Fresh look at inventory could help with tax planning

Taxpayers looking for cash tax planning opportunities, as well as ways to decrease administrative burden, should take a deeper look at their inventory methods under Section 263A.

When the IRS issued final regulations (T.D. 9843) under the uniform capitalization (UNICAP) rules of Section 263A in 2018 (the 2018 regulations)¹, many taxpayers rushed to implement the changes to the simplified methods without performing a full analysis to determine whether other methods may provide a more beneficial methodology.

Additionally, changes in business operations, processes or reporting over the intervening years may have created complexities and inadvertent departures from the initially implemented simplified methods. This includes taxpayers that perform research activities and may need to align their UNICAP analysis with their most recent Section 174 specified research or experimental (SRE) analysis.  

Whether a taxpayer aims to reduce capitalization or simplify the annual UNICAP computation, they can review existing UNICAP methods and identify alternative UNICAP methods and sub-methods tailored to their tax planning goals.

Common potential areas for substantial cash tax savings include:

• Non-simplified UNICAP methods ꟷ Alternatives to simplified methods, such as a specific identification method or burden rate method generally offer more flexibility and can reduce cost capitalization, depending on the facts and available information.
• Method for allocating mixed service costs ꟷ While the simplified service cost method usually is beneficial for resellers, certain manufacturers may be able to reduce the amount of allocable mixed service costs by using a specific identification method.
• Historic absorption ratio (HAR) ꟷ Taxpayers using the simplified methods for three or more consecutive tax years can simplify their annual UNICAP calculation by electing HAR, which uses an average ratio from prior years instead of a detailed annual calculation, thus achieving a few years reduction in burden and costs associated with the more complex method.

Taxpayers that perform research activities can also establish UNICAP methods and sub-methods that align with the Section 174 SRE analysis. Many changes within UNICAP are eligible for automatic procedures for changes in method of accounting. Taxpayers that timely implemented the 2018 regulations may be eligible to use the automatic procedures to change to these UNICAP methods beginning in 2024.

Background

Under Section 263A, a taxpayer must generally capitalize the direct and indirect costs that are allocable to the taxpayer’s property produced or acquired for resale, unless the taxpayer is a small business that has aggregate average gross receipts of less than $30 million for the three taxable years prior to 2024.² Therefore, businesses that don’t meet the “small business” definition must capitalize more costs than those typically capitalized for financial statement purposes.³ The additional costs required to be capitalized for tax purposes include costs such as purchasing, storage and handling, and a portion of general and administrative costs (mixed service costs). Taxpayers are required to capitalize all these costs on a tax basis, so book-tax differences also must be taken into account.⁴

To allocate capitalizable Section 263A costs, the regulations permit taxpayers to use a variety of methods including a specific identification method, burden rate method, standard cost method, another reasonable allocation method, or one of the simplified methods ꟷ the simplified resale method (SRM), the simplified production method (SPM) or the modified simplified production method (MSPM).⁵ The IRS’s position is that unless a taxpayer is using one of the simplified methods, costs allocated to ending inventory using any of these other methods must be allocated to inventory using the same specificity as used for financial statement purposes.⁶ This can result in complexity as the IRS generally translates this to mean that the costs must be allocated to and among individual items of inventory rather than capitalized as lump sums.

Taxpayers that use the simplified methods often capitalize more costs than under a different method such as a burden rate method because, under the simplified methods, costs are capitalized to inventory as a lump sum. Many taxpayers disregard this possibility, opting to use the simplified methods due to the perception that it eases the administrative burden associated with allocating and capitalizing additional Section 263A costs, including book-tax differences. However, changes made by the 2018 regulations resulted in considerable burden and complexity for many taxpayers, even when using one of the simplified methods. For example, many manufacturers implemented the MSPM, which often reduces the costs capitalized (as compared to the SPM), but at the cost of much additional burden and complexity.

Alternatives to the simplified methods

There are several rules in the 2018 regulations that prohibit certain costs from being capitalized using one of the simplified methods (e.g., uncapitalized direct costs or variances). Instead, taxpayers are generally required to adjust their financial statement inventory for any costs under one of these rules. Because the IRS position is that such costs must be allocated to and among individual items of inventory rather than capitalized as lump sums, taxpayers likely have had and will continue to have substantial burden to comply. For example, the 2018 regulations provide de minimis safe harbors that generally allow taxpayers using the SRM, SPM or MSPM to allocate certain uncapitalized direct material costs, direct labor costs, and variances using the simplified methods to the extent the relevant cost does not exceed a 5% limit.⁷

Commonly, taxpayers exceed one or more of these safe harbors and are required to adjust their financial statement inventory as a result. For instance, companies with substantial amounts of trade discounts (e.g., large retailers) that do not take them into account in ending inventory for financial statements may exceed the de minimis rule for uncapitalized direct materials. It is also common for many taxpayers to exceed the safe harbor for variances that are not included in ending inventory for financial statements.

