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Capitalization Period of Direct and Indirect Costs

Method Pre-Production
Costs to be Expensed
Production
Costs to be Capitalized
Pre-Sale
Costs to be Expensed
Sale
Costs to be Expensed

Full Absorption
(i.e., GAAP)

Design Costs
Bidding Expense
Purchasing

Direct Materials
Direct Labor
Direct Production Costs
Indirect Production Costs

Storage
Handling
Excise Tax

Selling Costs
Distribution Costs
Income Taxes
Warranty Costs
Excise Tax

 

Method Pre-Production
Costs to be Capitalized
Production
Costs to be Capitalized
Pre-Sale
Costs to be Capitalized
Sale
Costs to be Expensed

UNICAP -
§ 263A

Design Costs
Bidding Expense
Purchasing

Direct Materials
Direct Labor
Direct Production Costs
Indirect Production Costs

Storage
Handling
Excise Tax (a)

Selling Costs
Distribution Costs
Income Taxes
Warranty Costs
Excise Tax (a)

(a) Depends on the timing of the levy; if before sale, tax is inventoriable; if after sale tax is a period cost.

Under the uniform capitalization rules, you must capitalize direct and indirect costs incurred during the pre-production and pre-sale periods in addition to the actual production period. Under the former full absorption rules direct and indirect costs are generally capitalized for the production period only.

Activities Subject to the Rules

You are subject to the uniform capitalization rules if you do any of the following in the course of a trade or business or an activity carried on for profit:

  • Produce real or tangible personal property for use in the business or activity
  • Produce real or tangible personal property for sale to customers
  • Acquire property for resale. However, this rule does not apply to personal property if your average annual gross receipts are $10 million or less

Producing Property

You produce property if you construct, build, install, manufacture, develop, improve, create, raise, or grow the property. Property produced for you under a contract is treated as produced by you to the extent you make payments or otherwise incur costs in connection with the property.

Tangible Personal Property

Under the uniform capitalization rules, this includes films, sound recordings, video tapes, books, artwork, photographs, or similar property containing words, ideas, concepts, images, or sounds. However, free-lance authors, photographers, and artists are exempt from the uniform capitalization rules if they qualify as explained next.

Exceptions to the Uniform Capitalization Rules

The uniform capitalization rules do not apply to:

  • Resellers of personal property with average annual gross receipts of $10 million or less for the 3 prior tax years
  • Property used for personal or non-business purposes or for purposes not connected with a trade or business or an activity conducted for profit
  • Research and experimental expenditures deductible under Section 174
  • Intangible drilling and development costs of oil and gas or geothermal wells or any amortization deduction allowable under Section 59(e) for intangible drilling, development, or mining exploration expenditures
  • Property produced under a long-term contract, except for certain home construction contracts described in Section 460(e)(1)
  • Timber and certain ornamental trees raised, harvested, or grown, and the underlying land
  • Qualified creative expenses incurred as a free-lance (self-employed) writer, photographer, or artist that are otherwise deductible on your tax return
  • Costs allocable to natural gas acquired for resale, to the extent these costs would otherwise be allocable to "cushion gas" stored underground
  • Property produced if substantial construction occurred before March 1, 1986
  • Property provided to customers in connection with providing services. It must be de minimus, and not be inventory in the hands of the service provider
  • Loan originations
  • The costs of certain producers who use a simplified production method and whose total indirect costs are $200,000 or less

Steps to Approaching Uniform Capitalization Rules

  1. Identify the entities production or resale activities.(Note, a business may be regarded as the producer of property if it contracts with another to produce such property)
    • Did you produce any self-constructed assets?
    • Did you produce property for sale to customers?
    • Did you resell property to customers?
  2. Determine the application of any special rules or exemptions.
  3. Identify the costs subject to capitalization.
  4. Allocate the mixed service costs to production or resale activities.
  5. Allocate all the direct and indirect costs that directly benefit or were incurred by reason of production or resale activities to the property produced or acquired for resale. See steps in computing Uniform Capitalization Allocation.
  6. Determine whether you produced "designated property," and, if so, the amount of interest required to be capitalized.

