and the change from a historic absorption ratio to an
actual combined absorption ratio during an updated test period are not
considered changes in methods of accounting under section 446(e) and,
thus, do not require the consent of the Commissioner or any adjustments
under section 481(a).
xiii.
Revocation of election. A taxpayer may only revoke its election to use
the historic absorption ratio with the consent of the Commissioner in a
manner prescribed under section 446(e) and the regulations thereunder.
Consent to the change for any taxable year that is included in the
qualifying period (or an extended qualifying period) will be granted only
upon a showing of unusual circumstances.
xiv.
Reporting and recordkeeping requirements
1. Reporting. A taxpayer making an election must attach a statement
to its federal income tax return for the taxable year in which the
election is made showing the actual combined absorption ratios
determined under the simplified resale method during its first test
period.
2. This statement must disclose the historic absorption ratio to be
used by the taxpayer during its qualifying period. A similar
statement must be attached to the federal income tax return for the
first taxable year within any subsequent qualifying period (i.e.,
after an updated test period).
xv.
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Recordkeeping. A taxpayer must maintain all appropriate records and
details supporting the historic absorption ratio until the expiration of the
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statute of limitations for the last year for which the taxpayer applied the
particular historic absorption ratio in determining additional section
263A costs capitalized to eligible property.
xvi.
Transition rules. Taxpayers will be permitted to elect a historic
absorption ratio in their first, second, or third taxable year beginning
after December 31, 1993, under such terms and conditions as may be
prescribed by the Commissioner.
xvii.
Taxpayers are eligible to make an election under these transition rules
whether or not they previously used the simplified resale method. A
taxpayer making such an election must recompute (or compute) its
additional section 263A costs, and thus, its historic absorption ratio for
its first test period as if the rules prescribed in this section and
§§1.263A-1 and 1.263A-2 had applied throughout the test period.
xviii.
Examples: - see Appendix I
Interest Issues
I.
Avoided cost Method – Interest: One must first understand what “avoided cost” means.
Under 263A, generally all costs that directly benefit or are incurred because of the
production of property are required to be capitalized, regardless of whether the costs are
incurred before, during or after the production period.
a)
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Interest, however, is required to be capitalized only to the extent that it is
incurred during the production period.
i.
The amount of interest to be capitalized is determined using the avoided
cost method.
ii.
The avoided cost method operates on the principle that if the taxpayer
had used the amounts expended for the production of designated
property to instead reduce its outstanding debt, it would have avoided
interest costs to the extent that its debt could have been reduced.
iii.
Under the avoided cost method, the taxpayer must first capitalize interest
incurred on traced debt during each measurement period and then
capitalize interest on accumulated production expenditures in excess of
traced debt.
iv.
Traced debt is all outstanding eligible debt that is allocated to
accumulated production expenditures for a unit of designated property
and includes unpaid interest that already has been capitalized under
these rules.
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v.
Eligible debt generally includes all outstanding indebtedness with
certain exceptions, such as related party debt bearing interest at less than
the required applicable federal rate and accounts payable bearing no
interest..
What to do when sections 460(b) and 263A both apply
I.
II.
Court case found that you first apply the costs to the contract and then only the
incremental costs are allocated to the 263A costs.
This is not what the IRS wanted done.
III.
The 263A rules state, more or less, that allocations within 263A are done proportionally
IV.
That is not the rule when dealing with the interaction of 460 with 263A costs
Special Rules and Rulings:
I.
For automobile dealerships see TAM 200736026 of Sept 7, 2007 for cost allocation
methods and conclusions on its various departments.
a)
II.
For use of the safe harbor methods for resellers and method changes see RP
2010-44
For changes to 263A costs or methods see TAM 200627025, July 7, 2006, on using an
estimating technique to compute the 481(a) adjustment resulting from the change
III. For utilities regarding temporary utility lines during a construction period of less than a
year – capitalize to self-constructed assets or to the electric provided? See TAM
200811021
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Appendix A - Definitions:
1. Absorption Ratio. Under the simplified production method, the absorption ratio is
determined as follows:
Additional Code Sec. 263A costs incurred during the taxable year
divided by the
Code Sec. 471 costs incurred during the taxable year.
(Reg. §1.263A-2(b)(4)(ii)(A)(1))
2. Additional 263A costs= mixed service costs, other than interest, that were:
a. not capitalized under the taxpayer's method of accounting immediately prior to
the effective date of the UNICAP rules,
b. adjusted as appropriate for any changes in accounting method for Code Sec. 471
costs,
c. but that are required to be capitalized under the UNICAP rules (Reg. §1.263A1(d)(3); Reg. §1.263A-2(b)(4)(ii)(A)(2)).
d. For new taxpayers, "additional Code Sec. 263A costs" are those costs, other than
interest, that the taxpayer must capitalize under the UNICAP rules, but which the
taxpayer would not have been required to capitalize if the taxpayer had been in
existence prior to the effective date of the UNICAP rules (Reg. §1.263A-1(d)(3)).
e. Examples include purchasing costs, handling costs, storage costs, depletion, rent,
and taxes.
3. Capitalize = in the case of property that is inventory in the hands of a taxpayer, to
include in inventory costs and, in the case of other property, to charge to a capital account
or basis.
a. Costs that are capitalized under section 263A are recovered through depreciation,
amortization, cost of goods sold, or by an adjustment to basis at the time the
property is used, sold, placed in service, or otherwise disposed of by the taxpayer.
b. Cost recovery is determined by the applicable Internal Revenue Code and
regulation provisions relating to the use, sale, or disposition of property.
4. Code Sec. 263A costs. "Code Sec. 263A costs" are those costs that a taxpayer must
capitalize pursuant to the UNICAP rules. Thus, Code Sec. 263A costs are the sum of a
taxpayer's Code Sec. 471 costs, its additional Code Sec. 263A costs, and interest required
to be capitalized under the UNICAP rules (Reg. §1.263A-1(d)(4)). Examples would
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include direct material costs and direct labor costs.
5. Code Sec. 263A labor and total labor costs = the total labor costs (excluding labor
costs included in mixed service costs) allocable to property produced and property
acquired for resale under section 263A that are incurred in the taxpayer's trade or
business during the taxable year. Total labor costs are defined as the total labor costs
(excluding labor costs included in mixed service costs) incurred in the taxpayer's trade or
business during the taxable year. Total labor costs include labor costs incurred in all parts
of the trade or business (i.e., if the taxpayer has both property produced and property
acquired for resale, the taxpayer must include labor costs from resale activities as well as
production activities).
6. Code Sec. 263A production costs = the total costs (excluding mixed service costs and
interest) allocable to property produced (and property acquired for resale if the producer
is also engaged in resale activities) under section 263A that are incurred in the taxpayer's
trade or business during the taxable year. Total costs are defined as all costs (excluding
mixed service costs and interest) incurred in the taxpayer's trade or business during the
taxable year.
