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Section 263A Calculation – Anyone?

May 24th 2010
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Let me start out by stating, I feel I am a pretty intelligent person.  Passed the CPA exam the first time (way back when it was given in four parts with a pencil and calculator) and have a masters degree in taxation but Section 263A befuddles me.  Yes I know who it applies to, manufacturers, wholesalers and retailers with average annual gross receipts of $10 million for the preceding three years but after that, stumped.  Could it be I have an aversion to cost accounting? I really did hate that course in college.   I understand the concept, matching the costs of producing goods with the revenues received from selling those goods, got it.  But why do they make it so difficult to apply the uniform capitalization rules?

I have worked for respectable firms with very bright accountants and the general consensus is - no one knows how to do it or they are not exactly sure they are doing it right.  This became very evident to me recently.  I have a client that underwent a Federal tax audit a few years back and one of the areas that was chosen for examination was the Section 263A calculation.  This was not surprising to me because this is a very subjective area and very open to interpretation.  The agent examined my calculation and for the most part agreed with my figures. The only change was the absorption ratio.  He stated that based upon his experience, for the type of industry my client was in, it should have been higher.  How do you refute this position? Hmmm.  Not sure but since I was dealing with a timing issue and the adjustment being very small,  I agreed to the change.  I actually felt a sense of accomplishment that maybe I had finally gotten it. 

This feeling was short lived.  The same client was examined the following year and one of the areas the agent chose to focus on was surprise, surprise Section 263A. 

Being that this area was recently examined and I had followed the audit methodology, I felt comfortable and self assured that there would be no change to my calculation.  The IRS brought in a Section 263A specialist to examine the calculation.  Really, there are people who actually audit this area every day, no thanks.... 

With confidence I gave him my workpapers.  How bad could it be? This was just audited the year before and for the most part, no change.  I followed the previous auditor's methodology and documented the workpapers up the ying yang.  After his very thorough review of my calculation, he determined that my absorption ratio was too low.  I said "how can this be, I followed the previous agents workpapers, calculations and methodology, how can it be to low?"  He looked at me, smiled and said "No one really knows how to do it." Not even the IRS!
 

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By Yogi
Jun 26th 2015 01:10

Wow.  I am preparing the 263A for my company and for some reason....I found this to be very comforting.  Thanks for the post.

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By Gabriela
Jun 26th 2015 01:10

Just started working at a small accouting firm, I passed all section of the CPA exam last year. I am presently working on a client that will require a Section 263A calcuation and found you posting most comforting too.
Thank you.

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Replying to Gabriela :
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By Taxnerd
Apr 29th 2018 20:09

In order to understand § 263A you first need to differentiate it from § 471. IRC § 263A expanded the rules for capitalization for all self-constructed assets, not just inventory capitalization under § 471. Furthermore, § 471 does not capture indirect costs such as officers’ salaries and employee benefits that are not considered production costs.

IRC § 471 covers inventory capitalization for manufacturers. The permissible methods pretty much parallel cost accounting methods for measuring work in process and finished inventory. The regulations are fairly flexible on what method a taxpayer may use to capitalize costs. Typically, a manufacturer will calculate one or more burden rates and multiply the rates to units of production, such as direct labor hours. The manufacturer can design any method as long as the method is applied consistently and is a fair and reasonable estimate that clearly reflects income. See Reg. §1. 446-1(a)(2).

For a manufacturer, IRC § 263A is an “add-on” to capture certain costs that are not included in the manufacturer’s burden rates. So the Code provides for a § 263A method of allocation as also described in § 471. The good news is that the taxpayer doesn’t have to get that complicated. Under §§ 1.263A-1(h)(2)(i)(D) and 1.263A-2(b)(2)(i)(D) qualifying taxpayers may use the simplified service cost and simplified production methods

IRC § 263A expands capitalization of for inventory that is purchased for resale. Capitalization under § 1.471-3(b) requires the net purchase price plus transportation costs and then refers to § 263A to include other costs such as handling and indirect costs. The indirect cost part gets confusing because the Code goes into the methods without clearly explaining what it’s trying to accomplish. Basically, the Code is separating costs into two activities: (a) selling and outbound shipping or (b) in-bound shipping, acquisition, storage, handling. To add to the confusion, § 263A adds more rules to differentiate. For example, the cost of holding goods includes all of the costs of an off-site warehouse, but not the retail store space. If goods are at the selling location available for sale then they are selling costs.

Once the taxpayer knows the ratio of total selling costs verses all total acquisition, storage and handling costs, the ratio is multiplied by the remaining expense items that constitute indirect overhead costs per § 263A.

Handling costs are tricky. For example, a grocery store maintains fruit in the retail store, but holds green fruit in a climate control room to ripen it. That space in the store and all costs associated with it are handling costs that have to be capitalized. The handling costs also go into the ratio described above for allocating other § 263A indirect costs.

IRC § 263A also covers long-term contracts and self-constructed assets for the taxpayer’s own use. That’s a whole other topic.

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By Marghi
Jun 26th 2015 01:11

I am a home tax preparer (do family and friends for free ), worked for H&R Block where I got my training. My thought is, it makes no sense for the IRS to audit u on something they admittantly do not understand themselves. DURRRRR. WRONG on so many levels.

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By Janice
Jun 26th 2015 01:12

Thanks for sharing!
It is nice to know that i am not the only one that finds this calculation complicated.

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