The historic absorption ratio method and TAM 9810003 - will good tax policy be turned bad?

In Letter Ruling (TAM) 9810003, the IRS National Office ruled that the simplified production method with the historic absorption ratio (HAR) election, used to allocate additional costs to inventory under the uniform capitalization rules, is not subject to the reasonableness standard required of other uniform capitalization allocation methods. According to the IRS 1998 Priorities for Tax Regulations and Other Administrative Guidance, the Service's 1998 Business Plan includes reconsidering the HAR method in light of this TAM.

The HAR Method

The HAR is used to allocate capitalizable costs between cost of goods sold and ending inventory under the Sec. 263A uniform capitalization (UNICAP) rules. The HAR may be elected only if either the simplified production method or the simplified resale method has been used for three years. Once elected, the HAR is an accounting method that may be changed only with IRS permission. Developed in the final UNICAP regulations issued in 1994, the HAR provides further simplification, in addition to the simplification provided by the simplified production and resale methods.

Under the simplified production and simplified resale methods, the amount of additional UNICAP costs requiring inventory capitalization is determined by computing an absorption ratio and applying it to ending inventory for FIFO, or a LIFO increment for LIFO. The absorption ratio equals "additional Sec. 263A costs" divided by "Sec. 471 costs." Sec. 471 costs generally include all costs previously capitalized by the taxpayer under the taxpayer's method prior to the effective date of the uniform capitalization rules; additional Sec. 263A costs generally include all costs required to be capitalized under UNICAP that are not Sec. 471 costs. Because, prior to the UNICAP's effective date, there were few book or tax differences in computing the value of ending inventory, many taxpayers using either simplified method could use their existing book capitalization methods, enabling taxpayers to make an "add-on" computation under UNICAP for tax purposes (rather than maintaining an entirely separate and complete tax inventory system). Taxpayers using LIFO may compute the LIFO inventory value without considering the UNICAP's effect, and simply increase the value of any increment by the absorption ratio.

According to the preamble to the final UNICAP regulations issued in 1994, the HAR was intended to eliminate costly and me-consuming annual computations. Commentators had requested that industry averages be used to compute a UNICAP adjustment, but the Service encountered difficulty in collecting the necessary industry-specific data to facilitate development of safe-harbor percentages. Instead, the HAR was developed.

Under the HAR, a weighted-average absorption ratio is computed by combining the absorption ratios computed under the simplified method used for the last three years prior to the first year the HAR is elected. The three-year period used to compute the HAR is referred to as the "test period." The HAR is used for the next five years. During this five-year period (referred to as the qualifying period), no UNICAP analysis is required; the only adjustment necessary is the application of the ratio to a FIFO ending inventory or a LIFO increment.

The ability to prepare a UNICAP adjustment without performing any UNICAP analysis provides a significant amount of simplification to taxpayers. The HAR must be tested in the sixth year (referred to as the recomputation year) by computing an actual absorption ratio for that year. The same UNICAP methods used in the test period to compute the HAR must be used to compute the actual absorption ratio in the recomputation year. If the ratio is within one half of one percent (plus or minus) of the HAR, the HAR is used for the sixth year and another five-year qualifying period. The ratio is tested after each qualifying period. If the ratio is not within one half of one percent of the HAR, the actual ratio is used for the recomputation year and the following two years. After three years of performing actual computations, a new weighted-average HAR is computed and used for the next qualifying period.

Letter Ruling (TAM) 9810003

In Letter Ruling (TAM) 9810003, the taxpayer properly elected the HAR for one subsidiary of an affiliated group filing a consolidated return. In the first year it was subject to the HAR, the taxpayer placed a substantial amount of plant and equipment in service, a large portion of which qualified for a five-year recovery period under the modified accelerated cost recovery system provided in Sec. 168. As a result of the increased additional Sec. 263A costs (additional tax over book depreciation), the actual absorption ratio for the year at issue greatly exceeded the HAR used. The issue was whether the HAR could be used in a year that it greatly exceeded the actual absorption ratio.

After analyzing the applicable sections of the UNICAP regulations, the IRS National Office concluded that the simplified method in combination with the HAR was not subject to the reasonableness standard required for other allocation methods. Regs. Sec. 1.263A-1 (f)(4) provides "[a]n allocation method is reasonable if ... (i) The total costs actually capitalized during the taxable year do not differ significantly from the aggregate costs that would be properly capitalized using another permissible method described in this section or in [subsections] 1.263A-2 and 1.263A-3 ...; (ii) The allocation method is applied consistently by the taxpayer; and (iii) The allocation method is not used to circumvent the requirements of the simplified methods in this section or in [sections]1.263A-2, [sections] 1.263A-3, or the principles of section 263A." Based on its analysis, the Service concluded that the HAR could be used even though it greatly exceeded the actual absorption ratio for a year.

HAR Is Good Tax Policy

The HAR is based on the simplified allocation methods. These methods allow the continued use of allocation methods used prior to UNICAP with an add-on adjustment. This allows previously used (and possibly previously examined) LIFO and FIFO methods to be used. When the simplified methods are coupled with the HAR, no UNICAP computations are required in the qualifying period. Consequently, no UNICAP workpapers exist for these years. In addition to saving administrative costs for taxpayers, the HAR should save administrative costs for the government, because there is nothing to examine for five years, once the test period and computation of the HAR are examined. In addition, the HAR is an incentive to use the simplified production or simplified resale methods. Because these methods average total costs (including, for example, raw materials in determining the turn-rate inherent in the methods), they are generally viewed as resulting in higher taxable income.

It is a concern that the government may be reconsidering the HAR in light of the TAM. The HAR provides significant simplification that should be encouraged. The HAR provides an incentive to use the simplified production or resale method, which reduces compliance costs for taxpayers and examination costs for the IRS. The HAR and TAM 9810003 should be applauded for their simplification, and should not be altered by the perceived benefit to one taxpayer without considering the impact any changes or deletion of the HAR would have on all other taxpayers and the government.

FROM ROBERT A. KILINSKIS, CPA, J.D., LL.M., AND HERBERT J. GUARASCIO, CPA, CHICAGO, IL