7. Code Sec. 263A total mixed service costs = as the total costs incurred during the taxable
year in all departments or functions of the taxpayer's trade or business that perform mixed
service activities.
8. Code Sec. 471 costs. "Code Sec. 471 costs" are costs, other than interest, that were
capitalized under its method of accounting immediately prior to 263A (i.e. the full
absorption rules of Reg. §1.471-11). These costs include direct material costs, direct labor
costs as well as some noninventory costs that were capitalized or included in production
or acquisition costs (Reg. §1.263A-1(d)(2)(i)). For most taxpayers, Code Sec. 471 costs
are those that are included in inventory for financial statement purposes. Note that these
costs continue to be capitalized after the adoption of Code Sec. 263A, which serves only
to add additional costs that must be capitalized for tax purposes.
9. Code Sec. 471 costs remaining on hand at year-end.. "Code Sec. 471 costs" means the
Code Sec. 471 costs that a taxpayer incurs during its current tax year which remain in its
ending inventory or are otherwise on hand at year end. For LIFO inventories of a
taxpayer, the Code Sec. 471 costs remaining on hand at year end means the increment, if
any, for the current year stated in terms of Code Sec. 471 costs (Reg. §1.263A2(b)(3)(ii)(B)).
10. Contract = any agreement providing for the production of property if the agreement is
entered into before the production of property delivered under the contract is completed.
a. Whether an agreement exists depends on all of the facts and circumstances.
b. For example, a contract may exist if a taxpayer makes prepayments or enters into
an arrangement to make prepayments before production of a property is
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completed.
c. Similarly, the fact that the actual producer has made significant expenditures for
property of specialized design or specialized application that is not intended for
self-use is indicative of the existence of a contract ( Reg. §1.263A-2(a)(1)(ii)(B)
(2)(i)).
11. Historic Absorption Ratio. Under the simplified production method, the historic
absorption ratio is determined as follows (Reg. §1.263A-2(b)(4)(ii)):
a. Additional Code Sec. 263A costs incurred during the test period/Code Sec. 471 costs incurred during the test period.
12. Indirect costs for producers and resellers.
a. For producers, indirect costs are defined as all costs other than direct material
costs and direct labor costs.
b. For resellers, indirect costs are defined as all costs other than acquisition costs.
Indirect costs are properly allocable to property produced or property acquired for
resale when the costs directly benefit or are incurred by reason of the performance
of production or resale activities.
c. Indirect costs may be allocable to both production and resale activities, as well as
to other activities, that are not subject to the uniform capitalization rules. In such
an instance, producers and resellers must make a reasonable allocation of the
indirect costs between the production or resale activities and the other activities
(Code Sec. 263A(a)(2); Reg. §1.263A-1(e)(3)(i)).
13. Inventory Property = stock in trade or other property properly includible in the
inventory of the producer (Reg. §1.263A-2(b)(2)(i)(A)).
14. Noninventory Property (held for sale) = is property held by a taxpayer primarily for
sale to customers in the ordinary course of its trade or business (Reg. §1.263A2(b)(2)(i)(B)).
15.
On-site facility = a storage facility that is physically attached to, and an integral part of, a
retail sales facility.
The following are examples of facilities that typically qualify as on-site storage facilities:

A backroom furniture warehouse attached to a showroom. Even though retail customers do not enter the
warehouse, it is physically attached to and an integral part of the facility.

Auto dealership lots separated from the main dealership facility, provided customers select automobiles from
both lots (see Regs. Sec. 1.263A-3(c)(5)(ii)(B)(2) and Rev. Proc. 2010-44).

Home improvement centers that occasionally sell to other retailers (e.g., contractors) as well as end users of
merchandise.
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The following are examples of facilities that typically do not qualify as on-site storage facilities:

Catalog and mail-order centers. Even though their customers are exclusively retail customers, the sales are not
made to customers who are physically present (see Regs. Sec. 1.263A-3(c)(5)(v), Example (1)).
16. Pooled stock facilities used for regional distribution. Even though these facilities function as backup
storage for sales that are made at nearby retail outlets, the storage facilities are not physically attached to
outlets (see Regs. Sec. 1.263A-3(c)(5)(v), Example (2)
17. Post-production costs = all indirect costs incurred subsequent to completion of
production that are properly allocable to the property produced. For example, storage and
handling costs incurred while holding property produced for sale after production must be
capitalized to the property to the extent properly allocable to the property (Reg. §1.263A2(a)(3)(iii)).
18. Pre-production costs. = the direct and indirect costs allocable to property held for future
production even though production has not begun. Such costs include purchasing,
storage, and handling costs. If property is not held for production but is reasonably likely
that production will occur at some future date, indirect costs incurred prior to the
production period must be allocated to the property and capitalized. For example, a
manufacturer is required to capitalize the costs of storing and handling raw materials
before the raw materials are committed to production. Similarly a real estate developer
must capitalize property taxes incurred with respect to property if, at the time the taxes
are incurred, it is reasonably likely that the property will be subsequently developed
(Reg. §1.263A-2(a)(3)(ii)).
19. Producers. = taxpayers that construct, build, install, manufacture, develop, improve,
create, raise, or grow real property or tangible personal property for use in its trade or
business or for sale to its customers (Code Sec. 263A(g)(1); Reg. §1.263A-2(a)(1)(i)).
20. Production period = is the period beginning on the date on which production of the
property begins and ending on the date on which the property is ready to be placed in
service or is ready to be held for sale (Code Sec. 263A(f)(4)(B); Reg. §1.263A2(a)(3)(i)).
21. Retail sales facility = a facility where a taxpayer sells merchandise exclusively to retail
customers in on-site sales
22. Test Period. = is generally the three-tax-year period immediately prior to the test year
that the historic absorption ratio is elected (Reg. §1.263A-2(b)(4)(ii)(B)(1)).
23. Updated Test Period = test period begins again with the beginning of the first tax year
after the close of a "qualifying period". This new test period, the "updated test period," is
the three-tax-year period beginning with the first tax year after the close of the qualifying
period (Reg. §1.263A-2(b)(4)(ii)(B)(2)).
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24. Qualifying Period = includes each of the first five tax years beginning with the first tax
year after a test period or an updated test period (Reg. §1.263A-2(b)(4)(ii)(C)(1)).
25. Indirect costs = costs other than direct material costs and direct labor costs in the case of
property produced. Taxpayers subject to section 263A must capitalize all indirect costs
when the costs directly benefit or are incurred by production activities.
a. Indirect costs may be allocable to production activities as well as to other
activities that are not subject to section 263A.
b. Taxpayers subject to section 263A must make a reasonable allocation of indirect
costs between production and other activities.
c. Indirect costs are allocated using either:
i. a specific identification method,
ii. a standard cost method,
iii. a burden rate method, or
iv. Any other reasonable allocation method.
