9

Uniform Capitalization Rules

§9.01 OVERVIEW Section 263A of the Code prescribes a single set of rules (the “Uniform Capitalization” or “UNICAP” rules) for determining the types and amount of costs that must be capitalized, rather than expensed in the current period. Under Section 263A, taxpayers must capitalize their direct costs and a properly allocable share of their indirect costs to property produced or property acquired for resale.1 To determine these capitalizable costs, taxpayers must allocate or apportion their costs to various activities, including production or resale activities. After Section 263A costs are allocated to the appropriate production or resale activities, the costs are allocated to the items of property produced or property acquired for resale during the taxable year and capitalized to the items that remain on hand at the end of the taxable year.2

§9.02 APPLICATION OF RULES §9.02(a) Generally The application of the UNICAP rules involves the steps listed below. • Step 1—It must be determined to whom or to what activities the rules apply.3 • Step 2—It must be determined what property is subject to the rules.4 • Step 3—It must be determined what costs are subject to the rules.5 • Step 4—Mixed service costs must be allocated between production/resale activities and other

activities of the taxpayer.6 • Step 5—Direct and indirect costs must be allocated to inventory.7 §9.02(b) Exemptions Exemptions from Section 263A capitalization include8 • Small resellers;9 • Long-term contracts;10 1 Reg. §1.263A-(1)(a). 2 With some exceptions, taxpayers subject to the Uniform Capitalization Rules must capitalize direct costs and an allocable portion of most indirect costs associated with production or resale activities. (Sections 263A(b), (c), (g)). Costs attributable to producing or acquiring property must be capitalized by charging the costs to capital accounts or basis. Costs attributable to property that is inventory in the hands of the taxpayer generally must be capitalized by including the costs in inventory. 3 See §9.03 et seq., below. 4 See §9.04 et seq., below. 5 See §9.05 et seq., below. 6 See §9.11 et seq., below. 7 See §9.13 et seq., below. 8 Reg. §1.263A-1(b). 9 See §9.04(b), below.

179

• Costs incurred in certain farming businesses; • Costs incurred in raising, harvesting, or growing timber; • Qualified creative expenses; • Certain not-for-profit activities; • Intangible drilling and development costs; • Natural gas acquired for resale; • Research and experimental expenditures; • Certain property that is substantially constructed; • Certain property provided incident to services; • Certain producers with total indirect costs of $200,000 or less; and • Loan originations. Moreover, inventories valued at market (under either the market method or the lower of cost or market method) are not subject to Section 263A capitalization, if the market valuation used by the taxpayer equals the property’s fair market value.

§9.03 TAXPAYERS/ACTIVITIES TO WHICH RULES ARE APPLICABLE

§9.03(a) Generally The UNICAP rules apply to • Retailers/wholesalers—merchandise for resale; • Manufacturers who produce property for sale; and • Taxpayers who construct assets for their own trade or business. §9.03(b) Trade Or Businesses Application §9.03(b)(1) Generally The UNICAP rules must be applied separately to each trade or business of the taxpayer.11 A taxpayer with several trades or businesses may elect to use a different method (including a simplified method authorized under Section 263A) for each trade or business. In general, the more trades or businesses within a particular centralized operation, the greater the flexibility in manipulating methods and costs within each business to minimize the effect of the Section 263A rules. Although the regulations do not define a trade or business, several factors are considered in determining what is a “trade” or “business” for the purpose of applying a method of accounting in Reg. §1.446-1(d), including • Whether a separate and complete set of books and records exists; • Whether no shifting of profits or losses between trades or businesses exists, so that income is

not clearly reflected; and • Whether each trade or business should be independent and self-sustaining.12

10 See §9.04(c), below. 11 Reg. §1.263A-1(j)(3). 12 Peterson Produce Co. v. United States, 313 F.2d 609 (8th Cir. 1963).

180 Fundamentals of Tax Accounting

§9.03(b)(2) Tax Planning Considerations For taxpayers with a significant mix of products with various inventory turnovers, the UNICAP costs allocated to inventory can be minimized by shifting a larger portion of the costs (primarily general and administrative (G&A) costs) to the business with higher inventory turnovers (lower inventory levels). This is particularly beneficial in an affiliated group situation in which centralized overhead can be reallocated to each trade or business to minimize the capitalization of costs. A company with several business segments may benefit from treating each segment as a trade or business. Careful tax planning should be done to qualify each segment as a separate business. It should be noted, however, that once a trade or business has been established for applying the UNICAP rules, any change in that business constitutes a change in accounting method. §9.03(c) Production Activities §9.03(c)(1) Generally To apply the UNICAP rules properly, it is frequently necessary to know whether a taxpayer is engaged in a “production activity” (as opposed to a resale activity). Reg. §1.263A-2(a)(1)(A) sheds some light on the meaning of the root term “produce.” The regulation makes it clear that to construct, build, install, manufacture, develop, improve, create, raise, or grow is “to produce” within the meaning of Section 263A of the Code. In determining whether an activity is a “production activity,” several factors need to be considered, including whether the process • Adds utility to the product; • Makes the product more suitable for use or consumption; or • Transforms materials into more readily marketable materials. In Revenue Ruling 81-272,13 the IRS described several situations in which it determined that the processes engaged in by “hypothetical” companies constituted “production activities.” • A company buys white towels and arranges for an unrelated party to dye and design them. The

taxpayer retains title, and after processing is complete, stores, packages, and distributes the towels to its customers.

• The second situation is the same as the first except that an unrelated party stores, packages, and distributes the towels.

