Does your business own or hold inventory?
If you answered yes, you may be subject to tax adjustments that may have a significant impact on your tax liability. Furthermore your business must also be in compliance with the Uniform Capitalization Rules in Section 263A.
The uniform capitalization (UNICAP) rules of Internal Revenue Code (IRC) Section 263A state that certain costs that are normally expensed need to instead be capitalized or treated as product cost for income tax purposes; this means that you may not get to deduct these costs in the current tax year.
Costs subject to the UNICAP rules include:
- Rent
- Real Estate Taxes
- Utilities
- Wages
- Other costs your business incurs in order to maintain its inventory.
In essence, a business that is subject to UNICAP will not be able to deduct certain costs associated with inventory until the inventory is sold, this will result in a higher tax liability than if the business were not subject to UNICAP. The UNICAP rules generally always apply to manufacturers and producers, but there are special rules for resellers. Resellers of real property are always subject to the UNICAP rules, but there’s a small reseller exception for those dealing in personal property who have a 3-year average of $10 million or less in gross receipts. If you ignore the UNICAP rules you may face significant penalties for non-compliance, it is important to be in compliance with the UNICAP rules as well as prepare for the effect of the adjustments that take place on your annual tax returns.
So what are these “certain costs” that fall under Section 263A? All direct costs should be capitalized, which include acquisition costs of property for resale or direct material and direct labor costs for manufacturers and producers. Any indirect costs properly allocable to property produced or acquired for resale should also be capitalized. This means that any cost that directly benefits or is incurred in the performance of production or resale activities should be subject to capitalization.
Some examples of these indirect costs are:
- Handling and Storage
- Purchasing costs
- Employee benefits
- Rent
- Utilities
- Insurance
- Interest
- (specific rules apply given different scenarios), taxes, licensing and trademark royalties, engineering and design, and bidding costs—to only name a few.
It’s important to note that not all indirect costs directly benefitting production or resale should be automatically capitalized. Instead, the key to applying Section 263A is a “reasonable allocation” of indirect costs relative to production activities and other activities. The method of allocation can be done based on specific identification, standard cost, utilization of burden rates, election of one of the simplified methods allowed by the IRS, or any other reasonable allocation method as long as it’s applied consistently and without circumvention of the simplified methods.
Most businesses find that the most cost effective way of applying the UNICAP rules is to elect one of the simplified uniform capitalization methods:
- The simplified production method
- The simplified service cost method
- The simplified resale method
All in all, UNICAP may sound overwhelming, but garvey & garvey, CPAs can easily assist business owners with establishing a method that is appropriate for them so that there are no unwelcome surprises when an audit rolls around.