The Uniform Capitalization (UNICAP) rules of section 263A of the Internal Revenue Code (IRC) prescribe the method for determining the types and amounts of costs that must be capitalized, rather than expensed in the current period.
The UNICAP rules apply to those, who in the course of a trade or business, produce real or tangible personal property for the use in the business or activity; produce real or tangible personal property for sale to customers; or acquire property for resale. However, if the taxpayer’s annual gross receipts do not exceed $10 million the rules do not apply.
To determine whether or not an activity is a production activity, several factors must be considered, including whether the process adds utility to the product, makes the product more suitable for use or consumption, or transforms the material into more readily marketable materials.
The UNICAP rules require a taxpayer to capitalize all direct costs and certain indirect costs properly allocable to property produced or property acquired for resale.
Direct costs are defined as the direct material costs and direct labor costs for a producer and the acquisition costs for a reseller.
Indirect costs are defined as all costs other than those considered direct material costs and direct labor costs or acquisition costs. Indirect costs are properly allocable to property produced when the costs directly benefit or are incurred by reason of the performance of production activities. Indirect costs can be categorized into two groups: those that must be capitalized and those that are allowed to be expensed in the current period.
The UNICAP rules allow for certain indirect costs to be expensed in the current period. These costs include the marketing, selling, advertising, and distribution expenses, general and administrative expenses not related to production, non-production officers salaries, research and experimental expenses, as well as depreciation, amortization and cost recovery allowances on equipment and facilities that are temporarily idle.
A taxpayer that produces property must capitalize all costs incurred before, during and after the production process of the property. Pre-production costs must be capitalized, including the costs of storing raw materials and the carrying costs related to the holding of realty for future development. Production period costs are those costs that fall between the date on which production begins and production ends. Production is deemed to have ended once the property is placed in service or ready for sale. Any costs incurred after the production process would be considered a post production costs. Post production activities include storage, warehousing, insurance, and handling. Interest, however, need only be capitalized during the production stage.
There are various methods that can be used to allocate the direct and indirect costs to the property produced. Depending on the taxpayer’s needs and type of production, a specific and detailed identification method can be used. These methods, the burden rate method and the standard cost method tend to be rather complex and may not be suitable for all taxpayers.
The most common approach to capitalizing indirect costs to inventory under the UNICAP rules is to use the simplified service cost method in conjunction with its simplified production method.
The approach uses a three step process to apply the UNICAP rules. The taxpayer determines what portion of the mixed service costs is allocable to production. The costs should be classified into one of three different categories:
- Costs that can be capitalized
- Deductible costs and
- Mixed service costs. Mixed service costs are defined as those costs that are only partially allocable to production activities. These costs are generally administrative or supportive in nature.
The taxpayer will then calculate the percentage of additional section 263A costs to capitalize to production costs. The additional 263A costs include mixed service costs allocable to production activities and indirect production costs that have not already been capitalized by the taxpayer. The additional 263A costs are then divided by the current year’s code section 471 costs. These are the costs that were included in the entities method of accounting immediately prior to the effective date of the UNICAP rules. The regulations refer to this computation as the absorption ratio.
Finally, the taxpayer will multiply the computed absorption ratio with the code section 471 costs. The resulting number will then be added to the ending inventory amount.
The UNICAP rules will affect almost any corporation that has inventories. Many of the costs that were previously deductible as period costs are now accumulated and allocated between the costs of goods sold and inventory. The UNICAP rules delay the expensing of capitalized costs which ultimately results in the acceleration of taxable income.