Final regulations under the uniform capitalization (UNICAP) rules adopt a new simplified method called the modified simplified production method—for determining additional Code Sec. 263A costs allocable to property produced by a taxpayer or acquired for resale ( T.D. 9843). This method is in addition to the current simplified methods. The final regulations redefine how certain types of costs are categorized for the simplified methods, and provide rules for the treatment of negative adjustments in additional Code Sec. 263A costs. A separate revenue process allows taxpayers to change their accounting method to comply with the final regulations. The final regulations adopt previously issued proposed regulations with minor changes ( REG-126770-06, I.R.B. 2012-38, 347).
Modified Simplified Production Method
The new modified simplified production method allocates additional Code Sec. 263A costs including, negative adjustments, among raw materials, work-in-process, and finished goods inventories on hand at the end of the year. Taxpayers using this method are not required to track separately direct material costs that are integrated into work-in-process and finished goods inventories. Additionally, the types of methods permitted to allocate mixed service costs between pre-production and production additional Code Sec. 263A costs are increased. A taxpayer using the new simplified method may also allocate 100% of capitalizable mixed-service costs to pre-production or production additional Code Sec. 263A costs if 90% or more of the costs would otherwise be allocated to that amount.
Additional clarifications to the modified simplified production method provide that:
- Additional Code Sec. 263A costs allocable to property produced under a contract and property acquired for resale are included in pre-production additional Code Sec. 263A costs;
- Code Sec. 471 costs for property produced under a contract and property acquired for resale are included in pre-production Code Sec. 471 costs; and
- Direct material costs include property produced under a contract that are direct material costs when the property is used in an additional production activity of the taxpayer.
Section 471 Costs
The final regulations provide that for purposes of any of the simplified methods, Code Sec. 471 costs are the types of costs that a taxpayer capitalizes to produced property or inventory in its financial statement. Furthermore, taxpayers must include all direct costs of property produced or acquired for resale in Code Sec. 471 costs regardless of the treatment on a financial statement. A de minimis exception described below applies. Code Sec. 471 costs are determined by reference to the Code Sec. 471 costs incurred during the tax year for federal income tax purposes.
The regulations prioritize various types of financial statements for determining Code Sec. 471 costs.
An alternative method of determining Code Sec. 471 costs is provided for taxpayers with an audited financial statement as well as other specified statements that are deemed reliable. Under the alternative method, Code Sec. 471 costs are the costs capitalized to property produced or property acquired for resale in the taxpayer’s financial statement. However, financial statement write-downs, reserves, or other financial statement valuation adjustments are not taken into account. The alternative method must be applied consistently to all Code Sec. 471 costs in order to limit potential distortions in the absorption ratios used under the simplified methods. Also, if the alternative method is used, additional Code Sec. 263A costs include all negative adjustments to remove Code Sec. 471 costs, as well as all permitted positive and negative book-to-tax adjustments.
De Minimis Safe Harbors
The final regulations provide a de minimis rule that allows a taxpayer using a simplified method to include in additional Code Sec. 263A costs, and exclude from Code Sec. 471 costs, direct labor costs that are not capitalized in a taxpayer’s financial statement. The de minimis rule is only available if uncapitalized direct labor costs are less than 5% of total direct labor costs incurred during the tax year. Basic compensation, overtime, and costs included in a taxpayer’s standard cost or burden rate methods used for Code Sec. 471 costs are not covered by the de minimis rule.
Another de minimis rule allows taxpayers using a simplified method to include in additional Code Sec. 263A costs, and exclude form Code Sec. 471 costs, direct material costs that are uncapitalized on financial statements if the amount of those costs comprise less than five percent of total direct material costs incurred during the tax year.
Additionally, a final de minimis rule allows taxpayers using a simplified method to include in additional Code Sec. 263A costs, and exclude from Code Sec. 471 costs, capitalized variances and under- or over-applied burdens if the sum of these amounts is less than 5% of the taxpayers’ s total Code Sec. 471 costs for all items for which the taxpayer uses a standard cost or burden rate method to allocate costs.
Negative Adjustments
Under the final regulations, negative adjustments included in additional Code Sec. 471 costs to remove Code Sec. 471 costs are only allowed if a taxpayer uses the simplified production method, the simplified resale method, or the new modified simplified production method. The final regulations impose a consistency requirement mandating that taxpayers that include negative adjustments in additional Code Sec. 263A costs must use this method of accounting for all Code Sec. 471 costs permitted to be removed using negative adjustments. However, certain specified costs such as bribes, lobbying expenses, and fines may not be removed from Code Sec. 471 costs as a negative adjustment.
A taxpayer using the simplified production method may include negative adjustments in additional Code Sec. 263A costs only if its average annual gross receipts for the three prior tax years are $50 million or less.
Accounting Method Changes
An accounting method change procedure has been issued in conjunction with the final regulations (Rev. Proc. 2018-56). The procedure grants taxpayers automatic consent to make an accounting method change to comply with the regulations. These changes include, for example, a change to comply with the new definition of Code Sec. 471 costs, the treatment of negative adjustments, or a change to the new modified simplified production method. Rev. Proc. 2018-31, I.R.B. 2018-22, 637, which provides a comprehensive listing of automatic accounting method changes, is modified and amplified to include the changes described in Rev. Proc. 2018-56.
Effective Date
The final regulations apply to tax years beginning on or after November 20, 2018. The IRS will not challenge return positions consistent with all of the final regulations for any tax year that both begins before November 20, 2018, and ends after November 20, 2018.
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