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IRS Will No Longer Challenge Negative Additional Sec. 263A Costs

IRS will not challenge taxpayers who use their allocation methods to apportion negative costs between ending inventory and cost of goods sold.

June 2007
from The Tax Adviser

Negative additional Sec. 263A costs generally arise when taxpayers capitalize certain expenses for financial accounting purposes, even though they are not required or permitted to capitalize them for tax purposes. The Service recently issued Notice 2007-29 to provide interim guidance on this issue. Until further guidance is published, the IRS has stated that it will not challenge taxpayers who use their Sec. 263A allocation methods to allocate negative costs between ending inventory and cost of goods sold.

Generally, negative additional Sec. 263A costs are costs that are not required or permitted to be capitalized for Federal income tax purposes, but are capitalized for financial reporting purposes. These costs may be reflected as unfavorable Schedule M adjustments (such as excess book over tax depreciation), or they may not be required to be capitalized for Federal income tax purposes (such as Sec. 174 costs), but have to be included in Sec. 471 costs.

Notice 2007-29

In the notice, Treasury and the IRS announced that they are reviewing the propriety of using negative Sec. 263A costs in computing additional costs for purposes of the simplified accounting methods under Sec. 263A (the uniform capitalization rules (UNICAP)). Until future guidance is published, Notice 2007-29 provides that:

  1. The Service will not challenge the inclusion of negative amounts in computing additional costs under Sec. 263A or the permissibility of aggregate negative additional Sec. 263A costs;
  2. The IRS will not raise these issues in any tax year ending on or before publication of anticipated guidance;
  3. If already raised as an issue in examination or before Appeals or the Tax Court, the issue will not be pursued by the Service; and
  4. The IRS will not deny consent for changes in method of accounting solely on the basis that the proposed method involves the inclusion of negative amounts in computing additional costs under Sec. 263A. However, it will not grant a taxpayer permission to treat a cost as a negative Sec. 263A cost unless the taxpayer already treats it as a Sec. 471 cost. In Notice 2007-29, the government also requested comments as to types of costs and instances in which negative Sec. 263A costs are appropriate, as well as possible modifications or additions to the existing simplified methods for allocating those costs.

In Notice 2007-29, the government also requested comments as to types of costs and instances in which negative Sec. 263A costs are appropriate, as well as possible modifications or additions to the existing simplified methods for allocating those costs.

Overview

Sec. 263A provides specific capitalization rules for certain producers and resellers. Prior to its enactment, manufacturers were required to follow the full-absorption rules provided in Regs. Sec. 1.471-11 when valuing their inventories for tax purposes. In many respects, those rules mirrored a taxpayer’s book method of costing its inventory, in part because the tax treatment of costs listed in Regs. Sec. 1.471-11(c)(2)(iii) de-pended on the taxpayer’s financial reporting method. Consequently, prior to the enactment of UNICAP, the value of a taxpayer’s tax inventory would frequently closely approximate its book value.

The legislative history underlying Sec. 263A indicates that Congress believed that the full-absorption rules may have allowed manufacturing costs to be deducted currently when such costs would be more appropriately included in the basis of the property produced and recovered when the property was sold. In addition, it wanted to provide consistency as to the types of costs required to be capitalized for both manufacturers and resellers; it enacted Sec. 263A to provide for the capitalization of costs in addition to those required to be capitalized under the full-absorption rules. For this reason, Sec. 263A is generally regarded as an add-on provision.

The Sec. 263A regulations, as well as the Sec. 461(h) economic-performance rules, clarified that certain costs (such as Sec. 174 costs and unfavorable Schedule M items) were not required or permitted to be included in a taxpayer’s tax inventory. Consequently, taxpayers that capitalized such costs for financial accounting purposes were required to remove them from tax inventory to comply with Sec. 263A — a negative additional Sec. 263A adjustment.

The Problem

The problem is that the IRS was not comfortable with negative additional Sec. 263A adjustments. Regs. Sec. 1.263A-1(d)(2), (3) and (4) define three types of costs:

  1. Sec. 471 costs: Generally, these are the costs, other than interest, capitalized under the taxpayer’s accounting method immediately before the effective date of Sec. 263A.
  2. Additional Sec. 263A costs: Generally, these are the costs, other than interest, not capitalized before the effective date of Sec. 263A, but required to be capitalized under that provision.
  3. Sec. 263A costs: These are the costs a taxpayer must capitalize under Sec. 263A.

