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As producers prepare to close their books on 2009, it's important to be aware of any potential federal tax procedures. 2009 could be the year to reassess how you account for your inventory.
If your company has inventory onsite, which would be the case for all concrete producers, you should know about a tax regulation called 263A. Not complying with 263A could cost a concrete producer thousands of dollars.
Section 263A, also called UNI-CAP, requires taxpayers to capitalize all direct and indirect costs that they incur in the production of real or tangible personal property that are allocable to that property. A taxpayer must capitalize not only the direct costs that they incur with constructing a product, such as paying employees, but also any indirect costs, such as facility depreciation.
The UNICAP rules generally apply to: 1. real or tangible personal property produced by the taxpayer, and 2. real or personal property that is stock in trade of the taxpayer or other property of a kind which would be included in the inventory if it is on hand at the close of the taxable year. Also included is property held by the taxpayer primarily for sale to customers in the ordinary course of his or her trade or business, such as inventory.
One would believe that since the only inventory remaining at the end of each day are the raw materials, and no value has been given to the raw material, UNICAP should not be applicable. But the IRS is applying a very liberal view of the standard to raw materials inventory and forcing many companies with a similar process to capitalize costs for tax purposes.
You might think this view of the regulation does not apply to the ready-mix industry. Operations do not inventory product either in a work-in-process nor a finished good state. Most ready-mix customers' orders are received daily for production and delivery on the same day.
The vast amount of costs in a ready-mix operation are associated with delivering the raw material components to the production facility, charging the material and water into the drum on the truck, and mixing the concrete on the way to the customer. Hence, it is logical that those costs should be expensed and matched against the sale of the concrete, especially since the entire process usually occurs within hours.
Raw material costs
UNICAP allows the specific identification method under Reg. Sec. 1.263A-1(f) (2), which more accurately identifies those costs attributable to the raw materials inventory instead of an arbitrary and often grossly unfair percentage of all costs. The specific identification is also supported in Reg. Sec. 1.263A-2(a) (3)(ii), which clearly states that a taxpayer should capitalize buying, storing, handling, and other costs attributable to property held for future production, such as raw materials inventory.
The IRS stated a similar position in a technical advice memorandum regarding raw material inventories (TAM 200437035, Sept. 10, 2004). Even given the citations above, the IRS will likely force your company to use the simplified method if you have no system in place since it is easier for them to audit and provides the service a more favorable position.
One-way to escape the capitalization requirement of the UNICAP regulation is by applying the use of the lower of cost or market to the producer's inventory. The issue here is that the company must be able to present objective evidence that the cost of inventory is below market cost. If a company feels that its inventory is below market, it should obtain market quotes from its vendors so that it has the documentation and can perform the analysis at year-end.
Reg. Sec. 1.471-4(a)(1) defines market to mean the current bid price prevailing at the date of the inventory for the particular merchandise in the volume in which the taxpayer usually buys it. Since most producers' raw material inventory turns in an average of five to six days, it can be submitted that the current bid price for the raw materials is the same as replacement cost the company would have to pay in the open market to buy the raw materials. While this argument has merit, it might not work since the IRS may require the quotes mentioned previously.
If a producer can't prove it is valuing its inventory at lower or cost of market and it doesn't have a cost accounting system, the IRS will likely apply the simplified production method without historic absorption ratio election. This will result in the greatest adjustment for the IRS.
The allocation described can easily equal 25% of the year-end raw material inventory that has yet to be placed into production. Many times the IRS will also compute the additional costs to be capitalized by including: 1. 100% of the indirect production costs that were directly related to the performance of producing finished goods and have no direct or indirect relationship with the raw material inventories. 2. Potentially 50% of the taxpayer's general and administrative expenses for applying the simplified service cost method for allocating mixed service.
If you are placed on the simplified method, the following items should not be included as mixed service costs: