The historic absorption ratio method and TAM 9810003 - will good tax policy be turned bad?

• Author: Kilinskis, Robert A.
• Position: IRS Technical Advice Memorandum

In Letter Ruling (TAM) 9810003, the IRS National Office ruled that the simplified production method with the historic absorption ratio (HAR) election, used to allocate additional costs to inventory under the uniform capitalization rules, is not subject to the reasonableness standard required of other uniform capitalization allocation methods. According to the IRS 1998 Priorities for Tax Regulations and Other Administrative Guidance, the Service's 1998 Business Plan includes reconsidering the HAR method in light of this TAM.

The HAR Method

The HAR is used to allocate capitalizable costs between cost of goods sold and ending inventory under the Sec. 263A uniform capitalization (UNICAP) rules. The HAR may be elected only if either the simplified production method or the simplified resale method has been used for three years. Once elected, the HAR is an accounting method that may be changed only with IRS permission. Developed in the final UNICAP regulations issued in 1994, the HAR provides further simplification, in addition to the simplification provided by the simplified production and resale methods.

Under the simplified production and simplified resale methods, the amount of additional UNICAP costs requiring inventory capitalization is determined by computing an absorption ratio and applying it to ending inventory for FIFO, or a LIFO increment for LIFO. The absorption ratio equals "additional Sec. 263A costs" divided by "Sec. 471 costs." Sec. 471 costs generally include all costs previously capitalized by the taxpayer under the taxpayer's method prior to the effective date of the uniform capitalization rules; additional Sec. 263A costs generally include all costs required to be capitalized under UNICAP that are not Sec. 471 costs. Because, prior to the UNICAP's effective date, there were few book or tax differences in computing the value of ending inventory, many taxpayers using either simplified method could use their existing book capitalization methods, enabling taxpayers to make an "add-on" computation under UNICAP for tax purposes (rather than maintaining an entirely separate and complete tax inventory system). Taxpayers using LIFO may compute the LIFO inventory value without considering the UNICAP's effect, and simply increase the value of any increment by the absorption ratio.

According to the preamble to the final UNICAP regulations issued in 1994, the HAR was intended to eliminate costly and me-consuming annual computations...