How to Apply
UNICAP:
Uniform Capitalization Rule 263A
Simplified Production Method and
Simplified Service Cost Method are really simple!
by William Brighenti,
Certified Public Accountant, Certified QuickBooks ProAdvisor
Accountants CPA
Hartford, LLC, Berlin, Connecticut
In concept, the uniform capitalization
(UNICAP) rules of the
Internal Revenue Code Section 263A appear straightforward and not too
difficult to understand: producers of tangible property (except those
specifically excluded) must include in inventory the indirect costs,
including mixed service costs, as
well as the direct costs of producing that inventory. The difficulty of
the UNICAP rule arises in its application: how to property allocate the
additional indirect and mixed service costs required to be capitalized
under Section 263A
in a reasonable and consistent manner. This is primarily a result of
the confusing and ill-defined terminology throughout Section 263A and
its related regulations.
The most publicized approach to capitalize indirect and mixed service
costs to inventory
under the requirement of the Uniform Capitalization Rules is to use
Section 1.263A 2(b)'s simplified service cost method in conjunction
with its simplified production method. In essence, this approach of
applying the Uniform Capitalization Rules involves a sequential three
step process: first, determining what portion of the mixed
service costs are allocable to production; then, secondly, calculating
the percentage of additional Section 263A costs to capitalized
production costs; and, thirdly, increasing ending inventory by this
percentage of additional Section 263A costs to be capitalized
determined in step two. These three steps in the capitalization
of indirect costs to inventory are presented below in more detail,
employing the simplified service cost method in step one, and the
simplified production method in steps two and three.
But in order to understand the calculations, the variables in the
formulas of the simplified service cost and production methods need to
be clearly defined first.
"Section 471 costs" are
defined by the Treasury Department in its own inimitable, enigmatic
manner, as those costs which were included in inventory under the
entities method of accounting immediately prior to the effective date
of the Uniform Capitalization Rules. In plain English, they are those
costs that the taxpayer already has capitalized to inventory prior to
including the additional Section 263A costs. Section 471 costs include
direct material costs, direct labor cost, and allocated indirect costs.
Indirect costs often allocated to inventory prior to allocating
additional Section 263A costs include independent contractors,
supplies, tools, equipment, engineering, design, and the like.
“Indirect costs” are costs
other than direct material costs and direct labor costs in the case of
property produced. Taxpayers subject to section 263A must capitalize
all indirect costs when the costs directly benefit or are incurred by
production activities. Indirect costs may be allocable to production
activities as well as to other activities that are not subject to
section 263A. Taxpayers subject to section 263A must make a reasonable
allocation of indirect costs between production and other
activities. Indirect costs are allocated using either a specific
identification method, a standard cost method, a burden rate method, or
any other reasonable allocation method.
"Mixed service costs"
are defined by the Treasury Department as service costs that are
partially allocable to production or resale activities (capitalizable
mixed service costs) and partially allocable to non-production or
non-resale activities (deductible mixed service costs). Or in
more concise English, they are service costs that are only partially
allocable to production activities. Service costs are a type of
indirect cost. They are general and administrative costs,
typically administrative, supportive, and of service in nature.
Examples include purchasing, handling, warehousing, security, cost
accounting, data processing, production coordination costs. Mixed
service and indirect costs exempt from capitalization include
marketing, selling, advertising, income taxes, tax services,
distribution, research and experimental, warranty, etc.
"Additional 263A costs"
include mixed service costs allocable to production activities and
indirect production costs not already capitalized by the producer. It
is because of these costs that the Uniform Capitalization Rule evolved
in order to allocate and capitalize them. The simplified service and
simplified production methods are the Internal Revenue Service's
specifically recommended means of implementing the Uniform
Capitalization Rule. Since previous years' additional 263A costs
presumably have already been capitalized in prior years, additional
263A costs equals current year additional 263A costs.
Assuming a first-in, first-out (FIFO) inventory flow, the first step in
capitalizing these additional Section 263A costs is to calculate the
portion of mixed service costs allocable to production by using the
simplified service cost method:
Production Mixed Service Costs
=
Total
Production Costs for Year, |
|
|
excluding
Mixed Service Costs and Interest |
|
|
|
X
|
Total
Mixed Service Costs
|
Total
Costs for the Year, excluding Mixed Service Costs |
|
|
Interest,
and Federal, State, and Local Income Taxes |
|
|
The numerator, referred to by the IRS as "Total Section 263A Production Costs Total
for the Year",
includes direct labor, direct materials, indirect costs incurred during
the year, excluding mixed service cost and interest. The denominator,
"total costs for the year", includes all current year production and
non production costs of the taxpayer's trade or business, except mixed
service costs, interest, and income taxes: e.g., direct and indirect
costs allocable to property produced; salaries and other labor costs of
all personnel; all depreciation taken for federal income tax purposes;
research and experimental expenditures; and selling, marketing, and
distribution costs.
The second step is the computation of an "absorption ratio" in order to
allocate the unapplied indirect production costs and production related
mixed service costs to ending inventory.
|
|
Current
Year Additional Section 263A Costs |
Absorption Ratio |
= |
|
|
|
Current
Year Section 471 Costs |
The current year additional Section 263A costs includes mixed service
costs allocable to production plus allocable indirect production costs
incurred during the year; the current year Section 471 costs include
all production costs incurred and allocated during the year.