Identify the Costs Subject to Capitalization

As a threshold requirement, one must determine whether the costs would, but for Section 263A, be otherwise deductible. A cost that is not otherwise deductible may not be allocated to property produced or acquired for resale.

In addition, any cost required to be capitalized under Section 263A may not be included in inventory or charged to capital accounts or basis any earlier than the taxable year during which the amount is incurred within the meaning of Section 1.446-1(c)(1)(ii) of the Regulations. See, Section 1.263A-1(c)(2)(ii) of the Regulations.

After meeting these threshold requirements, the resulting pool of costs may be divided into three groups: (i) capitalizable costs, (ii) deductible costs, and (iii) mixed service costs. Section 263A requires the capitalization of direct and an allocable portion of the indirect costs that benefit or are incurred by reason of a production or resale activity.

Capitalizable costs except as otherwise provided, the direct and indirect costs that benefit or are incurred by reason of the production or resale activities must be capitalized to the property produced or acquired for resale.

Steps in Computing Uniform Capitalization Allocation

Section 1.263A 2(b) of the Regulations provides a simplified method of accounting for production costs. This method may be used in conjunction with the simplified method for allocating mixed service costs as provided by Section 1.263A 1(h) of the Regulations. After determining the total amount of additional Section 263A costs, a manufacturer must allocate these costs between cost of goods sold and its ending inventory. A manufacturer can allocate the additional Section 263A costs by using a facts and circumstances method, such as burden rate, or the simplified production method, which is provided by the regulations. The following are steps to apply the simplified production method.

1. Allocation of Mixed Service Costs to production or resale activities

Determine what percentage of the mixed service costs are required Section 263A costs. This may be accomplished using the Simplified Service Cost Method per Section 1.263A 1(h) of the Regulations. Once the costs have been segregated, it is a relatively simple allocation formula because it uses the entities own cost numbers as the basis. The formula is as follows:

 Total Mixed Service Costs

 x

Total Section 263A Production Costs Total for the year *


Total of all Costs for the year @ 

 =

Portion of mixed service costs allocable to production

Footnotes:

* = Amount excludes mixed service costs and interest. Includes the direct production and indirect production costs.

@=Amount includes all costs (production and non production) except those categorized as mixed service costs, interest and Federal/State/Local income taxes.

2. Computation of Absorption Ratio

You may then proceed with the allocation of the indirect production costs and production related mixed service costs. This can be accomplished through the Simplified Production Method as stated in Section 1.263A 2(b)(3)(ii) of the Regulations. The formula is similar to the mixed service cost method in that it relies upon the entities own numbers for the allocation method.

The absorption ratio is computed as follows:

Additional Section 263A Costs incurred during the taxable year #


Section 471 Costs incurred during the taxable year

 =

 absorbtion ratio

Footnote:

# = Amount includes mixed service costs allocable to production plus allocated indirect production costs.

3. Computation of the Section 263A Amount Allocable to Ending Inventory

Next compute the additional Section 263A costs allocable to ending inventory of property produced and other eligible property on hand at the end of the taxable year (Section 1.263A 2(b)(3)(i)(A) of the Regulations):

Absorption Ratio X Section 471 costs in ending inventory = Section 263A costs to add in ending inventory

The regulations define the Section 471 Costs as those which were included in inventory under the entities method of accounting immediately prior to the effective date of the Uniform Capitalization Rules.

Section 1.263A-2(b)(3)(iii) of the Regulations provides for special rules for use in conjunction with the LIFO inventory method. Taxpayers must first determine, without regard to additional § 263A costs, whether there has been an increment or decrement, then the taxpayer applies § 263A to the increment or decrement.

Example of the Simplified Production Method for Determining the Additional Section 263A Costs Allocable to Ending Inventory
IRC §1.263A-2(b)(3)(v), Example 1 - FIFO BASIS

The following illustrates the simplified production method for determining the additional section 263A costs properly allocable to ending inventories of a manufacturing company using the FIFO inventory method and accounts for indirect manufacturing costs consistent with Section 1.471-11 of the regulations.

