FBA ANNUAL TAX CONFERENCE An Analysis of the Impact of the New UNICAP Regulations #TaxLaw19 #FBA
Moderator Les Schneider, Ivins, Phillips & Barker Washington, D.C. Panelists Carol Conjura, KPMG Washington, D.C. Scott Rabinowitz, Skadden, Arps Washington, D.C. Scott Dinwiddie, Associate Chief Counsel Income Tax & Accounting, Internal Revenue Service Natasha Mulleneaux Branch VI, Income Tax & Accounting, Internal Revenue Service Ellen Martin, Attorney-Advisor Office of Tax Legislative Counsel, U.S. Treasury
Background 1. After evaluating the operation of the simplified production method (“SPM”) for a number of years, the IRS reached the conclusion that the allocation formula that was contained in the SPM had the potential to create distortions in computing the cost of a taxpayer’s inventory. a. In some cases, the SPM over-allocates additional § 263A costs to a taxpayer’s ending inventory in comparison to a facts-and- circumstances allocation method. b. In other cases, the SPM under-allocates additional § 263A costs to a taxpayer’s ending inventory. 3
2. In the light of the foregoing conclusions, the Treasury and IRS issued proposed regulations several years ago that provided a new modified and simplified production method (“MSPM”) to correct the distortions that the IRS perceived were present under the SPM. The preamble to those proposed regulations also alluded to various a. issues with respect to the classification of additional § 263A costs that might more properly be regarded as components of direct costs (i.e., direct material costs or direct labor costs). However, no explicit guidance was provided on that issue. b. 4
3. In response to the proposed regulations, numerous criticisms were received by the IRS and Treasury concerning the operation of the original proposed version of the MSPM. Complaints were registered regarding the vague guidance in the a. preamble concerning costs that might be classified as direct costs. In addition, there were complaints that data was not available to b. calculate the appropriate burden rates under the new MSPM because of the need to split out the raw material content of work-in-process, finished goods from labor, overhead costs, and allocate that raw material content together with raw materials. 5
4. Accordingly on November 19, 2018, new final regulations were issued. These regulations contain a revised version of that MSPM. a. However, these final regulations also contain detailed, and in some b. respects, extremely burdensome new rules for determining the starting point for all of the simplified allocation methods, including the new MSPM. 5. These new regulations are generally effective for the 2019 taxable year, but a taxpayer may optionally apply the new regulations to any taxable year beginning before November 20, 2018 and ending after that date (i.e., 2018 calendar taxable years). 6
The Starting Point for Tax UNICAP Calculations 1. The starting point for SPM and MSPM calculations is the inventory method that is presently used for financial reporting purposes. The general rules are that the starting point for the calculations under the SPM or MSPM, which is described as a taxpayer’s “§ 471 costs,” are based on the types of costs included in the inventoriable costs for financial reporting purposes. Treas. Reg. § 1.263A-1(d)(2)(i). 7
2. To treat a taxpayer’s § 471 costs as taking into account the amount of costs included in the inventoriable costs in their financial statements, they must also elect to use the new so-called “alternative method.” Treas. Reg. § 1.263A-1(d)(iii). If a taxpayer’s financial statements are subject to audit by a. independent certified public accountants, they must elect to use the MSPM in order to be able to treat both the types of costs and the amounts of costs included in the inventoriable costs for financial reporting purposes as their § 471 costs. Treas. Reg. § 1.263A- 1(d)(2)(iii)(A). However, certain small taxpayers may elect the alternative method b. without electing the MSPM. 3. Question- Why did the IRS adopt this complex regime? Why not simply adopt the rule that except for certain small taxpayers, a taxpayer must elect the MSPM to get the benefit of using the amount of the inventoriable costs included in their financial statements as its § 471 costs? 8
Exceptions to the § 471 Cost Starting Point 1. Even if a taxpayer elects the alternative method, modifications may need to be made to the starting point for a taxpayer’s UNICAP allocation system in three areas. 2. Before addressing the exceptions to this requirement, several questions are posed... Question- Why didn’t the IRS simply adopt the AICPA suggestion that a. the amount of a taxpayer’s inventoriable costs in financial statements is the starting point for the SPM and MSPM, and any costs excluded from the inventoriable costs for financial reporting purposes, whether direct or indirect, may be treated as an additional § 263A cost? 9
Question- If a taxpayer is required to treat a component of direct b. costs that has been excluded from the inventoriable costs for financial reporting purposes as a § 471 cost, what degree of specificity is required as part of such treatment? Must the taxpayer carry the allocation of such a cost down to the level of the unit cost of each individual item in the taxpayer’s inventory? Question- In the past, the IRS has been concerned about taxpayers c. that included direct costs in the inventoriable costs for financial reporting purposes, but treated such direct costs as indirect costs. TAM 200437006. The new final regulations appear to allow such treatment, as all of the restrictions on reclassifying direct costs as § 471 costs appear to relate to costs that are entirely excluded from the inventoriable costs for financial reporting purposes. As a result, a taxpayer treating a direct costs as an indirect cost for financial reporting purposes, but nevertheless including the cost in the inventoriable costs need not reclassify that cost as a direct cost. Is that correct? 10
3. Turning to the exceptions from treating all the inventoriable costs for financial reporting purposes as additional § 263A costs that are either: Costs that should be included in direct material costs. a. Costs that should be included in direct labor costs. b. Standard cost variances or unabsorbed burden, in an allocation c. system where a burden rate method is used. 4. These exceptions apply to taxpayers using either SPM, MSPM, or the SRM. 1 1
5. Exception One for a direct material costs: If a taxpayer excludes a component of direct material costs, such as a. freight-in or cash or trade discounts, from the inventoriable costs for financial reporting purposes, such a taxpayer may be required to treat those direct material costs as an adjustment to their § 471 costs, rather than as an additional or negative additional, § 263A cost, unless the taxpayer satisfies a de minimis test in the regulations. Treas. Reg. § § 1.263A-1(d)(2)(II)(A) & (B). This requirement applies even to a taxpayer that uses the alternative b. method. However, if the taxpayer uses the alternative method, this c. requirement does not apply to a Schedule M adjustment with respect to the amount of a direct material cost, so that if the book amount of the component of direct material costs is included in the inventoriable costs for financial reporting purposes, a Schedule M adjustment for the amount of that cost may be treated as an additional § 263A cost, regardless of the de minimis test. 12
Question- Why do the regulations separate the treatment of book d. amounts from tax amounts, once it has been determined that a direct cost has been excluded from the inventoriable costs for financial reporting purposes? To apply the de minimis test, the taxpayer must compute a ratio, the e. numerator of which is the amount of direct material cost components that are excluded from the inventoriable costs (computed on a book basis and by aggregating positive and negative amounts) and the denominator of which is the total amount of raw materials’ costs incurred (computed on a book basis). Treas. Reg. § 1.263A-1(d)(2)(iv)(C). If the ratio is less than 5%, the taxpayer may treat the excluded f. direct material costs as additional § 263A costs. If the ratio equals or exceeds 5%, the taxpayer must treat the book g. amount of the excluded direct material costs as an adjustment to § 471 costs, rather than as an additional § 263A cost. Question- Why are positive and negative amounts netted in this h. test? 13
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