The third step is the actual computation of the additional Section 263A
costs allocable to ending inventory on hand at the end of the taxable
year.
Section 263A
Costs to Add in Ending Inventory =
Absorption
Ratio |
X
|
Section
471 Costs in Ending Inventory |
This amount computed above would simply be added to the ending
inventory amount on the books.
For a last-in, first-out inventory cost flow assumption, the absorption
ratio would be applied to the increment or decrement in Section 471
costs. An increase in Section 263A costs would be added to the Section
263A costs at the beginning of the year; a decrease would be subtracted.
Assume the following data for a manufacturing company:
|
Inventory,
January 1, 2009: |
|
|
|
|
|
Section 471 Costs |
|
|
300,000 |
|
|
Additional
Section 263 Costs |
|
|
50,000 |
|
|
Beginning
Inventory |
|
|
350,000 |
|
|
|
|
|
|
|
|
Year 2009 Section 471 Costs: |
|
|
|
|
|
Direct Labor |
2,500,000 |
|
|
|
|
Direct Materials |
2,000,000 |
|
|
|
|
Indirect Production Costs
|
500,000 |
|
|
|
|
Current Section
471 Costs |
|
|
5,000,000 |
|
|
|
|
|
|
|
|
Year 2009 Additional 263A Costs:
|
|
|
|
|
|
Indirect
Production Costs Not Already Capitalized
|
|
|
|
|
|
Pension |
100,000 |
|
|
|
|
Depreciation |
150,000 |
|
|
|
|
Rent |
60,000 |
|
|
|
|
Insurance |
150,000 |
|
|
|
|
Repairs and
maintenance |
40,000 |
|
|
|
|
Current Indirect
Production Costs Not Already Capitalized
|
|
|
500,000 |
|
|
|
|
|
|
|
|
Mixed Service
Costs |
|
|
|
|
|
Accounting |
80,000 |
|
|
|
|
Office salaries |
205,000 |
|
|
|
|
Legal |
30,000 |
|
|
|
|
Warehousing |
50,000 |
|
|
|
|
Security |
35,000 |
|
|
|
|
Current Mixed
Service Costs |
|
|
400,000 |
|
|
|
|
|
|
|
|
Indirect/Mixed
Service Costs Exempt from Section 263: |
|
|
|
|
|
Marketing |
100,000 |
|
|
|
|
Selling |
125,000 |
|
|
|
|
Advertising |
150,000 |
|
|
|
|
Income taxes |
100,000 |
|
|
|
|
Distribution |
200,000 |
|
|
|
|
Warranty |
75,000 |
|
|
|
|
Total Exempt Costs |
|
|
750,000 |
|
|
|
|
|
|
|
|
Inventory,
December 31, 2009: |
|
|
|
|
|
Section 471 Costs |
|
|
500,000 |
|
The first step is to calculate the portion of the
mixed service costs that are allocable to production. Note that
the Total Production Costs for the
Year, excluding Mixed Service Costs
and Interest, includes not only 2009 Section 471 costs but also
2009 Additional 263A's indirect production costs.
|
|
5,000,000
+ 500,000 |
|
|
|
|
Production Mixed Service Costs |
=
|
|
X
|
400,000 |
=
|
352,000 |
|
|
5,000,000
+
500,000 + 750,000 |
|
|
|
|
The second step is to calculate the Absorption
Ratio in order to
allocate the unapplied indirect production costs and production related
mixed service costs to ending inventory. Observe that the Absorption Ratio's 2009
Additional Section 263A Costs includes not only the mixed service costs
allocable to production but also the indirect production costs not
already capitalized.
|
|
500,000
+ 352,000
|
|
|
Absorption Ratio
|
= |
|
= |
17% |
|
|
5,000,000 |
|
|
The third step is to compute the applicable amount of Section 263A
costs to allocate to ending inventory.
Section 263A Costs to Add
in Ending Inventory |
= |
17% |
X |
500,000 |
= |
85,000 |
Finally, just add this additional amount to the Section 471 costs
already capitalized in ending inventory.
Consequently, Ending Inventory
= 500,000 + 85,000 = 585,000.
Once you understand the different terminology employed in the
simplified service cost method and the
simplified production method, the UNICAP computation is fairly straight
forward: first compute the mixed service costs allocable to
production by using the simplified service cost method; secondly,
compute the absorption ratio using the simplified production method;
and, thirdly, allocate the production mixed service costs and the
uncapitalized indirect production costs to ending inventory using the
simplified production method. One, two, three, and the
implementation of the Uniform Capitalization Rule of Section 263A is
complete. All that is required is understanding the different
terminology of UNICAP and the three computational steps required!
In conclusion, it is worth noting that the uniform capitalization rules
do not apply to certain producers who
use a simplified production method and whose total indirect costs are
$200,000 or less nor to resellers of personal property with average
annual gross receipts of $10 million or less for the 3 prior tax years.
Have a tax or an accounting question? Please feel free to submit it to William
Brighenti, Certified Public Accountant, Certified
QuickBooks ProAdvisor under "Comments". For information and
assistance on any tax
and accounting issue, please visit our website: Accountants CPA Hartford, LLC.
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