26. Mixed service costs = service costs that are partially allocable to production or resale
activities (capitalizable mixed service costs) and partially allocable to non-production or
non-resale activities (deductible mixed service costs).
a. Service costs that are only partially allocable to production activities.
b. Service costs are a type of indirect cost.
c. Are general and administrative costs, typically administrative, supportive, and of
service in nature. Examples:
i. Purchasing, handling, warehousing, security, cost accounting, data
processing, production coordination costs.
d. Mixed service and indirect costs exempt from capitalization:
i. Marketing, selling, advertising, income taxes, tax services, distribution,
research and experimental, warranty, etc.
27. Sec. 481(a) adjustment. The Code Sec. 481(a) adjustment is the sum of those
adjustments that are necessary to prevent the duplication or omission of amounts as a
result of the change in accounting method (Code Sec. 481(a)). Essentially, for this
particular Service, the Code Sec. 481(a) adjustment is equal to the change in value of the
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inventory at the beginning of the year of change.
28. Sec. 481(a) adjustment period. A positive adjustment (i.e., one that results in an
increase to taxable income) is taken into income over four tax years beginning with the
year of change. If a positive adjustment is less than $25,000, the taxpayer may opt to take
the entire adjustment into account in the year of change. If the Code Sec. 481(a)
adjustment is negative, the adjustment is taken into account over a one-year period. In
recognizing the Code Sec. 481(a) adjustment, a short tax year is treated as a full twelvemonth tax year. Thus, no annualization procedures are applied. See Rev. Proc. 2002-19,
modifying and amplifying Rev. Proc. 2002-9 and Rev. Proc. 97-27, modified and
clarified by Rev. Proc. 2009-39. Also see Rev. Proc. 2002-54.
29. Self-constructed assets = assets produced by a taxpayer for use by the taxpayer in its
trade or business. Self-constructed assets are subject to section 263A.
30. Service Provider = is defined with reference to its ordinary and accepted meaning under
federal income tax principles. In determining whether a taxpayer is a bona-fide service
provider, the nature of the taxpayer's trade or business and the facts and circumstances
surrounding the taxpayer's trade or business activities must be considered. Taxpayers
qualifying as service providers include those performing services in the fields of health,
law, engineering, architecture, accounting, actuarial science, performing arts or
consulting ( Reg. §1.263A-1(b)(11)).
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Appendix B – Flowchart
Inventory: Simplified Production Method: Using the Actual Absorption Ratio
Identify
applicable
taxpayers or
clients
Client Letter
and Eligibility
Determination
No
Benefit?
Flowchart
Inventory: Simplified
Production Method:
Using the Actual
Absorption Ratio
Yes
Identify Additional
Code Sec. 263A
Costs
Identify Code Sec.
471 Costs
Determine Actual
Absorption Ratio
Compute Additional
Code Sec. 263A
costs allocable to
eligible property
No
Calculate Code Sec.
481(a) Adjustment
1st year of
additional
Code Sec.
263A Costs?
Yes
Prepare
Government
Filings
File Form 3115
with Tax Return
and National
Office
Prepare Statement
Electing Simplified
Method
File Tax Return
with Statement
Attached
Stop
Stop
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Appendix C –1 (adapted from CCH)
Simplified Production Method: Using the Actual Absorption Ratio
Example Data Input Sheet-For a FIFO Taxpayer
Direct and Indirect Costs Required to be Allocated
Sec. 471 Costs Incurred During Year
Raw material
$
Work in progress
Finished goods
Total $
Sec. 471 Ending Inventory
Raw material
Work in progress
Finished goods
Total $
1,057,500
975,000
967,500
3,000,000
Total $
250
150
100
120
30
150
15,000
300
500,000
250,000
150,000
350
450
350
1,000
7,500
37,300
1,050
500
4,800
10,000
1,600
19,000
1,000,000
$
3,500,000
Additional Sec. 263A Costs Incurred During Year
Officers's compensation
Pension and other related costs
Employee benefit expense
Purchasing costs
Handling costs
Storage costs
Cost recovery
Depletion
Rent
Taxes
Insurance
Utilities
Repairs and maintenance
Engineering and design costs
Spoilage
Tools & equipment
Quality control
Bidding costs
Licensing and franchising costs
Capitalizable service costs
Administrative costs
Research & experimental costs - long term contracts
Interest
Other costs
Total Ending Inventory including §471 and §263A costs
5,000,000
1,250,000
3,750,000
10,000,000
Indirect Costs Not Required to be Allocated *
Additional Sec. 263A Costs
Selling and distribution costs
$
Research and experimental expenditures
Unsuccessful bidding expenses
General and administrative costs
Taxes assessed on the basis of income
Strike expenses
Warranty and product liability costs
Section 179 costs
On-site storage costs
Cost recovery allowances on temporarily idle equipment and
facilities
Other Costs
Total $
2,300
3,500
1,000
1,000
1,000
15,000
23,800
* Note: These indirect costs are not required to be capitalized under Section 263A.
See Reg. Sec. 1.263A-1(e)(3)(iii).
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Appendix C –2
Simplified Production Method: Using the Actual Absorption Ratio
Actual Absorption Ratio Calculation -For a FIFO Taxpayer
Actual Absorption Ratio
Additional Sec. 263A Costs Incurred During Year
Total Sec. 471 Costs Incurred During the Year
÷
$
1,000,000
$ 10,000,000
10%
Add'l Sec. 263A Costs in Ending Inventory
Sec. 471 Costs in Ending Inventory
Actual Absorption Ratio
$
3,000,000
X 10%
$300,000
Ending Inventory (UNICAP)
Add'l Sec. 263A Costs in Ending Inventory
Sec. 471 Costs in Ending Inventory
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$
300,000
$
3,000,000
$3,300,000
263A
Appendix C –3
Simplified Production Method: Using the Actual Absorption Ratio
481(a) Adjustment – For a FIFO Taxpayer
Ending Inventory under New Method
$3,300,000
Ending Inventory under Old Method
$
3,500,000
Section 481(a) Adjustment
$
(200,000)
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Appendix D
Mixed service costs - Direct reallocation method Example
A company has five departments consisting of three production departments and two mixed
service departments. The production departments are (1) Assembling, (2) Painting, and (3)
Finishing. The mixed service departments are (1) Human Resources and (2) Data Processing.
The company allocates the human resources department's costs on the basis of total payroll costs
and the data processing department's costs on the basis of data process hours. Under the direct
reallocation method, the company allocates the human resources department's costs directly to
assembling, painting and finishing, and not to data processing.
Department
Human
Res's
Data Proc'g
Assembling
Painting
Finishing
Total Dept.
Costs
Amount of Payroll
Costs
Allocation Ratio
$ 50,000
—
15,000
—
15,000 15,000/285,000
90,000 90,000/285,000
180,000 180,000/285,000
$ 500,000
250,000
250,000
1,000,000
2,000,000
$4,000,000
Amount
Allocated
<$500,000 >
—
26,316
157,895
315,789
$350,000
After the company allocates the human resources department's cost, it then allocates the costs of
the data processing department in the same manner.
