IRS ITG Audit Techniques Chapter 6.1
Chapter 6.1 – Uniform Capitalization
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The allocation of project costs in cost segregation studies for self-constructed assets may be impacted by the Uniform Capitalization (UNICAP) rules of IRC § 263A(a). In addition, the interest capitalization rules of IRC § 263A(f) may also apply. A brief summary of these provisions is presented below.
APPLICATION OF THE CAPITALIZATION RULES UNDER IRC § 263A
The uniform capitalization (UNICAP) rules require the capitalization of all direct costs and certain indirect costs properly allocable to real property and tangible personal property produced by the taxpayer. For purposes of the uniform capitalization rules, to “produce” means to construct, build, install, manufacture, develop, improve, create, raise or grow [§ 263A(g)(1); Treas. Reg. § 1.263A-2(a)(1)(i)]. Self-constructed assets and property built under contract are treated as property “produced” by the taxpayer and the rules under IRC § 263A(a) govern.
In addition, § 263A(f) requires the capitalization of interest expense when the taxpayer produces certain property. The interest capitalization rules under Treas. Reg. § 1.263A-8 contain precise definitions of designated property and include inherently permanent structures in the definition of real property. In summary, all real property and certain tangible personal property are subject to the interest capitalization rules. Therefore, any change in the allocation of costs between real and tangible personal property may have an impact on the amount of capitalized interest. Many taxpayers attempt to exclude all § 1245 property from interest capitalization arguing that the § 1245 property is tangible personal property that does not meet the classification thresholds of Treas. Reg. § 1.263A-8(b)(1). Most of the § 1245 property in these situations are inherently permanent structures (real property) subject to interest capitalization without any restrictions.
The following text summarizes the capitalization rules of § 263A(a) and the interest capitalization rules of § 263A(f). Further detail and updates can be obtained from Jim Peschl, § 263A Technical Advisor, at (763) 549-1020 (James.F.Peschl@irs.gov); or Barbara J. Martin, § 263A (Inventory) Technical Advisor, at (708) 503-3540 x205.
Capitalization of Costs under IRC § 263A(a)
How does § 263A identify the costs subject to capitalization? As a threshold requirement, one must determine whether the costs would, but for § 263A, be otherwise deductible. A cost that is not otherwise deductible may not be allocated to property produced or acquired for resale.
In addition, any cost required to be capitalized under § 263A may not be included in inventory or charged to capital accounts or basis any earlier than the taxable year during which the amount is incurred within the meaning of § 1.446-1(c)(1)(ii).
What costs are capitalized under § 263A? Except as otherwise provided, direct and indirect costs that directly benefit or are incurred by reason of the performance of production or resale activities must be capitalized to the property produced or acquired for resale. For a producer the direct costs generally include direct material and direct labor. The regulations include examples of indirect costs [see § 1.263A-1(e)(3)(ii)]. Examples of indirect costs required to be capitalized are:
- bidding costs
- capitalizable service costs (including capitalizable mixed service costs)
- cost recovery allowances (however, remember depletion is only allocated to inventory produced and sold during the year)
- engineering and design
- employee benefit expenses
- handling costs
- indirect labor costs
- indirect material costs
- interest (see special rules under § 263A(f))
- licensing and franchise costs
- officers’ compensation
- pension and other related costs
- purchasing costs
- quality control
- repairs and maintenance
- storage costs
- tools and equipment
Producers must capitalize costs (other than interest) whether incurred before, during, or after the production period of property. Interest is only capitalized during the production period of property. Pre-production costs are subject to capitalization if the property is held for future production or if it is reasonably likely that the property will be produced at a future date. Thus, costs of storing raw materials and carrying costs of realty held for development are required to be capitalized. Some issues may arise in determining the taxpayer’s intent and the taxpayer’s change in intent. Production period costs are costs incurred beginning on the date on which production of the property begins and ending on the date on which the property is ready to be placed in service or is ready to be held for sale. Post-production costs are costs incurred after the actual production and may include costs of storage, warehousing, insurance, materials, and handling.
Treas. Reg. § 1.263A-1(f) sets forth various detailed or specific cost allocation methods that a taxpayer may use to allocate direct and indirect costs to property produced. Under § 1.263A-1(f) a taxpayer may use a specific identification method, burden rate method, standard cost method, or any other reasonable method to allocate costs. In addition, in lieu of these methods, producer taxpayers may use the simplified production method provided in § 1.263A-2(b).
Capitalization of Interest under IRC § 263A(f)
Treas. Reg. §§ 1.263A-8 through 1.263A-15 provides guidance with respect to the capitalization of interest under IRC § 263A(f). These regulations are effective for 1995 and after, or at taxpayer’s election, 1994. For years prior to the final regulations, Notice 88-99, 1988-2 C.B. 422, and temporary regulations provide guidance with respect to the capitalization of interest.
Interest is capitalized with respect to each unit of designated property. Interest is capitalized during each computation period; the amount of interest that is capitalized is a function of two components:
- the amount of accumulated production expenditures; and,
- the amount of outstanding debt on each measurement date.
In determining the amount of outstanding debt, traced debt is considered first. The excess expenditure amount is the amount (if any) by which the accumulated production expenditures exceed the amount of traced debt. Interest on non-traced debt, up to the excess expenditure amount, must be capitalized, based upon a weighted average interest rate.
Designated property is defined in IRC § 263A(f)(1) and Treas. Reg. § 1.263A-8(b)(1). In general, §263A(f) applies to designated property. Designated property is any property that is produced and that is:
- real property; or,
- tangible personal property that meets any of the following classification thresholds:
- Property with a class life of 20 years or more that is not inventory in the hands of the taxpayer or a related person;
- Property with an estimated production period exceeding 2 years; or
- Property with an estimated production period exceeding 1 year and estimated cost of production exceeding $1,000,000.
Note: All real property is subject to the rules of § 263A(f); the classification thresholds only apply to tangible personal property.
The classification thresholds are applied individually to each unit of property.
Treas. Reg. § 1.263A-8(c)(1) defines real property. Real property includes land, unsevered natural products of land, buildings, and inherently permanent structures. Any interest in real property, including fee ownership, co-ownership, a leasehold, an option, or a similar interest is real property. Unsevered natural products of land include growing crops and plants (that have a preproductive period in excess of 2 years), mines, wells, and other natural deposits. Real property includes the structural components of both buildings and inherently permanent structures.
Inherently permanent structures include property that is affixed to real property and that will ordinarily remain affixed for an indefinite period of time. Examples are swimming pools, roads, bridges, tunnels, paved parking areas and other pavements, special foundations, wharves and docks, fences, inherently permanent advertising displays, inherently permanent outdoor lighting facilities, railroad tracks and signals, telephone poles, power generation and transmission facilities, permanently installed telecommunications cables, broadcasting towers, oil and gas pipelines, derricks and storage equipment, grain storage bins and silos. For purposes of this section, affixation to real property may be accomplished by weight alone. [Treas. Reg. § 1.263A-8(c)(3)]
Property may constitute an inherently permanent structure even though it is not classified as a building for purposes of former IRC§ 48(a)(1)(B) and Treas. Reg. § 1.48-1. Any property not otherwise described in this paragraph (c)(3) that constitutes other tangible property under the principles of former IRC § 48(a)(1)(B) and Treas. Reg. § 1.48-1(d) is treated for the purposes of this section as an inherently permanent structure. [Treas. Reg. § 1.263A-8(c)(3)]
A structure that is property in the nature of machinery or is essentially an item of machinery or equipment is not an inherently permanent structure and is not real property. In the case, however, of a building or inherently permanent structure that includes property in the nature of machinery as a structural component, the property in the nature of machinery is real property. A structure may be an inherently permanent structure, and not property in the nature of machinery or essentially an item of machinery, even if the structure is necessary to operate or use, supports, or is otherwise associated with, machinery. [Treas. Reg. 1.263A-8(c)(4)]