Attention food processors and beverage bottlers
Section 263A or the uniform capitalization (UNICAP) rules require a taxpayer to capitalize additional costs into ending inventory that might not be capitalized under GAAP. Most food processors and beverage bottlers currently opt to use the simplified production method within the regulations because of the simplicity afforded under this method.
As part of the simplified production method taxpayers are required to allocate 263A costs to raw materials at the same rate they are required to allocate 263A costs to work in process and finished good. This may distort (overstate) the actual costs required to be capitalized as very few of these 263A costs may relate to raw materials and this particularly affects food processors with large stores of raw materials. Any good cost accountant can attest to the fact that raw materials should only be allocated costs related to pre-production and not costs incurred in the actual production process.
As part of IRS proposed regulations, taxpayers are now given the option of using the simplified production method or a new modified simplified production method. Under the new methodology taxpayers can now use an absorption ratio for raw materials and a separate ratio for WIP and finished goods. This will allow a food processor with slower inventory turns or significant raw material stockpiles at year end to avoid the pitfall of capitalizing excessive 263A costs to those raw materials.
Some of the common costs that would be included in pre-production for raw materials would include purchasing and storage costs. Additionally costs related to the storage should include components such as utility and rent which should be allocated to both pre-production and production. Direct costs such as labor or depreciation on machinery used in the manufacturing process shouldn’t be allocated to raw materials. For purposes of computing the allocable portion of preproduction related additional section 263A costs, raw material costs on hand at year end include unprocessed raw materials and raw materials that are integrated into work in progress and finished goods. Under the modified simplified production method, producers determine the allocable portion of all other additional section 263A costs using a production cost absorption ratio and a pre-production absorption ratio.
Let’s assume a processor maintains a large raw materials inventory because they fear a long lead-time on acquiring raw materials if there is a shortage, but maintains a small ending inventory because of the shelf life of their product. Under current regulations the processor would be required to capitalize all 263A costs to ending inventory whether it’s raw materials or finished goods resulting in a large 263A adjustment. Under the proposed regulations this same taxpayer could have 2 separate absorption ratios to allocate 263A costs to production and pre-production. As a majority of 263A costs are production costs, in this example the taxpayer would be capitalizing a much smaller amount by virtue of having their raw materials inventory excluded from having additional production costs allocated to it.
Under the proposed regulations the IRS also addresses the use of negative amounts in computing additional Section 263A costs for purposes of the simplified production method. Taxpayers were using negative numbers to decrease the costs required to be capitalized under Section 263A. One example was occurring when costs were being capitalized for financial statement or Section 471 purposes but not required to be capitalized under Section 263A. This would result in the decrease of ending inventory that would exceed the related costs originally capitalized into ending inventory and result in a smaller adjustment. A taxpayer could be capitalizing depreciation for financial statement purposes but not be required to capitalize for section 263A and thus creating a "negative" adjustment in the numerator of the 263A calculation. Thus a taxpayer's method of removing the 263A cost could result in the elimination of an amount different then the amount that would be removed if the taxpayer changed what was included in their Section 471 costs. The IRS issued interim guidance (Notice 2007-29) that suspended this practice until further guidance was issued.
Using the modified simplified production method allows a taxpayer to include negative amounts in their calculation while still allowing them to allocate additional costs to both raw materials, work in process and finished goods in a way that better reflects pre-production and production costs. Taxpayers who choose to continue using the simplified production method will have to remove any negative adjustments from their calculation and continue using one absorption ratio in their calculation.
By prohibiting the removal of Section 471 costs from inventory via the Section 263A computation for taxpayers using certain methodologies, the proposed regulations would require most large taxpayers to file an accounting method change either to use the new modified simplified production method or to remove such "negative Section 263A" costs using a reasonable method that approximates the manner in which the costs were originally capitalized to inventory. It remains to be seen what methods the IRS will consider reasonable for this purpose.
While the regulations are not final, there is opportunity for taxpayers to start planning for the change and how they can gather the necessary information that is currently proposed under the regulations. Filing of an accounting method change under the new regulations provides audit protection to open tax years and gives the taxpayer who might not be on an acceptable method of accounting to comply with the regulations.
The advantage of capitalizing fewer costs into ending inventory under the modified simplified production method should encourage food processors to switch to this new method even if it requires some additional work.