IRS issues fifth directive on the allocation of mixed service costs.

• Author: Ford, Robert

In general, taxpayers subject to Sec. 263A, governing capitalization and inclusion in inventory costs of certain expenses, must categorize service costs as capitalizable, deductible, or mixed service costs. The IRS has been scrutinizing how taxpayers have allocated mixed service costs to self-constructed assets under Sec. 263A. As a result, the IRS has issued a number of industry director directives (IDDs) and has elevated the method of allocating these costs to Tier I status. It has divided the issues into two phases.

The first phase of the Tier I issue emanated from taxpayers asking to change accounting methods for uniform capitalization from the facts-and-circumstances method to the simplified service cost method to allocate mixed service costs between inventory and self-constructed property. The second phase is related to the reasonableness of methods used to allocate mixed service costs between inventory and self-constructed assets based on a facts-and-circumstances method. IDD No. 5 (LMSB 04-0809-033), issued in fall 2009, provides examples of proper and improper methods of allocating mixed service costs using a facts-and-circumstances approach.

Background

In accordance with Regs. Sec. 1.263A-1(e)(4)(ii)(C), mixed service costs are defined as service costs that are partially allocable to production or resale activities (capitalizable) and partially allocable to nonproduction or non-resale activities (deductible). Mixed service costs are typically thought of as general and administrative costs. Thus, for example, a company's personnel department may incur costs to recruit employees engaged in the production of self-constructed assets (capitalizable) as well as costs to recruit employees engaged in nonproduction activities (deductible). Under the uniform capitalization rules of Sec. 263A, a variety of methods exist to allocate mixed service costs between capitalizable and deductible costs.

One such method is the simplified service cost method, which allows taxpayers to allocate mixed service costs using a labor-based allocation ratio or a production cost allocation ratio. Many taxpayers, primarily in the utility industry, changed to the simplified service cost method due to its generally favorable outcome when applied to self-constructed property. The end result was that companies changing to the simplified service cost method capitalized fewer costs to self-constructed assets, which are capitalized and recovered over a period of years...