UNICAP controversy.

• Author: Strahle, Brian
• Position: Uniform capitalization

Based on recent IRS audit activity, it appears the IRS has developed a focused approach to examining taxpayers' UNICAP (Sec. 263A) calculations. It no longer appears to follow the "reasonable" approach analysis (i.e., it is not passing on adjustments just because a taxpayer is capitalizing a reasonable amount, if the taxpayer is not on a permissible method). Historically, taxpayers and tax advisers may not have focused as much on the actual methods being used, but rather on the reasonableness of the amount of additional costs being capitalized to ending inventory. This approach was not followed without justification, as the IRS itself seemed to be concerned with the reasonableness of the amount being capitalized, rather than the actual methods being used. It appears the IRS is now enforcing the regulations more strictly. As such, taxpayers should gain an understanding of the IRS's new approach and review their UNICAP calculations to determine what, if any, corrective action may be appropriate.

The Main Audit Issue

Generally, additional Sec. 263A costs must be allocated to the specific items of property produced or property acquired for resale during the tax year and capitalized to the items that remain on hand at the end of the tax year; see Regs. Sec. 1.263A-1(c)(1). The only exceptions to this rule are the simplified production method (SPM) and the simplified resale method (SRM); see Regs. Sec. 1.263A-2(b) and -3(d). Thus, any other "facts and circumstances" method, such as specific identification, burden rate, standard cost or "other reasonable allocation methods," must allocate costs to specific inventory items; see Regs. Sec. 1.263A-1(f). Hence, the primary audit issue or exposure involves taxpayers who are using a facts-and-circumstances method that does not allocate costs to specific inventory items.

Recent audit activity indicates the IRS will require taxpayers to use one of the simplified methods (SPM or SRM) when it determines that a taxpayer is using a facts-and-circumstances method that does not allocate costs to specific inventory items. The simplified methods generally cause the taxpayer to capitalize greater costs than if a facts-and-circumstances method were used. However, many taxpayers historically have not invested the time and resources to develop this method. Thus, they have generally chosen to use one of the simplified methods. Unfortunately, many businesses use a "simple" method, which is not necessarily one of the...