Additionally, the amount of the costs capitalized to inventory must be the tax amount. Taxpayers without applicable financial statements⁸ are not eligible to account for book/tax differences related to costs capitalized in their financial statement inventory through the simplified methods. Instead, such taxpayers are required to adjust their financial statement inventory for relevant book/tax differences prior to computing capitalization under one of the simplified methods.

Accordingly, taxpayers with facts that require separate complex calculations to implement one of the simplified methods may want to investigate other non-simplified methods that could prove more cost beneficial.

One alternative that frequently results in less cost capitalization for taxpayers is the use of a burden rate method. Under this method, the taxpayer develops predetermined rates for capitalizing additional costs and book/tax differences at various points of the inventory life cycle, such as the stages of the supply chain.

For example, resellers with large distribution hubs that use the burden rate method might establish separate burden rates (purchase, receive, move to storage, pick and pack for delivery to store) that better align the costs incurred at each stage with the units of inventory at each stage, often resulting in less UNICAP costs capitalized to ending inventory. Generally, for the burden rate method to be cost-beneficial, taxpayers must be able to generate the information necessary to develop the burden rates, which includes both:

• Cost-level information for each stage
• Inventory reports for each stage that depict inventory in a consistent unit of measure (e.g., pairs of shoes)

The burden rate method provides more flexibility than the simplified methods, and taxpayers with significant amounts of inventory that invest the time to establish a more elaborate burden rate method can often significantly reduce their cost capitalization.

Allocation of mixed service costs

One UNICAP sub-method that could be advantageous for taxpayers to evaluate is the method for allocating mixed service costs. Mixed service costs are those costs that are partially capitalizable to inventory and partially deductible. Typically, these costs are incurred by a taxpayer’s general and administrative departments (e.g., Human Resources). One of the most common approaches that taxpayers use to allocate mixed service costs is the simplified service cost method⁹, which is a high-level allocation method based on labor or production costs. Although the relative simplicity of the simplified service cost method may be appealing to taxpayers, it could result in a disproportionate amount of mixed service costs being capitalized. This is often the result for manufacturers because labor and other costs are primarily associated with production activity.

As an alternative, taxpayers may consider using the specific identification method to allocate mixed service costs. Under the specific identification method, costs are allocated based on a cause and effect or other reasonable relationship.¹⁰ For example, labor costs incurred by the Human Resources department could be allocated based on headcount under a specific identification method. The specific identification method often proves most cost-beneficial for manufacturers.

Section 174

Additionally, Section 174 SRE expenditures are generally not required to be capitalized for UNICAP purposes. To comply with the capitalization and amortization requirements of the Section 174 statute, effective for taxable years beginning on or after Dec. 31, 2021, many taxpayers now perform a detailed Section 174 SRE analysis. Amounts identified as Section 174 SRE expenditures in the UNICAP analysis should align with the Section 174 SRE analysis and taxpayers may find opportunity to reduce capitalization to the extent Section 174 SRE expenditures have not been properly identified in the UNICAP calculation.

Historic absorption ratio (HAR)

One option for simplification is the use of the HAR, which allows taxpayers that have been using one of three simplified methods ꟷ SPM, MSPM, or SRM ꟷ for three or more consecutive tax years to use an average ratio for several years rather than perform a complete computation each year. Taxpayers that may benefit most from the potential simplification of using the HAR are those companies (often smaller) with consistent operations and book/tax differences.

However, the HAR may not be a good choice for companies with regularly evolving business operations, particularly if they are acquisitive. Additionally, the average ratio must be tested every few years to determine if a complete recomputation is required. Many taxpayers may find that the process of trying to replicate sub-methods that haven’t been computed in years leads to additional complexity. 

The HAR also does not remove the complexity associated with the very common issue of the capitalization of certain costs that are not allowed to be included in the simplified method. Once the HAR is elected, it is administratively challenging to revoke the election, which may deter some taxpayers from implementing the HAR, despite the potential simplification.

Implementation procedures

Generally, a change from a simplified method to an alternative method such as the burden rate method is a change in method of accounting and requires filing a Form 3115 Application for Change in Accounting Method. Such a change may be eligible for the automatic procedures in 2024 for taxpayers that implemented the 2018 regulations on their 2019 tax return, as such taxpayers are beyond the five-year prohibition.¹¹ A taxpayer that wishes to use the HAR is not required to file a Form 3115 and instead must include an election statement with its timely filed federal income tax return.¹²

The issuance of the 2018 regulations prompted many taxpayers to quickly implement simplified methods without fully analyzing other potentially beneficial methods. Revisiting these methods could be advantageous, especially if complexities or deviations have arisen since implementation (e.g., Section 174, M&A transactions, etc.). Changing UNICAP inventory methods might offer valuable cash tax planning opportunities and reduce administrative burdens. It’s also important to consider how refining Section 263A methods could impact other tax calculations (e.g., reducing the impact of the interest limitation under Section 163(j)) and broader tax planning strategies like international tax planning.)