Uniform Capitalization Rules

[WhiteOleander]

Ok, can someone explain these rules in plain english? I have been reading and re-reading Pub. 538. And it just seems to talk in circles.

First of all it says if you produce real or tangible personal property you are subject to the rules. Then it goes on to give exceptions for when you are not subject to the rules.

One that seems odd to me is: you are exempt if "the property produced to use as personal or non-business property or for uses not connected with a trade or business or an activity conducted for profit." So, if this is the case, why in the world would you be keeping and inventory? If you are just doing it for ":fun", you wouldn't be keeping up with it at all. What am I missing? I know there has to be a point to that rule.

I just can't get a handle on this.

Thanks.

[Bees Knees]

Unicap

You are correct. If you don’t do it for business, you wouldn’t be keeping track of all that garbage. The rule is meant to make us feel better for not doing something we don’t have to do.

Actually, the exception applies to non-profit organizations and hobbies. They don’t have to worry about the rule either. Other people who don’t have to worry about the rule are retailers with less than $10 million gross receipts and manufacturers with less then $200,000 indirect costs, and construction people like home building contractors who finish their work in less than 2 years with average annual receipts of less than $10 million. Artists, writers and photographers are also exempt.

UNICAP is basically cost accounting, for those of us who tried to stay awake during cost accounting in college. It isn’t really that difficult. It merely allocates a certain percentage of indirect costs to the cost of goods sold calculation. We all understand that direct raw materials get dumped into inventory. We know how to count beginning inventory, plus purchases, minus ending inventory to come up with the cost of goods sold.

UNICAP (or cost accounting) simply adds a percentage of indirect costs to inventory, such as the phone bill, electric, insurance, etc. An example of how to do this is to take direct labor hours to total labor hours, and multiply that percentage by each indirect expense. So for example, say you have 2,000 total man hours in your labor force, of which 1,500 represents assembly line workers, and 500 represents office workers. That means 75% of your labor force is made up of direct labor producing the product you are selling. You then take 75% of all indirect costs, and add them to inventory. Then as the inventory is sold, that 75% of the electric bill gets expensed.

It is more tedious than complicated.

[WhiteOleander]

Thank you.

Now I can actually see what point the IRS is going for.

In a small town in Texas, not sure how often I'll run into it, but at least I'll know the situation could exist.

Also, just imagine the riveting conversations at dinner parties. :>)

[Lion]

Indirect Costs

Oh, oh. I have someone with less than $10 million in sales but more than $200,000 in non-inventory expenses. He DOES come under the unifom capitalization rules? He does contract manufacturing, however, of the spices he sells, has no employees except himself. How do I compute how much of that telephone bill, plane ticket, insurance premium, etc., I must allocate to inventory? And, returned products get trashed and not resold, so do the indirect costs move into inventory and then back out again or remain with inventory? Does his salary (CEO, marketer, everything) get partially allocated to inventory, also, or go on the line for officers' salaries? I'd better start reading that Pub!!

[Snaggletooth]

My two cents

This discussion is about 95% cost accounting and 5% taxes. If you have a degree in accounting, (not every tax professional does) then you remember the chapter which explains "overhead" costs. The undergraduate degree focuses its training on a mid-sized manufacturing firm, although these firms are becoming extinct, having been either bought by a multinational conglomerate, or else giving way to service industries, and (perish the thought) even governmental agencies.

The essence of overhead is to absorb costs into the product which would otherwise be indirect. Obvious costs are fringe benefits and payroll taxes (applying to labor), facility costs such as rent, heat, light, garbage pickup, etc. which apply to the manufacturing process, and such things as property taxes which attach to the facility and equipment.
And such things as freight (in), purchasing, parts warehousing, etc. which attach to materials consumed in manufacturing.

A proper synonym for "overhead" costs in a manufacturing environment is "inventoriable"
meaning, these are captured as overhead, held in inventory, and not expensed until the product actually leaves. A typical "widget" may have $10.00 in material cost, $5.00 in labor, and $3.00 in overhead. The cost of the widget is thus $18.00, and each widget is inventoried at this cost. 1,000 widget thus inventories at $18,000.

Nearly all of these so-called indirect costs require an allocation of some sort. For example, if you have $75,000 in Direct Wages, and $25,000 in Administrative Wages, then you would allocate 75% to Overhead. If you have 50,000 sq. ft in your facility, and some 40,000 sq. ft. in the production area, then 80% of your facility costs allocate to Overhead.

The examples may sound simplistic, but if you are involved in an operation like this, make the rules as simple as you can, and if you have the chance, allocate as little to "overhead" as you can -- your client will save taxes.

Regards, Ron J.

[Lion]

UniCap

Thank you, Ron. That was very helpful. It's been many years since I took accounting courses, and most of my businesses are service. I appreciate your time to refresh my aging memory.

[WhiteOleander]

Yes,thanks Ron and Bees Knees.

I neglected to thank you for the time you took to really explain the issue.

It is appreciated.

[Lion]

And, Bees Knees, too

And, thank you very much to Bees Knees, too, as well as Ron. I'm sorry. I didn't mean to leave you out of my thanks, Bees. You both gave helpful information, and I'm grateful to you both and to everyone who takes the time to answer questions on this board. I apologize for not saying, "Thank You," more often. Thanx.

[dyne]

full absorption

When I was an IRS Agent almost 30 years ago, the Uniform Capitalization rules
were a new issue for which we were trained and it was called the Full Absorption method.
All of the manufacturers which I audited failed to make an adjustment to include
expenses required by the then full absorption rules. By now, most preparers know
better I imagine.

[S T]

Confused on Unicap

Taxpayer has a small electronics assembly business. For the purposes of Unicap, are assembly and manufacturing the same? Taxpayer purchases the raw equipment, such as wires, connectors, etc and then assembles and sells to client, or client supplies certain components and t/p adds connectors, wires, etc.

To allocate indirect costs under Unicap, can I use the Simplied production method (no historic absorption ratio, as t/p started business in 4/05), and then use the worksheet in TB on page 24-11, rather than the direct to total labor hours burden rate method in QF.

Thanks,

Sandy

[Bees Knees]

Yes, your small electronics assembly business would be treated as a manufacturer, subject to UNICAP, unless the business has total indirect costs of $200,000 or less.

And yes, I prefer the simplified production method under Reg. Sec. 1.263A-2(b)(3), which is what the worksheet on page 24-11 in TTB is based on, over the direct to total labor hours burden rate method in QF.

Both are allowed, but I think the simplified production method is easier to compute.

[veritas]

How about a new mfg business that operates 5 months in the first year? Would the $200,000 be applicable for a part year?

[Bees Knees]

I don't see anything in the regulations concerning a short year in regards to the $200,000 indirect cost exception. It applies to the $10 million rule, but I don't see it applying to the $200,000 rule. So I would say the short year would be treated as if it were a full 12 month period.

[veritas]

Thank you Bees.

[S T]

Thank you

Thanks Bees, these rules are becoming a little clearer as I proceed.

Sandy