Regs. Sec. 1.263A-1(d)(2) clarifies that Sec. 263A costs are the sum of a taxpayer’s Sec. 471 costs, its additional Sec. 263A costs and interest. Thus, to ensure that its Sec. 263A costs are not overstated, a taxpayer whose Sec. 471 costs include amounts not required or permitted to be capitalized under Sec. 263A (inappropriate costs) must reduce its additional Sec. 263A costs by the inappropriate costs. Otherwise, the taxpayer’s Sec. 263A costs would exceed the total costs it must capitalize under Sec. 263A, in direct conflict with the definition of Sec. 263A costs. Thus, negative Sec. 263A costs are needed in conjunction with simplified methods to adjust for the capitalization of inappropriate costs.

Many taxpayers desiring to determine their inventory for tax purposes in a manner that was consistent with UNICAP applied their Sec. 263A allocation methods to add costs to and remove costs from their inventory values reported for financial accounting purposes (generally, their Sec. 471 costs). Despite the apparent need for negative additional Sec. 263A costs, Service field examiners mounted challenges to taxpayers that included negative amounts in their additional Sec. 263A costs.

In TAM 200607021, the IRS finally articulated in published form its concern with the inclusion of negative amounts in a taxpayer’s additional Sec. 263A costs. It explained that because Sec. 471 costs (generally, the costs a taxpayer includes in inventory for book purposes) are usually allocated to inventory under a different method than that used to allocate additional Sec. 263A costs, the costs removed under additional Sec. 263A allocation methods will generally differ from the costs allocated to inventory under a taxpayer’s book-inventory method. The TAM, however, did not address the evident mandate of the regulatory definitions or Congress’s expectation that the Sec. 263A regulations would adopt simplifying methods of allocating additional costs.

Recognizing the continued uncertainty surrounding the permissibility of negative additional Sec. 263A costs, forthcoming guidance was announced in the 2003-2004 Treasury/IRS Business Plan. This guidance project was also included in the business plans for 2004-2005, 2005-2006 and 2006-2007. Finally, in Notice 2007-29, the government published the much-anticipated guidance.

Notice’s Effect

As mentioned above, the Service announced in Notice 2007-29 that it will not challenge, and will no longer pursue in cases in which it has challenged, the inclusion of negative amounts in a taxpayer’s additional Sec. 263A costs. The government is also considering amending the Sec. 263A regulations to ban the use of some or all negative amounts in computing additional Sec. 263A costs. This is an apparent affirmation that negative Sec. 263A costs were indeed contemplated by the current regulations.

Notice 2007-29 provides taxpayers with much-desired certainty surrounding their methods of removing costs not required or permitted to be capitalized. Consequently, taxpayers whose methods have been under IRS scrutiny should bring the notice to the attention of the government representative reviewing the position taken.

In addition, and perhaps more significant, Notice 2007-29 provides that the Service will not deny consent for accounting-method changes solely on the basis that the proposed method involves the inclusion of negative amounts in computing additional costs under Sec. 263A. This provides taxpayers with certainty that Form 3115, Application for Change in Accounting Method, filed under either the advance-consent provisions of Rev. Proc. 97-27 or the automatic-consent provisions of Rev. Proc. 2002-9, as modified or amended, will not be rejected solely on the basis that the proposed method involves the inclusion of negative amounts in computing additional Sec. 263A costs. Consequently, Notice 2007-29 appears to encourage taxpayers whose Sec. 471 costs include expenses either not required or permitted to be capitalized for Federal income tax purposes, to consider filing Form 3115 to change their accounting method and begin removing such costs, provided such costs are not being removed under their current method.

Taxpayers are cautioned, however, to ensure that the applications are complete and accurate, because Forms 3115 that include negative additional Sec. 263A costs could undergo additional scrutiny.

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Michael Lueck, J.D., Detroit, MI, and John Suttora, CPA, Washington, DC, are contributing writers of The Tax Adviser. Their views as expressed in this article do not necessarily reflect the views of the AICPA or The Tax Adviser.