Total Dept. Cost
After Initial
Department
Allocation
Human
Res's
$0
Data Proc'g
250,000
Assembling
276,315
Painting
1,157,895
Finishing
2,315,790
$4,000,000
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Total Data
Proc. Hours
Allocation
Ratio
Amount
Allocated
—
—
—
—
<$250,000 >
2,000 2,000/10,000
50,000
0
0/10,000
0
8,000 8,000/10,000
200,000
2,000
12,000
Total Dept. Cost
After Final
Allocation
$0
326,315
1,157,895
2,515,790
$4,000,000
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Appendix E
Mixed service costs - Step-allocation method - Example
A company has five departments: (1) Manufacturing; (2) Marketing; (3) Finance; (4) Human
Resources and (5) Data Processing. Manufacturing is a production department, marketing and
finance are departments that incur only deductible service costs, and human resources and data
processing are mixed service costs departments. Using the step-allocation method, the company
allocates the human resources department's costs on the basis of total payroll costs and the data
processing department's costs on the basis of data process hours. Human Resources benefits all
four of the company's other departments, while data processing benefits only three departments.
Because human resources benefits the greatest number of other departments, the company first
allocates personnel's cost to manufacturing, marketing, finance and data processing as follows:
Department Total Cost of Dept. Total Payroll Costs Allocation Ratio Amount Allocated
Human Res's
$500,000
$50,000
—
<$500,000 >
Data Proc'g
250,000
15,000
15,000/300,000
25,000
Finance
250,000
15,000
15,000/300,000
25,000
Marketing
1,000,000
90,000
90,000/300,000
150,000
Manufac'g
2,000,000
180,000 180,000/300,000
300,000
$4,000,000
$350,000
The denominator of the company's allocation ratio includes the payroll costs of manufacturing,
marketing, finance and data processing. Next, the company allocates the costs of data processing
on the basis of data processing hours. Because the costs incurred by human resources have
already been allocated, no allocation is made to personnel.
Department
Human
Res's
Data Proc'g
Finance
Marketing
Manufac'g
Total Dept.
Cost After
Initial
Allocation
$0
275,000
275,000
1,150,000
2,300,000
$4,000,000
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Total Data
Proc. Hours
Allocation
Ratio
Amount
Allocated
—
—
—
—
<$275,000 >
2,000 2,000/10,000
55,000
0
0/10,000
0
8,000 8,000/10,000
220,000
Total Dept.
Cost After
Final
Allocation
2,000
$0
0
330,000
1,150,000
2,520,000
12,000
$4,000,000
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Under the second step, the denominator of the company's allocation ratio includes the data
processing hours of manufacturing, marketing, and finance but does not include the data
processing hours of human resources (the other mixed service department) because the costs of
that department were allocated previously.
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Appendix F
Mixed service costs - Simplified Mixed Service Cost Method - Example
Example 1. Y is a manufacturer of automobiles. During the taxable year Y produces numerous
substantially identical dies and molds using standardized designs and assembly line techniques.
The dies and molds have a 3-year applicable recovery period for purposes of section 168(c). Y
uses the dies and molds to produce or process particular automobile components and does not
hold them for sale. The dies and molds are produced on a routine and repetitive basis in the
ordinary course of Y's business for purposes of this paragraph because the dies and molds are
both mass-produced and have a recovery period of no longer than 3 years.
Example 2. Z is an electric utility that regularly manufactures and installs identical poles that are
used in transmitting and distributing electricity. The poles have a 20-year applicable recovery
period for purposes of section 168(c). The poles are not produced on a routine and repetitive
basis in the ordinary course of Z's business for purposes of this paragraph because the poles have
an applicable recovery period that is longer than 3 years.
i. General allocation formula: allocation ratio x total mixed service cost
ii. Producer may elect one of two allocation ratios:
1. the labor-based allocation ratio or
2. the production cost allocation ratio.
iii. A reseller may elect the simplified service cost method, but must use a
labor-based allocation ratio.
iv. Labor-based allocation ratio formula:
1. Section 263A labor costs / total labor costs
v. Production cost allocation ratio formula:
1. Section 263A production costs / Total costs
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Appendix G
Simplified Production Method – Example
Example 1 --FIFO inventory method (i) Taxpayer J uses the FIFO method of accounting for
inventories. J's beginning inventory for 1994 (all of which is sold during 1994) is $2,500,000
(consisting of $2,000,000 of section 471 costs and $500,000 of additional section 263A
costs). During 1994, J incurs $10,000,000 of section 471 costs and $1,000,000 of additional
section 263A costs. J's additional section 263A costs include capitalizable mixed service
costs computed under the simplified service cost method as well as other allocable costs. J's
section 471 costs remaining in ending inventory at the end of 1994 are $3,000,000. J
computes its absorption ratio for 1994, as follows:
Add'l §263A costs incurred during 94 $ 1,000,000
_____________________________________ = ___________ = 10%
Sec 471 costs incurred during 94
$10,000,000
(ii) Under the simplified production method, J determines the additional section 263A costs
allocable to its ending inventory by multiplying the absorption ratio by the section 471 costs
remaining in its ending inventory:
Add'l §263A costs = 10%  $3,000,000 = $300,000.
(iii) J adds this $300,000 to the $3,000,000 of section 471 costs remaining in its ending
inventory to calculate its total ending inventory of $3,300,000. The balance of J's additional
section 263A costs incurred during 1994, $700,000, ($1,000,000 less $300,000) is taken into
account in 1994 as part of J's cost of goods sold.
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Appendix H
Simplified Production Method without historic absorption ration election – Example
Example 1. FIFO inventory method.
1) Taxpayer S uses the FIFO method of accounting for inventories. S's beginning inventory for
1994 (all of which was sold during 1994) was $2,100,000 (consisting of $2,000,000 of
section 471 costs and $100,000 of additional section 263A costs). During 1994, S makes
purchases of $10,000,000. In addition, S incurs purchasing costs of $460,000, storage costs
of $110,000, and handling costs of $90,000. S's purchases (section 471 costs) remaining in
ending inventory at the end of 1994 are $3,000,000.
2) In 1994, S incurs $400,000 of total mixed service costs and $1,000,000 of total labor costs
(excluding labor costs included in mixed service costs). In addition, S incurs the following
labor costs (excluding labor costs included in mixed service costs): purchasing--$100,000,
storage--$200,000, and handling--$200,000. Accordingly, the following mixed service costs
must be included in purchasing costs, storage costs, and handling costs as capitalizable mixed
service costs: purchasing--$40,000 ([$100,000 divided by $1,000,000] multiplied by
$400,000); storage--$80,000 ([$200,000 divided by $1,000,000] multiplied by $400,000);
and handling--$80,000 ([$200,000 divided by $1,000,000] multiplied by $400,000).
