The Main Audit Issue
Generally, additional Sec. 263A costs must be allocated to the specific items of property produced or property acquired for resale during the tax year and capitalized to the items that remain on hand at the end of the tax year; see Regs. Sec. 1.263A-1(c)(1). The only exceptions to this rule are the simplified production method (SPM) and the simplified resale method (SRM); see Regs. Sec. 1.263A-2(b) and -3(d). Thus, any other "facts and circumstances" method, such as specific identification, burden rate, standard cost or "other reasonable allocation methods," must allocate costs to specific inventory items; see Regs. Sec. 1.263A-1(f). Hence, the primary audit issue or exposure involves taxpayers who are using a facts-and-circumstances method that does not allocate costs to specific inventory items.
Recent audit activity indicates the IRS will require taxpayers to use one of the simplified methods (SPM or SRM) when it determines that a taxpayer is using a facts-and-circumstances method that does not allocate costs to specific inventory items. The simplified methods generally cause the taxpayer to capitalize greater costs than if a facts-and-circumstances method were used. However, many taxpayers historically have not invested the time and resources to develop this method. Thus, they have generally chosen to use one of the simplified methods. Unfortunately, many businesses use a "simple" method, which is not necessarily one of the "simplified methods" For example, some taxpayers have multiplied the same percentage year-after-year to their ending inventory to determine Sec. 263A costs (this could be permissible if the taxpayer made the historical absorption ratio election); see Regs. Sec. 1.263A-2(b)(4) and-3(d) (4).
On audit, the IRS has brought in UNICAP specialists who appear to be following guidance provided by three letter rulings; see Letter Rulings (TAMs) 9717002, 9821001 and 200144003.A review of the letter rulings provides the following insights:
1. Taxpayers are generally required to allocate additional Sec. 263A costs to specific inventory items. The SPM and the SRM are the only exceptions.
2. other reasonable methods must allocate costs to specific inventory items.
3. Any method not allocating to specific inventory items will be compared to the SPM or SRM, to determine whether it is reasonable and permissible.
4. Any method that does allocate costs to specific inventory items may be compared to any other permissible method that allocates costs to specific inventory items to determine reasonableness (this is hardly ever the case).
5. If determined not to be reasonable (and thus not permitted), the IRS may require the taxpayer to use the SPM or SRM.
Other rules emphasized in all three rulings:
1. Allocation to specific inventory items is based on an inventory cost-flow assumption.
2. Simplified methods are based on absorption ratios (lump-sum approach).
3. Generally, a taxpayer may not modify simplified methods to fit facts. Simplified methods are used without regard to changes in facts.
4. Periodic re-evaluation of facts are required if using other permissible methods.
5. Taxpayers, who have not allocated costs to specific inventory items and have not kept records necessary to support the allocation of costs to specific inventory items, may not develop a hypothetical after-the-fact allocation method to support an otherwise impermissible method.
Summary of Each Ruling
Letter Ruling (TAM) 9717002: In this ruling, the taxpayer was using two absorption ratios, but not any of the simplified methods. The taxpayer used a standard cost system and adopted additional burden rates. According to the ILLS, the taxpayer was not using a burden rate method, because it did not allocate costs to specific inventory items. Thus, the IRS compared the method to the SPM to determine whether the taxpayer's method was permissible. The IlLS concluded the taxpayer's method was impermissible and required the taxpayer to use the SPM.
Letter Ruling (TAM) 9821001: In this ruling, the taxpayer indicated it was using the SPM on Form 3115, Application to Change Accounting Method. In reality, the taxpayer used two absorption ratios (not the SRM or SPM).The taxpayer retained its standard cost system and adopted an "additional method," to ensure adequate amounts of indirect costs were allocated to production. The IRS held that any variation of the SPM must be compared to the SPM to determine reasonableness. Further, taxpayers cannot compare variations of the SPM with a burden rate method or other method that would allocate costs to specific inventory items. Hence, they must compare specific item methods to specific item methods to determine whether the method is permissible. The IRS concluded the taxpayer's method was not a permitted method; the taxpayer did not allocate costs to specific inventory items, and was required to use the SPM.
Letter Ruling (TAM) 200144003: In this ruling, the taxpayer was using another reasonable method or variation of the SRM by excluding in-transit inventory and in-transit purchasing costs to determine the storage and handling ratio. The taxpayer's method allocated significantly fewer costs because of the significant amount of in-transit inventory. The IRS held that the taxpayer may not modify the simplified methods to fit its facts and circumstances. Periodic re-evaluation of the facts is required and allowed for other permissible methods. The IRS concluded the taxpayer's method was not a permitted method because the taxpayer did not allocate costs to specific inventory items, thus requiring the taxpayer to use the SRM.
Based on the IRS's new approach, taxpayers who have been playing the "wait and see" game with their UNICAP calculation (or who have even been audited in the past and received no adjustment to their UNICAP calculation) should consider taking a fresh look at their calculation to minimize their exposure.
Taxpayers that proactively choose to correct their methods can obtain a four-year spread of an unfavorable adjustment by filing Form 3115 prior to being audited (the accounting method change could be automatic or nonautomatic depending on the methods being changed); see Rev. Procs. 2002-54 and 2002-9 for details. On the other hand, if a taxpayer is audited and the IRS makes an unfavorable adjustment, the taxpayer would not get a four-year adjustment spread.
In addition, a fresh look at a taxpayer's UNICAP calculation does not always have to result in an unfavorable adjustment. There are methods a taxpayer can use to minimize the costs requiring capitalization, regardless of whether the client uses a facts-and-circumstances method or one of the simplified methods. Thus, taxpayers should review their UNICAP calculations to determine what, if any, corrective action should be taken.
FROM BRIAN STRAHLE, MST, MINNEAPOLIS, MN
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|Title Annotation:||uniform capitalization|
|Publication:||The Tax Adviser|
|Date:||Apr 1, 2006|
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