UNICAP errors, omissions and opportunities: TAM 200607021.

On Feb. 17, 2006, the IRS issued Technical Advice Memorandum (TAM) 200607021, which discusses the manner in which a taxpayer changed its method of accounting for deductible costs the taxpayer had capitalized prior to the enactment of Sec. 263A. Although limited to the taxpayer's particular facts, this TAM provides insight in to how the IRS views a particular approach to a change in accounting for capitalized costs under the uniform capitalization (UNICAP) rules of Sec. 263A.

Facts

In the TAM, the taxpayer applied for a change in its accounting method for pick-and-pack costs, distribution costs, recovery allowances for temporarily idle facilities, and costs related to budgeting, general policy-making and strategic business planning. By changing methods, it sought to stop capitalizing these amounts and to start deducting them. Some of these costs had been capitalized prior to the enactment of Sec. 263A, while others were initially capitalized subsequent to the enactment. The costs that had been capitalized under the standard cost method for book prior to the enactment were included in Sec. 471 costs for purposes of the simplified production method calculation under Sec. 263A. The taxpayer did not request in its application to reclassify any Sec. 471 costs as additional Sec. 263A costs, or vice versa. In a request for further information, it responded as follows:

The taxpayers are not changing their definition of [section] 471 costs and additional [section] 263A costs as a result of this accounting method change. Additional [section] 263A costs will continue to be defined as all costs, other than interest, that were not capitalized by the taxpayers prior to the effective date of [section] 263A but that are now required to be capitalized under [section] 263A. As such, additional [section] 263A costs represent the difference between the total amount of costs required to be capitalized under [section] 263A and those amounts properly classified as 471 costs. Thus, additional [section] 263A costs consist principally of mixed service costs and certain production costs. Section 471 costs will continue to be defined as all costs, other than interest, that were capitalized by the taxpayers immediately prior to the effective date of [section] 263A.

After receiving IRS consent to this method change, the taxpayer elected the historic absorption ratio (HAR) (Regs. Sec. 1.263A-2(b)(4)). In making this change, it did not remove deductible costs from its Sec. 471 costs (the denominator in calculating the HAR), though it did remove such costs from its additional Sec. 263A costs during the test period from the numerator. Thus, the adjustment resulted in a lower HAR in comparison to a removal of the costs from both the numerator and denominator. Moreover, the taxpayer did not remove these costs from Sec. 471 costs in its ending inventory.

IRS Analysis

The first issue presented by the IRS was whether the costs removed from the additional Sec. 263A costs (pick-and-pack costs, distribution costs, recovery allowances for temporarily idle facilities, and costs related to budgeting, general policy-making and strategic business planning) were within the meaning of Regs. Sec. 1.263A-1(d)(2). The IRS determined the costs were within the meaning because the taxpayer capitalized them and included them in its production costs prior to Sec. 263A's enactment. Thus, the costs were a part of the book costing system and included in Sec. 471 costs prior to Sec. 263A, which makes them subject to Sec. 263A (per Regs. Sec. 1.263A-1(d)(2)).

The second issue was whether the taxpayer improperly changed its method based on the IRS's consent agreement. The agreement allowed the taxpayer to deduct the particular costs, instead of capitalizing them. Thus, the taxpayer should have deducted them from Sec. 471 costs, instead of deducting them from additional Sec. 263A costs. Because the taxpayer stated it was not changing its definition of additional Sec. 263A costs (to which the IRS consented), the taxpayer incorrectly deducted the costs from additional Sec. 263A costs. It should have deducted the costs from Sec. 471 costs, as originally requested.

The final issue was whether the taxpayer's method of implementing the consent agreement resulted in the removal of costs other than those for which it was granted permission to remove. By reducing additional Sec. 263A costs, rather than Sec. 471 costs, the taxpayer effectively reclassified costs that were not the subject of the taxpayer's Form 3115, Application for Change in Accounting Method. That is, in using the simplified production method, the ratio of additional Sec. 263A costs/Sec. 471 costs results in a smaller absorption rate when costs are deducted from the additional Sec. 263A costs; see the exhibit for a simplified numerical example that demonstrates the difference.

Exhibit 1: Effects of reclassification on absorption rate

Original additional Sec. 263A costs: $10

Original Sec. 471 costs: $100

Cost to be deducted (removed from Sec. 471 costs): $5

Original absorption ratio: $10/$100 = 10%

Absorption ratio as should have been implemented by the taxpayer:

$10/$100-$5 = $10/$95 = 10.52% (applied to ending inventory less $5)

Absorption ratio as actually implemented by the taxpayer:

$10 - $5/$100 = $5/$1000 = 5%

Conclusion

Clearly, by adjusting the additional Sec. 263A costs (rather than the Sec. 471 costs), there is a much lower absorption ratio. Granted, the higher rate under the proposed method is applied to a lower ending inventory, but the product of the higher rate and lower ending inventory is still higher than the lower rate applied to the original ending inventory. Hence, the IRS determined that the taxpayer improperly removed costs other than those for which permission was granted to remove as originally noted in the consent agreement.

While it is virtually impossible to have a situation in which the IRS's interpretation would result in a lower amount of capitalized costs than the taxpayer's interpretation, it does provide an opportunity for the tax professional to review taxpayers' capitalization methods. Not only should the tax professional review for compliance with the regulations in terms of cost allocation, but he or she can also review for compliance with specific capitalization methods authorized for that taxpayer. Moreover, a review of the capitalization of Sec. 263A costs may easily result in identifying deductible costs (e.g., pick-and-pack), even though they are currently being capitalized. Lastly, depending on the nature of the taxpayer's business, a different method may be more appropriate for that taxpayer (i.e., the HAR is more appropriate for a taxpayer that is anticipating significant inflation and wants to lock in a lower rate).

While not specifically indicated, it appears that, unlike in TAM 200603027, which involved a LIFO taxpayer using the inventory price index computation method, the IRS did not revoke the taxpayer's letter ruling. Instead, TAIM 200607021 appears to have permitted the taxpayer to implement the change using a recomputed Sec. 481(a) adjustment.

The taxpayer made the mistake of not asking for the change that it actually intended to make. A taxpayer is allowed to redefine additional Sec. 263A costs to exclude otherwise deductible costs; however, it must explicitly request this and implement the change according to the consent agreement. In the TANI, the IRS notes that, at first glance, the taxpayer's proposed treatment could be proper, but it points out that the simplified methods provided in the regulations do not cover removing Sec. 471 costs by adjusting additional Sec. 263A costs. Accordingly, the lesson is to abide by the strict interpretation of the consent agreement. Seemingly innocuous differences in interpretation can and will have material effects, which the IRS may identify on examination and require retroactive adjustments and possibly assess penalties.

FROM PAUL K. GIBBS, CPA, AND REGINA L. RATHNAU, J.D., CPA, WASHINGTON, DC