3) S computes its purchasing costs absorption ratio for 1994 as follows:
1994 purchasing costs
$460,000 + $40,000
--------------------- = -----------------1994 purchases
$10,000,000
=
=
$500,000
-------$10,000,000
5.0%
4) S computes its storage and handling costs absorption ratio for 1994 as follows:
Storage and
----------($110,000 + $80,000) + ($90,000 + $80,000)
handling costs
=
-----------------------------------------Beginning inventory
$2,000,000 + $10,000,000
plus 1994 purchases
$190,000 + $170,000
= ------------------$12,000,000
$360,000
= --------
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$12,000,000
=
3.0%
5) S's combined absorption ratio is 8.0%, or the sum of the purchasing costs absorption ratio
(5.0%) and the storage and handling costs absorption ratio (3.0%). Under the simplified
resale method, S determines the additional section 263A costs allocable to its ending
inventory by multiplying the combined absorption ratio by its section 471 costs with respect
to current year's purchases remaining in ending inventory:
Additional §263A costs =
8.0% x $3,000,000
=
$240,000
6) S adds this $240,000 to the $3,000,000 of purchases remaining in its ending inventory to
determine its total ending FIFO inventory of $3,240,000.
Example 2. LIFO inventory method.
1) Taxpayer T uses a dollar-value LIFO inventory method. T's beginning inventory for 1994 is
$2,100,000 (consisting of $2,000,000 of section 471 costs and $100,000 of additional section
263A costs). During 1994, T makes purchases of $10,000,000. In addition, T incurs
purchasing costs of $460,000, storage costs of $110,000, and handling costs of $90,000. T's
1994 LIFO increment is $1,000,000 ($3,000,000 of section 471 costs in ending inventory less
$2,000,000 of section 471 costs in beginning inventory).
2) In 1994, T incurs $400,000 of total mixed service costs and $1,000,000 of total labor costs
(excluding labor costs included in mixed service costs). In addition, T incurs the following
labor costs (excluding labor costs included in mixed service costs): purchasing--$100,000,
storage--$200,000, and handling--$200,000. Accordingly, the following mixed service costs
must be included in purchasing costs, storage costs, and handling costs as capitalizable mixed
service costs: purchasing--$40,000 ([$100,000 divided by $1,000,000] multiplied by
$400,000); storage--$80,000 ([$200,000 divided by $1,000,000] multiplied by $400,000);
and handling--$80,000 ([$200,000 divided by $1,000,000] multiplied by $400,000).
3) Based on these facts, T determines that it has a combined absorption ratio of 8.0%. To
determine the additional section 263A costs allocable to its ending inventory, T multiplies its
combined absorption ratio (8.0%) by the $1,000,000 LIFO increment. Thus, T's additional
section 263A costs allocable to its ending inventory are $80,000 ($1,000,000 multiplied by
8.0%). This $80,000 is added to the $1,000,000 to determine a total 1994 LIFO increment of
$1,080,000. T's ending inventory is $3,180,000 (its beginning inventory of $2,100,000 plus
the $1,080,000 increment).
4) In 1995, T sells one-half of the inventory in its 1994 LIFO increment. T must include in its
cost of goods sold for 1995 the amount of additional section 263A costs relating to this
inventory, i.e., one-half of the $80,000 additional section 263A costs capitalized in 1994
ending inventory, or $40,000.
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Example 3. LIFO pools.
1) Taxpayer U begins its business in 1994, and adopts the LIFO inventory method. During
1994, U makes purchases of $10,000, and incurs $400 of purchasing costs, $350 of storage
costs and $250 of handling costs. U's purchasing costs, storage costs, and handling costs
include their proper allocable share of mixed service costs.
2) U computes its purchasing costs absorption ratio for 1994, as follows:
1994 purchasing costs
$400
--------------------- = ---1994 purchases
$10,000
=
4.0%
3) U computes its storage and handling costs absorption ratio for 1994, as follows:
1994 storage and handling costs
$350 + $250
------------------------------= ----------Beginning inventory plus 1994 purchases
$0 + $10,000
$600
=
---$10,000
=
6.0%
4) U's combined absorption ratio is 10%, or the sum of the purchasing costs absorption ratio
(4.0%) and the storage and handling costs absorption ratio (6.0%). At the end of 1994, U's
ending inventory included $3,000 of current year purchases, contained in three LIFO pools
(X, Y, and Z) as shown below. Under the simplified resale method, U computes its ending
inventory for 1994 as follows:
1994:
Total X
Y
Z
Ending section 471 costs ...................... $3,000 $1,600 $600 $800
Additional section 263A costs (10%) .......... 300 160
60 80
------ ------ ---- ---1994 Ending Inventory ......................... $3,300 $1,760 $660 $880
====== ------ ---- ---5) During 1995, U makes purchases of $2,000 as shown below, and incurs $200 of purchasing
costs, $325 of storage costs and $175 of handling costs. U's purchasing costs, storage costs,
and handling costs include their proper share of mixed service costs. Moreover, U sold goods
from pools X, Y, and Z having a total cost of $1,000. U computes its ending inventory for
1995 as follows.
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6) U computes its purchasing costs absorption ratio for 1995:
1995 purchasing costs
$200
--------------------= ---- = 10.0%
1995 purchases
$2,000
7) U comutes its storage and handling costs absorption ratio for 1995:
1995 storage and handling costs
$325 + 175
------------------------------=
---------Beginning inventory plus 1995 purchases
$3,000 + 2,000
$500
=
---=
10.0%
$5,000
8) U's combined absorption ratio is 20.0%, or the sum of the purchasing costs absorption ratio
(10.0%) and the storage and handling costs absorption ratio (10.0%).
1995:
Total
X
Y
Z
Beginning section 471 costs ................. $ 3,000 $ 1,600 $ 600 $ 800
1995 section 471 costs ..................... . 2,000 1,500 300 200
Section 471 cost of goods sold .............. (1,000) (300) (300) (400)
------- ------- ----- ----1995 Ending Section 471 costs ............... $ 4,000 $ 2,800 $ 600 $ 600
======= ------- ----- ----Consisting of:
1994 layer ............................... $ 2,800 $ 1,600 $ 600 $ 600
1995 layer ............................... 1,200 1,200 -- -------- ------- ----- ----$ 4,000 $ 2,800 $ 600 $ 600
Additional section 263A costs:
1994 (10%) ............................... $ 280 $ 160 $ 60 $ 60
1995 (20%) ............................... 240 240 -- -------- ------- ----- ----$ 520 $ 400 $ 60 $ 60
1995 ending inventory ....................... $ 4,520 $ 3,200 $ 660 $ 660
======= ------- ----- ----9) In 1995, U experiences a $200 decrement in Pool Z. Thus, U must charge the additional
section 263A costs incurred in prior years applicable to the decrement to 1995's cost of goods
sold. To do so, U determines a ratio by dividing the decrement by the section 471 costs in the
1994 layer ($200 divided by $800, or 25%). U then multiplies this ratio (25%) by the
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additional section 263A costs in the 1994 layer ($80) to determine the additional section
263A costs applicable to the decrement ($20). Therefore, $ 20 is taken into account by U in
1995 as part of its cost of goods sold ($80 multiplied by 25%).
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Appendix I
Simplified Production Method with historic absorption ration election – Example
Example.
1) Taxpayer V uses the FIFO method of accounting for inventories and in 1994 elects to use the
historic absorption ratio with the simplified resale method. After recomputing its additional
section 263A costs in accordance with the transition rules of paragraph (d)(4)(v) of this
section, V identifies the following costs incurred during the test period:
1991:
Add'l section 263A costs - $100 Section 471 costs - $3,000
1992:
Add'l section 263A costs - 200 Section 471 costs - 4,000
1993:
Add'l section 263A costs - 300 Section 471 costs - 5,000
2) Therefore, V computes a 5% historic absorption ratio determined as follows:
Historic
$ 100 + 200 + 300
$ 600
absorption = ----------------= ----= 5%
ratio
$3,000 + 4,000 + 5,000
$12,000
3) In 1994, V incurs $10,000 of section 471 costs of which $3,000 remain in inventory at the
end of the year. Under the simplified resale method using a historic absorption ratio, V
determines the additional section 263A costs allocable to its ending inventory by multiplying
its historic ratio (5%) by the section 471 costs remaining in its ending inventory:
Add'l section 263A costs = 5% x $3,000 = $150
4) To determine its ending inventory under section 263A, V adds the additional section 263A
costs allocable to ending inventory to its section 471 costs remaining in ending inventory
($3,150 = $150 + $3,000). The balance of V's additional section 263A costs incurred during
1994 is taken into account in 1994 as part of V's cost of goods sold.
5) V's qualifying period ends as of the close of its 1998 taxable year. Therefore, 1999 is a
recomputation year in which V must compute its actual combined absorption ratio. V
determines its actual absorption ratio for 1999 to be 5.25% and compares that ratio to its
historic absorption ratio (5.0%). Therefore, V must continue to use its historic absorption
ratio of 5.0% throughout an extended qualifying period, 1999 through 2004 (the
recomputation year and the following five taxable years).
6) If, instead, V's actual combined absorption ratio for 1999 were not between 4.5% and 5.5%,
V's qualifying period would end and V would be required to compute a new historic
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absorption ratio with reference to an updated test period of 1999, 2000, and 2001. Once V's
historic absorption ratio is determined for the updated test period, it would be used for a new
qualifying period beginning in 2002.
A. Additional simplified methods for resellers. The Commissioner may prescribe
additional elective simplified methods by revenue ruling or revenue procedure.
B. Cross reference. See §1.6001-1(a) regarding the duty of taxpayers to keep such
records as are sufficient to establish the amount of gross income, deductions, etc.
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Appendix J – Various 263A Questions and Answers
1.
Q: If you find that you have been using 263A and you meet one of the exceptions for not
using it, what do you need to do to discontinue its use in 2012?
A: The TP (taxpayer) would just reverse (write off in the current year) its beginning of
the year 263A additional costs and return to its costing under section 471.
2.
Q: If you have a number of companies owned by the same person with various types of
forms (partnership, S Corporation, 1 member LLC) and operations (some manufacturing
and some resellers), are the exceptions dealing with $10M in revenues and $200K in
indirect costs applied by entity? Does the fact that they are related parties make a
difference? We have always treated each separately.
A: No, the testing of a group’s trade or business revenues is measured by the total of all
of its entity’s trades or businesses. See 1.263A-3(b)(3) for details of the requirements for
the aggregation of gross receipts.
3.
Q: When applying 263(A), how do you deal with the Lower of cost or market inventory?
Do you apply the 263(A) ratio to the LCM inventory? Is this true for both producers and
resellers?
A: Under the LCM method, the valuation of an inventory item is determined by
comparing its costs and its market value. The item is valued at the lower or those two
amounts for ending inventory purposes. The LCM method must be consistently applied
to each inventory item included in goods purchased and on hand, goods in process of
manufacture, and finished manufactured goods on hand. The determination of the LCM
value is applied on an item-by-item basis rather than grouping the entire inventory
together. Under ordinary circumstances and for normal goods in an inventory, the term
“market” means the aggregate of the current bid prices prevailing at the date of the
inventory of the basic elements of cost reflected in inventories of goods purchased and on
hand, goods in process of manufacture, and finished manufactured goods on hand. The
entity would compare its ending 263A price, after including all of its required 263A
direct and indirect costs, and compare that to its LCM market value. An entity is
permitted to write down an item lower than its 263A costs. This applies for both
producers and resellers.
4.
Q: If you lease warehouse space from an unrelated party and make leasehold
improvements, then the depreciation on those leasehold improvements would not be
included in the 263A computation, correct? Would it matter if you were a reseller vs a
manufacturer? Would the use of the warehouse make a difference? For example, if you
stored raw material in the warehouse, would you still not include this depreciation in your
computation?
A: A taxpayer subject to 263A must include in its 263A costs all Post-production costs,
which are all indirect costs incurred subsequent to completion of production that are
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properly allocable to the property produced. For example, storage and handling costs
incurred while holding property produced for sale after production must be capitalized to
the property to the extent properly allocable to the property (Reg. §1.263A-2(a)(3)(iii). If
the warehouse space is attached to the retail facilities, its costs would not have to be
included in its 263A costing.
5.
Q: Why is an entity performing a real estate construction contract exempt from 263A,
while an entity doing its own construction for its own use is subject to 263A?
A: If an entity is performing a real estate construction contract it is subject to section
460(b), not 263A. If an entity is producing a real estate projection that it will hold for sale
under a speculation sale, once a contract is signed on that property, the entity would
move its costing from 263A to the cost-to-cost method of 460(b).
6.
Q: Is a software developer doing $15M in sales subject to 263A? If so, why?
If the software company resold someone else’s software, is it subject to 263A?
If it takes someone else’s software and customizes it greatly – is it subject to 263A?
A: No. Software development is covered under §§167(f) and 197 of the Internal Revenue
Code ( T.D. 8865, 2000-7 I.R.B. 589). See Rev. Proc. 2000-50, (Dec. 1, 2000).
7.
Q: We have scrap sales – Would you clarify what you said about reducing costs by scrap
revenue?
A: See “other recent rules” above. Essentially the difference is whether you are going to
reduce your COGS by the scrap sales or increase your gross revenues.
8.
Q: I work for a manufacturer / reseller. I’ve been calculating 263A for years. I also take
the Domestic Production Deduction. Can you please clarify what you said about the
matching?
