Section 263a Overview

Section 263a is a section of the US tax code that contains the Uniform Capitalization, or UNICAP, rules, which describe how cost types and their amounts are to be capitalized, or expensed long term, instead of expensed in the current tax period. In this section, a taxpayer must account for each expense on their profit/loss statement in order to determine if that expense is attributable directly to their inventory and thus a capitalized expense.

Section 263a mainly applies to those who are either considered producers or resellers. Producers are those who build, install, manufacture, construct, or improve in or on property. Resellers are those who do not create inventory but rather purchase it and then resell it to another party.

There are some instances where producers and resellers are not subject to Section 263a, but they are rather narrow. These instances include:

  • For producers, if the cost of the property produced is de minimis, or less than 5% of the price that is charged to the customer.
  • For producers, if the production is in long-term contracts under Section 460 that do not involve home production.
  • For producers, if their total indirect costs do not exceed $200,000.
  • For resellers, if their average gross receipts in a three-year period do not exceed $10 million and that $10 million applies to personal property only.

If you do not meet one of these exceptions, you must consider what costs must be capitalized. Capitalized costs include:

  • Direct costs. Labor costs and direct material costs that become integral to the property. Examples include worker salaries, production materials, and commissions.
  • Indirect costs. Costs that directly benefit the construction/production activity or are incurred during that activity. Examples include quality control costs, supervision salaries, depreciation, and insurance policies.
  • Service costs. Administrative and general expenses. Some of these costs need not be capitalized and can be expensed in the current period. Current period costs include selling, distribution, marketing, and advertising expenses; administrative and general expenses unrelated to development or construction; officer salaries unrelated to development or construction; experimentation and research expenses; and amortization and depreciation.
  • Property production costs. A taxpayer who produces property is required to capitalize any cost incurred during any part of the construction and development of the property, including many pre- and post-production costs, such as real estate taxes, zoning costs, and carrying costs.

There are a number of methods that can be used to determine what category a cost falls into and what adjustment must subsequently be made on the ending inventory and capitalize it for tax purposes, which may include both simplified production and self-developed methods.

Calculating Section 263a

Section 263a is one of the more difficult sections of the US tax code, but a basic overview of the calculation process runs thusly:

  1. Determine all indirect purchase costs, which could include any purchases made, processing fees, warehouse fees, support payroll costs, and assembly and repacking costs. These do not include advertising, marketing, research, or distribution costs.
  2. Allocate these costs between the cost of sold goods and the inventory. As examples, the materials used in product production would be a cost of sold goods, while the machinery used to make the product would be a part of the inventory.
  3. All allocated costs must then be classified as administrative, production, or mixed services, the last of which is anything that could be classified as both an administrative and production service. Examples of this include data processing and purchasing.
  4. Determine what adjustment is to be added to the ending inventory for tax purposes. If, for example, you use the simplified production method, you would then calculate the absorption ratio by dividing the additional 263a costs by the total inventory costs, then multiplying that ratio by the total end inventory. This yields the adjustment, which is then added on to the ending inventory, which results in the ending inventory reported to the IRS.

Such calculations can be very complex, and thus it is recommended that you retain the assistance of a profession tax preparer when making such calculations, who can also make sure you are in compliance with all IRS regulations.

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