The additional Section 263A costs attach schedule is used to itemize some of the costs associated with purchasing items to either resell or produce items that are sold by a business.

Some of these items include processing fees, re-packing costs, assembly costs, warehousing fees, and payroll for support personnel. This itemized schedule is attached to Form 1125-A, which is submitted with the business's tax return.

Why Use Section 263A?

Accepted principles of accounting state that businesses may not take tax deductions immediately for the direct costs incurred when producing inventory for sale. They also may not take deductions for the expense of purchasing items for resale. Instead of deducting those expenses directly, they capitalize the costs incurred while producing and purchasing these items. The costs may be deducted only when the business inventory is sold.

Congress passed the Tax Reform Act of 1986, and one of its provisions was aimed at perceived abuses of the rules businesses used to capitalize inventory. Businesses were finding loopholes allowing them to deduct the indirect costs associated with purchasing, storing, and acquiring inventory currently instead of capitalizing them along with the more direct expenses for a later deduction.

One example of an indirect cost is the salary paid to an officer who supervises the business operation. That compensation is not a direct expense associated with producing inventory. However, Congress believed this was unfair because the officer's job involved producing inventory.

Section 263A is used to analyze each expense that appears on a company's profit and loss statement. The taxpayer must determine if even a part of that expense may be considered an associated cost of producing inventory. If so, it must be capitalized along with the direct production expenses.

This complicated worksheet causes a lot of confusion. Some companies are exempt, but it's not easy to determine whether or not a company qualifies for an exemption.

Are Producers Subject to 263A?

All producers are subject to Section 263A. Along with obvious “producers,” such as manufacturers, the term also applies to construction companies, builders, installers, developers, or real estate improvers. This even includes taxpayers who contract with a third party to produce items for them — in that case, both parties are considered producers. There are few exceptions to this rule.

Are Resellers Subject to Section 263A?

Resellers are companies that do not create their own items for inventory. They buy items from other parties and sell them to their customers. It is possible for resellers to avoid the requirement to file Section 263A.

The most common way for a reseller to avoid Section 263A is to be considered a “small reseller.” This means it has average gross receipts of less than $10 million over the prior three years. However, the gross receipts must be figured together with other related parties in order to qualify for the $10 million limit.

Are You Computing Section 263A Properly?

Most taxpayers compute their Section 263A adjustment incorrectly. For most companies, calculating properly means paying tax advisors for many hours of work, and few are willing to spend that much money. It's also difficult for most taxpayers to understand the importance of this worksheet, considering the deductions are a matter of timing. If an expense cannot be deducted one year, it can usually be deducted in the following year when the inventory is sold.

Also, since the worksheet and its rules are so complicated, even many professional tax advisors do not understand it completely. It contains many mathematical formulas, ratios, obscure terms, and other intimidating factors. In the event of an Internal Revenue Service (IRS) audit, the general attitude is that as long as the calculation is consistent and makes reasonable sense, it won't be challenged.

The Basics of Calculating Section 263A

The first step of calculating Section 263A is to separate all of the company's expenses which appear on its profit and loss statement into three categories:

  • Capitalizable costs
  • Deductible costs
  • Indirect costs

Capitalizable costs include direct expenses for material and labor. Expenses that can be deducted currently include:

  • Costs of selling and distributing merchandise
  • Research and development expenses
  • Income taxes
  • Product liability and warranty expenses

It also includes costs associated with the following:

  • Quality control
  • General accounting
  • Business planning and strategy
  • Management
  • Personnel oversight
  • Internal auditing

The third category, indirect costs, is more complicated. We advise consulting an attorney or tax professional to make sure all expenses are properly categorized.

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