A: The taxpayer’s method of allocating its labor costs for sections 199 and 263A must
match. In other words, one cannot report more labor costs for section 199 than it allocates
for section 263A costing.
9.
Q: I am totally confused about how you are relating the tangible property regs of 263(a)
to 263A unless you are applying it in the fact that your direct or indirect depreciation or
expensed cost are now affected and you are saying this is a change in 263A cost and
therefore a change in accounting method?
A: Yes, exactly. If a taxpayer makes a change in its depreciation, repairs and
maintenance, or material and supplies costs under 263(a) it must also change its 263A
methods to match.
10.
Q: Is a financial statement only an “audited” statement or do reviewed and/or compiled
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financials count as Applicable Financial Statements (AFS) for the de minimis safe harbor
election?
A: Under the final tangible property regulations, only audits count as applicable financial
statements, unless reviewed or compiled financials are submitted to a government.
11.
Q: We are a manufacturer that produces tangible property and sells that to Wal-Mart,
Kmart, Target, etc. We have several outside distribution warehouses in the US owned by
unrelated parties. These warehouses store finished goods and ship it out to our customers
around the country. Are these costs subject to 263A? The books treat this cost as selling
expense, not cost of goods sold.
A: off-site storage facilities costs are required to be included in 263A costing. In your
situation only if the property is considered “sold” to the customer once it gets to the
outside warehouse, then its costs are not required to be included.
12.
Q: We have client that manufacturers wind chimes in the United States and has a consent
agreement from 2002 for a specific calculation of allocating costs under Sec. 263A. In
2011, as a side to the manufacturing activities, the client started selling retail items
through a newly created website and name, but all under the same company. (This was
just in line with the client’s passion to sell and promote products made in the USA.) At
12/31/11, the client did not qualify to apply the uniform capitalization rules for the retail
reseller on the resale inventory items as the client didn’t meet the 3-year average income
threshold ($10 million). When testing the 3-year average annual gross receipts for the
manufacturing versus the annual sales for the reseller, are we able to separate out the
resell sales from all manufacturing sales and test each separately?
A: No all business activity has to be included in the gross sales test.
13.
Q: For a producer or manufacturer, do you have any examples of applying indirect costs
to inventory other than the simplified production method?
A: See examples in the appendixes above.
14.
Q: Our firm did a lot of research last year with 263A and contacting the IRS experts in
this area and other expert firms. We had situations where our auditors didn’t capitalize
indirect costs to inventory under GAAP as it was either not required or immaterial. We
had to grasp an understanding of the difference between 471 costs verses additional 263A
costs. If we were aware the client’s financial statements did not capitalize all the required
471 costs, we had to include them as additional 263A costs. Can you comment on that?
(For example, we asked the IRS expert: If a client did not allocate/capitalize indirect
labor to the manufacturing process under the normal financial statement method (as 471
costs), then the client would need to allocate those indirect labor cost to inventory as
additional 263A costs? The answer was “Yes”)
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A: GAAP inventory costs are not usually or necessarily equal to the requirements of
263A costing rules. For GAAP, once can usually include in inventory costs what it
discloses as such, whereas for tax, 263A is more detailed and specific on what is required
for tax. I agree with the example you provided at the end of your question.
15.
Q: A client (S-Corporation) was a producer in a previous test period (2003-2005) and
used a 3-year average of those years and elected to use a historic absorption ratio during
the following 5-year qualifying period (2006-2010). In 2011, the client enters a new test
period; however, the client’s operations have naturally changed and they no longer
produce the product but have moved into more service-based operations and appears to
qualify to use the Simplified Resale Method for resale items, with de minimis production
activity. Can we just move into the Simplified Resale Method in the new test year
without a change in accounting method (Form 3115)?
A: No. See the regulations under 1.263A-7(a)(5)which covers the method changes for
263A:
(5) Definition of change in method of accounting. For purposes of this section, a change in method of accounting has
the same meaning as provided in §1.446–1(e)(2)(ii). Changes in method of accounting for costs subject to section
263A include changes to methods required or permitted by section 263A and the regulations thereunder. Changes in
method of accounting may be described in the preceding sentence irrespective of whether the taxpayer's previous
method of accounting resulted in the capitalization of more (or fewer) costs than the costs required to be capitalized
under section 263A and the regulations thereunder, and irrespective of whether the taxpayer's previous method of
accounting was a permissible method under the law in effect when the method was being used. However, changes in
method of accounting for costs subject to section 263A do not include changes relating to factors other than those
described therein. For example, a change in method of accounting for costs subject to section 263A does not include
a change from one inventory identification method to another inventory identification method, such as a change
from the last-in, first-out (LIFO) method to the first-in, first-out (FIFO) method, or vice versa, or a change from one
inventory valuation method to another inventory valuation method under section 471, such as a change from valuing
inventory at cost to valuing the inventory at cost or market, whichever is lower, or vice versa. In addition, a change
in method of accounting for costs subject to section 263A does not include a change within the LIFO inventory
method, such as a change from the double extension method to the link-chain method, or a change in the method
used for determining the number of pools. Further, a change from the modified resale method set forth in Notice 89–
67 (1989–1 C.B. 723), see §601.601(d)(2) of this chapter, to the simplified resale method set forth in §1.263A–3(d)
is not a change in method of accounting within the meaning of §1.446–1(e)(2)(ii) and is therefore not subject to the
provisions of this section. However, a change from the simplified resale method set forth in former §1.263A–
1T(d)(4) to the simplified resale method set forth in §1.263A–3(d) is a change in method of accounting within the
meaning of §1.446–1(e)(2)(ii) and is subject to the provisions of this section.
16.
Q: Section 263A(b)(2)(B) provides for a small reseller exception for a reseller with
receipts less than $10million. Is there a similar exception for a manufacturer?
A: No. The only exception that could apply for a manufacturer is if its indirect costs are
less than $200,000 a year, then it could avoid the 263A requirements.
17.
Q: 263A (UNICAP) is the most complex and time intensive book-tax adjustment that is
prepared each quarter for our company. Is there any software on the market, that you
recommend, which can be mapped to the trial balance and consequently streamline the
calculation of the UNICAP adjustment?
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A: none that I am aware of.
18.
Q: A corporation is a producer and rents the entire building which includes office space,
production space and a warehouse which stores both materials for production and
finished goods. How should rents be allocated to 263A? Also, the corporation has unused
capacity due to the economic downturn. Can rents allocated to Section 263A costs be
adjusted to reflect the unused capacity?
A: You are able to choose a method of allocation. Please see those allocation methods
above. Those particular allocation methods (whether chosen/employed/adopted/ or
elected) will greatly influence how those rents are allocated to the 263A inventory. For
the unused capacity, 1.263A-1(e)(3)(E) states that depreciation on idle assets does not
have to be allocated to 263A costs. However, costs related to temporary idle production
equipment or facilities, other than depreciation, are indirect costs that are required to be
capitalized. On the other hand, if you can support that the items are not temporary but are
permanent, then they would not have to be allocated.
