Sec. 263A: historic absorption ratio - simplify your UNICAP calculation.

The August 1993 issuance of final uniform capitalization (UNICAP) regulations under Sec. 263A introduced the "historic absorption ratio," allowing taxpayers the opportunity to elect this method in their first, second or third tax year beginning after Dec. 31, 1993. The historic absorption ratio could be a very favorable option for taxpayers to consider.

Historic absorption ratio--the basics

The historic absorption ratio is available to taxpayers using (or changing to) the simplified production method under Regs. Sec. 1.263A-2(b)(4) or the simplified resale method under Regs. Sec. 1.263A-3(d)(4). The historic absorption ratio is based on a three-year test period preceding the year of change. It is calculated by taking the ratio of the prior three years' additional Sec. 263A costs to Sec. 471 costs (e.g., 1994 historic ratio is based on 1991 through 1993). Once the historic absorption ratio is determined and elected, the taxpayer uses this ratio for five years without the need to recalculate UNICAP each year.

In the sixth year, the taxpayer recalculates an absorption ratio for this year (recomputation year). If the computed ratio for the sixth year alone is within one-half of one percentage point (plus or minus) of the previous historic absorption ratio (i.e., the ratio used in the previous five tax years), the taxpayer continues with the previous historic ratio for the recomputation year and the following five tax years. If, however, the recomputed ratio is not within those limits, the taxpayer must use the actual absorption ratios calculated for each of the sixth, seventh and eighth tax years. Then, in the ninth year, the taxpayer resumes with a new historic absorption ratio based on the actual ratios calculated for each of the sixth, seventh and eighth tax years. Note: The historic absorption ratio is elected by attaching a statement to the taxpayer's tax return showing the calculation of the historic absorption ratio to be used.

Transition rules--adopt a simplified method and correct UNICAP

calculation

The historic absorption ratio transition rules permit taxpayers to elect the historic absorption ratio method in their first, second or third tax year beginning after Dec. 31, 1993, with the IRS's automatic consent. This election is permitted during this transition period whether or not the taxpayer used the simplified production method or simplified resale method in prior tax years. (Remember the historic absorption ratio is normally available only to taxpayers already using one of these simplified methods.)

In other words, a taxpayer can elect the historic absorption method and change to a simplified method to calculate its UNICAP costs at the same time. In addition, the transition rules permit taxpayers to correct their UNICAP calculation to be consistent with the final Sec. 263A regulations when determining their historic absorptio ratio. (Note: These changes are only allowed during one of the tax years covered by the transition rules. After the transition years, taxpayers will have to request the IRS's approval for a change in accounting method.)

The changes permitted with the historic absorption ratio election are provided in the transition rules for both the simplified production method (Regs. Sec. 1.263A-2(b)(4)(v)) and the simplified resale method (Regs. Sec. 1.263A-3(d)(4)(v)):

Taxpayers are eligible to make an election [i.e., historic absorption ratio election] under these transition rules whether or not they used the simplified [production or 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 [the final Sec. 263A regulations] had applied throughout the test period. (Emphasis added.)

Rev. Proc. 95-25 provides the terms and conditions prescribed by the Service to make a change to the historic absorption ratio under the transition rules previously described. Rev. Proc. 95-25 applies to the taxpayer currently on the simplified production method or simplified resale method that has not used such simplified method for three or more years. In this situation, the taxpayer should first change to a simplified production method or simplified resale method pursuant to Rev. Proc. 94-49 or 92-20, then make the historic absorption ratio electio pursuant to Rev. Proc. 95-25 (both of these changes can be made in the same year). The taxpayer that has used a simplified method for three or more years is outside the scope of Rev. Proc. 95-25 and can adopt the historic absorption ratio pursuant to the regulations.

Related issues

The following related issues should be considered before electing the historic absorption ratio:

* The election to use the historic absorption ratio is a method of accounting. Once elected, it must be consistently used unless the taxpayer obtains the Service's consent to change it.

* In certain situations, the simplified production method or simplified resale method may overcapitalize costs into inventory compared to other UNICAP methods available to a taxpayer (e.g., a facts and circumstances method). In addition, the historic absorption ratio "locks" the taxpayer into an absorption ratio for the next five years. Later years' production or distribution cost efficiencies will not be reflected in the historic absorption ratio until a recomputation year.

* As indicated, the change to the historic absorption ratio is required to be elected on a "cut-off" basis, and thus, no Sec. 481(a) adjustment is required or permitted. This requirement could be a potential drawback to the taxpayer that overstated UNICAP costs in a prior year. For example, if a LIFO taxpayer has excess UNICAP costs capitalized to its LIFO layers, a change in accounting method pursuant to Rev. Proc. 94-49 should be considered to obtain the benefit of a negative Sec. 481(a) adjustment. However, a non-LIFO taxpayer that overcapitalized UNICAP costs in the prior year may be better off adopting the historic absorption ratio going forward to avoid the negative Sec. 481(a) adjustment being spread over four years when the inventory--and UNICAP costs--other-wise may have turned in one year.

Likewise, if a LIFO or non-LIFO taxpayer understated UNICAP costs in prior years, a change pursuant to Rev. Proc. 94-49 should be considered to preclude IRS exam adjustments for those years. Rev. Proc. 94-49 generally permits a four-year spread of the positive Sec. 481(a) adjustment. Note that the change to the historic absorption ratio cannot be made under Rev. Proc. 94-49. However, pursuant to Rev. Proc. 95-25, a taxpayer can correct its UNICAP computations under Rev. Proc. 94-49 and adopt the historic absorption ratio in the same year.

The ability of a taxpayer to simplify and correct the UNICAP calculation on a forward basis, and to be relieved of the yearly burden of calculating the absorptio ratio, may outweigh some of the other related issues. At a minimum, all taxpayers should be familiar with their options under the final Sec. 263A regulations, including the historic absorption ratio transition rules.