The IRS has proposed regulations on uniform capitalization (UNICAP) rules under Section 263A to address the use of negative amounts in computing additional Section 263A costs for purposes of the simplified production and simplified resale methods. The proposed regulations address distortion concerns of both taxpayers and the IRS relating to the simplified production method.
Under the proposed regulations, taxpayers are given the option to use either the simplified production method (as exists in the current regulations) or a modified simplified production method. The modified simplified production method will provide a more favorable outcome to many taxpayers because it will reduce the amount of Section 263A costs that are capitalized to ending inventory. Under the current simplified production method, costs are capitalized to raw materials at the same rate that they are capitalized to work in process and finished goods, which overcapitalizes to raw materials because little if any of the costs actually relate to raw materials. The new modified simplified production method allows producers to use two different absorption ratios, one for costs that relate to raw materials and one for costs that relate to work in process and finished goods.
The proposed regulations also address the use of negative additional Section 263A costs in the simplified production or simplified resale method. In a technical advice memorandum released in 2006 (TAM 2006-07-021), the IRS expressed concern regarding situations in which a taxpayer was including negative costs in the numerator of the simplified production method as a way to remove costs not required to be capitalized under Section 263A, even though they were being capitalized for purposes of their financial statements and Section 471. This meant that a taxpayer's method of removing the costs in the aggregate could result in the removal of an amount different from the amount that would be removed if the taxpayer readjusted its standard costs to stop including such costs in Section 471 costs. Typically, the use of negative additional costs would mean that the decrease in ending inventory would exceed the amount of correlating costs that were originally capitalized and included in ending inventory.
In 2007, the IRS provided interim guidance (Notice 2007-29) on the use of negative additional Section 263A costs. The notice provided a moratorium on the use of negative additional Section 263A costs until further guidance was issued. The IRS said it would not challenge the use of negative additional Section 263A costs or deny consent for changes in method of accounting solely on the basis that the proposed method involved including negative amounts in computing additional costs.
In the newly proposed regulations, the IRS has prohibited the use of negative additional costs for taxpayers that use the simplified production method (as it exists in the current regulations), but will allow the use of negative additional costs under the modified simplified production method. Taxpayers who do not want to change or cannot change to the modified simplified production method must remove costs that are not required to be capitalized for purposes of Section 263A (such as book-over-tax depreciation or book-over-tax compensation deductions) using a reasonable method that approximates the manner in which the taxpayer originally capitalized the costs to its inventory in its financial statements. This will require a separate more complex computation, so taxpayers will likely wish to change to the modified simplified production method if at all possible.
The fact that the modified simplified production method will capitalize less costs to ending inventory combined with the fact that taxpayers using this method will be able to use negative additional costs (rather than a more burdensome formula) should motivate producers to change to this more favorable simplified method, even if it requires a bit more work than the existing simplified production method.
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