19.
Q: Client is a manufacturer who has not used Section 263A in the past. We will have to
file Form 3115. The client is a calendar year S Corporation. When we calculate the
Section 481 adjustment, is it calculated based on the current year end (12/31/12) or on the
prior year end (12/31/11)?
A: Prior year end. For example, if a taxpayer has not (improperly) employed 263A
costing, and you are filing a 3115 in the current year to correct that situation, you will file
that correcting 481(a) adjustment as of the first day of the current tax year. So if the
taxpayer was filing a 3115 in tax year 2014 for 2014, the 481(a) adjustment would be
based on the difference as of the beginning of the tax year, which would have been 1231-13.
20.
Q: A client booked a $3M expense and liability for a settlement to (EPA) of possible
remediation of potential contamination. The contamination occurred prior to the
Company’s acquisition of the property. Is this included for purposes of 263A calculation?
A: Under the new final tangible property regulations, a taxpayer that ameliorates a
material condition or defect that existed prior to the property being acquired is required to
be capitalized as a betterment under 1.263(a) -3(l). Once capitalized, depreciation related
to the capitalization of that improvement will be required to be allocated under 263A. If
the condition was not material than the expenditure to remove the contamination will be a
repair. Repairs are also required to be allocated under 263A as indirect costs. Rev. Rul.
2004-18 concluded, therefore, that environmental remediation costs similarly are subject
to capitalization under § 263A and are required to be included in inventory costs under
the facts of that ruling. As with repair costs, environmental remediation costs are properly
allocable to inventory without regard to whether those costs are incurred before, during,
or after production. See § 1.263A-1(c)(2). Likewise, remediation costs are allocable
under § 1.263A-1(c)(1) to the property produced during the taxable year in which the
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costs are incurred. See Rev. Rul. 2005-42 for a complete discussion on environmental
remediation costs in general as related to 263A.
21.
Q: Small reseller exception applies in case average gross receipts for the past 3 years is
less than $10 million. This is determined by controlled group basis. Does the controlled
group contain foreign corporations for US subsidiaries?
A: see the regulations of 1.1563-1 for definition of controlled groups:
b) Component members— (1) In general—
(i) Definition. For purposes of sections 1561 through 1563, a corporation is with respect to its taxable
year a component member of a controlled group of corporations for the group's testing date if such
corporation—
(A) Is a member of such controlled group on such testing date and is not treated as an excluded
member under paragraph (b)(2) of this section; or
(B) Is not a member of such controlled group on such testing date but is treated as an additional
member under paragraph (b)(3) of this section.
(2) Excluded members—
(i) Temporal test. A corporation, which is a member of a controlled group of corporations on the
group's testing date, a date included within that member's taxable year, but who was a member of such
group for less than one-half of the number of days of its testing period, shall be treated as an excluded
member of such group for that group's testing date.
(ii) Qualification test. A corporation which is a member of a controlled group of corporations on a
testing date shall be treated as an excluded member of such group on such date if, for its taxable year
including such date, such corporation is—
(A) Exempt from taxation under section 501(a) (except a corporation which is subject to tax on its
unrelated business taxable income under section 511) or 521 for such taxable year;
(B) A foreign corporation not subject to taxation under section 882(a) for the taxable year;
Example: Throughout 1964, corporation M owns all the stock of corporation F which, in turn, owns
all the stock of corporations L1, L2, X, and Y. M is a domestic mutual insurance company subject to
taxation under section 821, F is a foreign corporation not engaged in a trade or business within the
United States, L1 and L2 are domestic life insurance companies subject to taxation under section 802,
and X and Y are domestic corporations subject to tax under section 11 of the Code. Each corporation
uses the calendar year as its taxable year. On December 31, 1964, M, F, L1, L2, X, and Y are members
of a parent-subsidiary controlled group of corporations. However, under paragraph (b)(2)(ii) of this
section, M, F, L1, and L2 are treated as excluded members of the group on December 31, 1964. Thus,
on December 31, 1964, the component members of the parent-subsidiary controlled group of which M
is the common parent include only X and Y.
Furthermore, since paragraph (b)(2)(ii)(E) of this section does not result in L1 and L2 being treated as
excluded members of a life insurance controlled group, L1 and L2 are component members of a life
insurance controlled group on December 31, 1964.
22.
Q: The comment that Section 199 wages allocable to DPGR cannot exceed 263A does
not make sense to me. Our 199 is W-2 wages which is cash method. Our 263 is all
accrual, so it may exceed the 199 wages. Nearly 100% of our Gross Receipts are DPGR.
Can you please clarify?
A: A taxpayer must be able to reconcile the wages reported on its section 199 amounts to
the wages paid and allocated for the tax return and the 263A allocations. If you can, you
are good to go.
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23.
Q: Taxpayer is a reseller who has just reached the $10 million threshold last year. Can the
taxpayer change from the Cost to Lower of Cost Or Market (a 3115 change) since his
inventory is worth a lot less than what he paid for it? This would obviously lessen the 471
Inventory to be multiplied by the absorption ratio. This assumes the 481 adjustment is
favorable.
A: see number 3 above.
24.
Q: We are an equipment wholesaler. Once received from the manufacturer, new
equipment requires significant direct labor and materials to put it in a state salable to
customers. Would the salary of a manager of that direct labor force qualify as a Section
263A capitalized cost?
A: if you are performing “significant direct labor and materials…” then you are a
producer and not a reseller. That would make the salary of a manager of the direct labor
force a 263A direct cost required to be capitalized.
25.
Q: Are engineering costs on a potential new product subject to section 263A?
A: Yes, under 1.263A-1(e)(3)(ii) engineering and design costs must be capitalized as
indirect costs.
26.
Q: What happens if a company outsources either its manufacturing or other costs (such as
handling, storage, shipping) – can it avoid 263A if it is producer or a reseller?
A: There was a recent court case on this issue where a vitamin seller outsourced its
manufacturing and provided specific instructions as to what the recipe should be to a
subcontractor who produced the product accordingly. The court concluded that the
vitamin seller was a producer.
27.
Q: Can you talk about officer compensation and what needs to be included in Sec 263A?
Corporation is a producer, officer handles all financial duties. How to allocate?
A: Under 1.263A-1(e)(3)(ii)(B) officer’s compensation is required to be allocated as
indirect costs. On the other hand, 1.263A-1(e)(4)(iv)(A) provides “Examples of
deductible service costs: Costs incurred in the following departments or functions are not
generally allocated to production or resale activities:
(A) Departments or functions responsible for overall management of the taxpayer or for
setting overall policy for all of the taxpayer's activities or trades or businesses, such as the
board of directors (including their immediate staff), and the chief executive, financial,
accounting, and legal officers (including their immediate staff) of the taxpayer, provided
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that no substantial part of the cost of such departments or functions benefits a particular
production or resale activity.
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