• A company purchases doll parts, assembles them, and markets the final product. • A printer and engraver purchase raw paper and print or engrave the paper in accordance with

customer specifications.

The underlying rationale for the IRS Ruling was that the processes added utility to the product and/or made it more suitable for consumption. 13 Rev. Rul. 81-272, 1981-2 C.B. 116.

Brunetti 181

§9.03(c)(2) Taxpayers Engaged in “Production Activities” In general, a taxpayer is not considered to be producing property unless the taxpayer is considered the owner of the property being produced. An exception to this rule provides that property produced for a taxpayer under a contract with another party is treated as property produced by the taxpayer to the extent the taxpayer makes payments or otherwise incurs costs with respect to the property.14 In Von-Lusk v. Commissioner,15 a taxpayer incurred costs related to commercial and real estate development. At issue was whether Von-Lusk’s activities fell within the description “construct, build, install, manufacture, develop, improve, create, raise or grow.” If they did, Von-Lusk would be considered a producer under Section 263A of the Code. In making its determination, the Tax Court considered the legislative intent behind the tax statute. The court stated:

Two purposes behind the enactment of Section 263A can be gathered from this legislative history. First, Congress expected that a single set of comprehensive rules would be applied to determine whether to capitalize costs. Second, Congress expected those rules to be applied from the acquisition of property, through the time of production, until the time of disposition. To give full effect to this Congressional purpose a broad definition of “produce” is necessary.

The court concluded that Von-Lusk’s activities represented the first steps in the development of the property, and therefore, Von-Lusk produced the property, as contemplated by Congress. Accordingly, Section 263A applied to the property, and Von-Lusk was required to capitalize the direct costs and a proper share of the indirect costs of the property.16

§9.04 PROPERTY SUBJECT TO UNICAP §9.04(a) Generally Property subject to Section 263A capitalization includes17 • Real property and tangible personal property produced by the taxpayer; • Real property and personal property described in Section 1221(1) of the Code that is acquired

by the taxpayer for resale; • Property produced in a farming business; • Costs incurred in the production and resale of creative property; and • Property produced or acquired for resale by foreign persons. 14 Section 263A(g)(2). For this purpose, a “contract” is defined as any agreement providing for the production of property if the agreement is entered into before the production of the property to be delivered under the contract is completed. Whether an agreement exists depends on all the surrounding facts and circumstances. 15 104 TC 107 (1995). 16 See also Reichel v. Commissioner, 112 TC 14 (1993), in which a real estate developer had to capitalize real estate taxes on properties he intended to, but never actually, developed. The taxes were indirect expenses to produce/develop property under Section 263A. The statute’s broad language required capitalization of costs incurred both before and during property’s production. The legislative history behind the statute reflected an intent to cover capitalization of property acquisition, production, and holding costs under a single set of rules. 17 Reg. §1.263A-1(a)(3).

182 Fundamentals of Tax Accounting

§9.04(b) “Small Reseller” Exemptions §9.04(b)(1) Generally Section 263A does not apply to any personal property acquired for resale during any taxable year if the taxpayer’s (or its predecessor’s) “average annual gross receipts” for the three previous taxable years, i.e., the test period, do not exceed $10 million.18 In other cases, except for the exception for small producers discussed in §9.04(e) below, property produced by a taxpayer is subject to the UNICAP rules regardless of the magnitude of the taxpayer’s gross receipts. It is important to know if a taxpayer is a producer or a reseller. The small reseller exemption is not available to producers. Consider Suzy’s Zoo v. Commissioner,19 for example. In this case, the Tax Court held that the taxpayer was a producer rather than a reseller, and therefore, it did not qualify for the “small reseller” exemption under the UNICAP rules. The taxpayer sold greeting cards and other paper products bearing an image of one or more of its licensed cartoon characters. The taxpayer’s employees developed and drew the originals of all of the characters, and the taxpayer transferred the original drawings to independent printing companies to reproduce the images of the drawings onto its paper products, which were made by the printers on the taxpayer’s behalf. The printers were required to reproduce the drawings and make the products in accordance with the taxpayer’s specifications, and they were prohibited from selling the taxpayer’s original drawings, reproductions, or paper products to third parties. Based on these facts, the court concluded that the taxpayer was a producer and denied the taxpayer the “small reseller” exemption. §9.04(b)(2) “Average Annual Gross Receipts” Determination Gross receipts are the total amount derived from all of the taxpayer’s trades or businesses, excluding the following amounts: (1) returns and allowances; (2) interest, dividends, rents, royalties, or annuities not derived in the ordinary course of a trade or business; (3) receipts from the sale or exchange of capital assets; (4) repayments of loans or similar instruments; (5) receipts from a sale or exchange not in the ordinary course of business; and (6) receipts from any activity other than a trade or business or an activity engaged in for profit. Gross receipts for a short taxable year must be annualized. Gross receipts (other than those arising from transactions between group members) are aggregated for purposes of determining whether the $10 million threshold is exceeded. If a taxpayer has been in existence for less than three years, the taxpayer determines its average annual gross receipts for the number of taxable years that it has been in existence. §9.04(b)(3) Resellers With Production Activities Property produced by a small reseller—i.e., a reseller who satisfies the $10 million exception—is exempt from the UNICAP rules if the taxpayer’s production activities are de

18 Reg. §1.263A-3(b). However, taxpayers that acquire real property for resale are subject to Section 263A with respect to real property regardless of their gross receipts. 19 114 TC 1 (2001).

Brunetti 183