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William Brighenti, Certified Public Accountant
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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

William Brighenti, Certified Public Accountant, Certified QuickBooks ProAdvisor, Accountants CPA Hartford, LLCIn 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.

If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose. The above tax advice was written to support the promotion or marketing of the accounting practice of the publisher and any transaction described herein. The taxpayer recipients of this offering memorandum should seek tax advice based on their particular circumstances from an independent tax advisor .
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