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How UNICAP Regulations Are Impacting Many Taxpayers Justin Herp, Senior Associate | DHG Tax

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How UNICAP Regulations Are Impacting Many Taxpayers Justin Herp, Senior Associate | DHG Tax views April 2020 How UNICAP Regulations are Impacting Many Taxpayers Justin Herp, Senior Associate | DHG Tax On Nov. 20, 2018, the Internal Revenue Service (IRS) published final regulations (the Regulations) under Internal Revenue Code (IRC) Section 263A (or UNICAP) introducing new provisions impacting taxpayers. The Regulations – effective for all tax years beginning on or after Nov. 20, 2018 (the date of publication) – change the way taxpayers identify costs allocable to inventory, restrict the use of negative costs in UNICAP calculations and introduce a new simplified method for UNICAP computations. Accordingly, taxpayers should review their current UNICAP methods for full compliance with the latest Regulations. What is UNICAP? Changes in the Definition of Section 471 Costs The rules under Section 263A and its related Regulations The Regulations define Section 471 costs as the types of costs require taxpayers producing or acquiring tangible property capitalized in a taxpayer’s financial statement to inventory for resale to capitalize certain direct and indirect costs to produced or acquired for resale in amounts determined under the basis of the property. Those costs include direct costs, the taxpayer’s federal income tax accounting methods.1 In allocable indirect costs and possibly costs in excess of what addition, the Regulations now require taxpayers to capitalize is capitalized for financial reporting purposes. In general, all direct costs as Section 471 costs.2 taxpayers whose average annual gross receipts for the three- In complying with the Regulations, a taxpayer may now be year period before 2019 exceed $26 million are subject to required to maintain two sets of books – its current set and UNICAP. one maintained for tax purposes – to properly determine its current year and on hand at year-end Section 471 costs Assurance | Tax | Advisory | dhg.com views (approximating cost of goods sold and ending inventory, The prohibition on the inclusion of negative adjustments in respectively) on a federal income tax basis (tax basis). additional Section 263A costs does not apply to taxpayers However, the Regulations also introduce relief to the requirement using the SRM or the MSPM. It also does not apply to discussed above requiring Section 471 costs to be capitalized taxpayers who use the SPM and have average gross receipts 4 on tax basis. Under the new Alternative Method of determining less than $50 million. Section 471 costs, an eligible taxpayer may determine the Further, negative adjustments in additional Section 263A amount of its Section 471 costs using the financial accounting costs are permitted for any taxpayers required to adjust methods used in its qualifying financial statement. Taxpayers additional Section 263A costs as a result of adopting the eligible to adopt this Alternative Method include the following Alternative Method of determining Section 471 costs or taxpayers with qualifying financial statements: one of the de minimis exceptions related to uncapitalized variances described later. • Taxpayers utilizing the simplified resale method (SRM) as prescribed in Treas. Reg. Section 1.263A-3(d) Treatment of Uncapitalized Direct Costs and • Taxpayers utilizing the simplified production method Uncapitalized Variances (SPM) as prescribed in Treas. Reg. Section 1.263A-2(b) whose average gross receipts do not exceed $50 million The Regulations now explicitly require taxpayers to include all direct material and direct labor costs as Section 471 • Taxpayers utilizing the modified simplified production method costs. Taxpayers must generally recompute Section 471 (MSPM) as prescribed in Treas. Reg. Section 1.263A-2(c) costs incurred and on-hand to account for uncapitalized Qualifying financial statements include: direct costs and direct cost variances (including under- and • Financial statements required to be filed with the U.S. overapplied burdens). Examples of uncapitalized direct costs Securities and Exchange Commission (SEC) (e.g., Form may include: 10-K) • Direct material and labor variances which are expensed • Audited financial statements used for any substantial directly to the income statement in the period incurred non-tax purpose • Over or underapplied material and labor burden or • Other financial statements (not including tax returns) overhead expensed in the period incurred required to be filed with any federal or state government • Employee benefits associated with direct labor costs or agency, excluding the SEC or IRS (e.g., vacation or holiday) • Materials and supplies directly expensed Restrictions on Negative Adjustments within Additional Section 263A Costs To ease administrative burden, the Regulations provide a series of de minimis thresholds that may allow for the Some taxpayers may find that the costs capitalized to inclusion of uncapitalized direct costs as additional Section inventory for financial reporting purposes exceed the costs 263A costs rather than as Section 471 costs (which, as required to be capitalized by UNICAP. In the past, taxpayers previously discussed, would require a recalculation of have removed these costs from ending tax-basis inventory Section 471 inventory on a tax-basis). The following types of through the inclusion of negative Section 263A costs in their uncapitalized direct costs are considered de minimis for this UNICAP computations. However, the Regulations introduce a purpose: broad prohibition on the use of negative Section 263A costs.3 • Direct labor costs – de minimis if the total of all Common examples of costs capitalized for financial statement uncapitalized amounts is less than five percent of total purposes which may have previously been removed from direct labor costs incurred UNICAP calculations with a negative adjustment include (but are not limited to): • Direct material costs – de minimis if the total of all uncapitalized amount is less than five percent of total • Research and development expenses under Section 174 direct material costs incurred • Distribution or selling costs (including outbound freight) • Uncapitalized variances and over/underapplied • The excess of book depreciation expense over tax burdens – de minimis if the total of all uncapitalized depreciation expense allocable to production or resale amounts is less than five percent of total Section 471 property costs incurred 2 Assurance | Tax | Advisory | dhg.com views In determining eligibility for de minimis treatment, each Accounting Method Changes Available to Taxpayers uncapitalized amount is treated as a positive amount – Revenue Procedure 2019-43 prescribes a number of regardless of whether the amount is a negative uncapitalized automatic method changes available to taxpayers to come cost (e.g., cost reduction, overapplied burden, etc.). into compliance with the final Section 263A regulations. A taxpayer may generally make one or more of the required New Simplified Method Available to Producers method changes by filing a single Form 3115 reflecting Historically, the simplified methods available to taxpayers concurrent changes. These changes are made with a Section have included the SPM and SRM. The Regulations introduce 481(a) adjustment. an additional method available to producers and producer- The eligibility rule under Revenue Procedure 2015-13 is resellers: the Modified Simplified Production Method. generally waived for a taxpayer’s first three taxable years While the SPM and SRM apply a single absorption ratio to all ending on or after Nov. 20, 2018.6 Thus, taxpayers who have inventory to compute a UNICAP adjustment, the MSPM uses recently filed a Form 3115 for a different change in method two separate ratios: a Preproduction ratio and a Production under Section 263A are not restricted from making another ratio. The Preproduction ratio is applied to raw materials change to adopt the Regulations. inventory and inventory acquired for resale while the Production ratio is applied to work-in-process and finished Summary 5 goods inventory. Taxpayers should comprehensively review their current Despite the added complexities in applying two separate UNICAP methods for tax years 2019 and 2020 since the ratios to two distinct pools of inventory, the MSPM may impacts of the Regulations are broad and multifaceted. With provide a significant tax benefit to producers and producer- the new rules introduced by the Regulations, it is possible that resellers whose inventory and purchases include substantial a taxpayer’s present UNICAP methods are not permissible amounts of raw materials and goods acquired for resale (i.e., under the revised guidance and, therefore, may require one Preproduction property). The primary driver of this benefit or more accounting method changes to become compliant. is that raw materials and goods acquired for resale (i.e., However, the MSPM also introduces a key opportunity for inventory which has not yet or will not enter the production producers and manufacturers to improve their UNICAP process) are not subject to the application of additional methods with a potentially tax favorable change from the Section 263A costs incurred during the production process. SPM. A favorable adjustment can be used to reduce taxable This represents a potentially significant advantage over the income in the year of change – which presents a significant legacy SPM methodology. opportunity for taxpayers to realize cash tax savings in a Another benefit of the MPSM is that users with qualifying turbulent and uncertain economy. financial statements are eligible to adopt the Alternative Method of determining Section 471 costs regardless of gross DHG Contact receipts and may include negative additional Section 263A Nathan Clark, CPA adjustments in their UNICAP computations. These benefits Partner, DHG Tax alone may outweigh any additional administrative burden [email protected] brought about via the MSPM (compared to the SPM). 1Treas. Reg. Section 1.263A-1(d)(2)(i) 2Treas. Reg. Section 1.263A-1(d)(2)(ii) 3Treas. Reg. Section 1.263A-1(d)(3)(ii) 4Treas. Reg. Section 1.263A-1(d)(3)(ii)(B) 5Treas. Reg. Section 1.263A-2(c)(3) 6Rev. Proc. 2019-43, Sections 12.01(2)(b) and 12.02(4) 3 Assurance | Tax | Advisory | dhg.com.
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