 

Inventory at Beginning of Year:  
Section 471 Costs

$2,000,000

Additional §263A Costs

 $500,000

    Total Inventory at Beginning of Year

$2,500,000

   
Current Year Section 471 Costs:  
Direct Production Material Costs

$5,000,000 

Direct Production Labor Costs

$3,500,000 

Indirect Production Costs

$1,500,000

    Total Current Year Section 471 Costs

$10,000,000

   
Current Year Additional 263A Costs:  
Mixed Service Costs*

$600,000 

Indirect Production Costs - Section 1.263A-1(e)(3)(i)

$400,000

     Total

$1,000,000

Additional §263A Costs Allocated to Ending Inventory (As Computed Below)

($300,000)

Additional §263A Costs Taken into Account as Part of Cost of Goods Sold

$700,000

   
Inventory at End of Year:  
Section 471 Costs

$3,000,000

Additional §263A Costs per Simplified Production Method:  
   

Step 1 - Computation of Simplified Production Absorption Ratio:

Current Year Additional §263A Costs

$1,000,000

Divided By

÷

Current Year §471 Costs

$10,000,000

Equals Simplified Production Absorption Ratio

10%

 
   

 

Step 2 - Determine the Amount of Capitalizable Additional Section 263A Costs:

Current Year Section 471 Costs in Ending Inventory

$3,000,000

Multiplied By

x

Simplified Production Absorption Ratio

10%

Equals Amount of Additional Section 263A Costs Added to E/I

$300,000

 
    
Additional Section 263A Costs Allocated to Ending Inventory (As Computed Above) 

$300,000

Total Section 263A Costs Remaining on Hand at Year End

$3,300,000

   
* Computed under the simplified service cost method.  

 

UNICAP Guidelines

The following listing reviews common costs and the treatment required under UNICAP for costs that benefit or are directly associated with the production activities. Mixed Service Costs benefit the operation as a whole and must be allocated between the cost centers to which they apply.

Description

Production

Non-Production

Mixed Service Cost

Direct Labor

X

   

Direct Materials

X

 
 

Repairs/Maintenance - Production

X

   

Repairs - Not Production

 

X

 

Utilities

X

   

Rent

X

   

Indirect Labor

X

   

Material & Supplies

X

   

Small Tools & Equipment

X

   

Quality Control

X

   

Excise Tax (Paid Prior to Sale)

X

   

Income Taxes

 

X

 

Real Estate Taxes

X

   

Payroll Taxes

X

   

Depreciation

X

   

Amortization

X

   

Allocable Administration Costs

X

   

Officer's Salary (Production)

X

   

Insurance

X

   

Pension Plans

X

   

Employee Benefits

X

   

Bottling & Packaging Labor

X

   

Rework Labor (scrap, spoilage)

X

   

Warehousing

X

   

Off-site Storage

X

   

Purchasing Department

X

   

Shipping (Purchases)

X

   

Shipping (Sales)

 

X

 

Marketing & Promotion

   

X

Selling Expenses

 

X

 

Strikes

 

X

 

G&A - Directly for Production

X

   

Mixed Service Costs Personnel

   

X

Data Processing

 

X

 

Accounting

   

X

Security Services

   

X

Management - Overall Policy

X

   

Tax Department

X

   

Internal Audit

X

   

Direct Costs

  • Direct Labor
  • Direct Materials

Indirect Costs Required to be Capitalized

  • Indirect labor costs
  • Officers compensation
  • Pension and other related cost
  • Employee benefit expenses
  • Indirect material costs
  • Purchasing costs
  • Handling costs
  • Storage costs
  • Cost recovery allowances on equipment, including depreciation and amortization
  • Depletion
  • Rent
  • Taxes
  • Insurance
  • Utilities
  • Repairs and maintenance
  • Engineering and design costs
  • Spoilage
  • Tools and equipment
  • Quality control
  • Bidding costs
  • Licensing and franchise costs
  • Interest
  • Capitalizable service costs

Indirect Costs Not Required to be Capitalized

  • Selling and distribution costs
  • Research and experimental expenditures
  • IRC section 179 costs
  • IRC section 165 costs
  • Cost recovery allowances on temporarily idle equipment and facilities
  • Taxes assessed on the basis of income
  • Strike expenses
  • Warranty and product liability costs
  • On site storage costs
  • Unsuccessful bidding expenses
  • Deductible service costs
Page Last Reviewed or Updated: 16-Apr-2014