The inventory capitalization rules of Code Section 263A often come as an unhappy surprise to clients. It’s especially true when a client has bought a bunch of new fixed assets and expects bonus depreciation to make their tax go away. If that bonus depreciation is attributable to manufacturing or production assets, a lot of it might end up as part of year-end inventory for tax purposes, pushing off the deduction for a year — and causing unexpected tax this year.
All “producers,” and retailers with receipts over $10 million, are subject to the Sec. 263A “uniform capitalization,” or “UNICAP” rules. Costs subject to 263A have to be capitalized as part of the cost of inventory or constructed property, and are only recovered when that property is sold. Costs commonly added to inventory under Sec. 263A include tax depreciation in excess of financial statement depreciation, indirect labor, and overhead costs that the tax law considers attributable to production activities.
A Texas custom homebuilder, Frontier Custom Homes, took a creative approach to getting around these rules. The Tax Court takes up the story:
As a preliminary matter, we must decide whether Frontier, as a custom homebuilder, is subject to the UNICAP rules under section 263A. Frontier contends its business model is centered around sales and marketing, not production-related services. The thrust of its argument is that custom homebuilders differ from speculation homebuilders because their price premiums and profitability come not from cost control, but rather from the creativity of their salespeople, designers, decorators, and marketing employees.
Section 263A requires taxpayers that produce real property to capitalize certain costs. The term “produce” includes “construct, build, install, manufacture, develop, or improve.” Sec. 263A(g)(1).
Frontier contends it is outside the scope of section 263A because it does not employ the tradesmen — e.g., carpenters, welders, and plumbers — who actually build the homes. All of those activities are subcontracted out. It therefore claims its actual employees’ services, and the related costs incurred, are more reflective of a sales and marketing company that manages the creation of a custom product rather than a construction company producing streamlined goods.
The Tax Court didn’t appreciate the creative approach (my emphasis, footnotes and citations omitted):
Speculative homebuilding is the classic production activity to which section 263A applies. Frontier’s argument is that custom homebuilding is different from speculative homebuilding and that this difference keeps its activities out of the reach of section 263A. Before Frontier sells a home, it builds it; before Frontier builds a home, it designs it. After Frontier creates the design for each custom home, it subcontracts out the physical labor to the tradesmen who actually build the home. Frontier’s use of subcontractors for the physical home construction is not enough to exempt Frontier from section 263A. The creative design of custom homes is ancillary to the actual physical work on the land and is as much a part of a development project as digging a foundation or completing a structure’s frame. The construction of a home cannot move forward if the design step is not taken. Therefore, we reject Frontier’s argument and find Frontier is a producer of real property subject to section 263A.
The court went on to uphold the IRS capitalization of specific costs attributable to production activities to the home inventory, including part of the owner’s salary, employee bonuses, design costs, salary for office employees, employee benefits, payroll taxes, insurance, and other office expenses. Because the taxpayer had not assigned costs to inventories, the court accepted the IRS numbers.
The moral? The IRS believes in Sec. 263A, and so does the Tax Court. There is no exception for creativity. Your Sec. 263A result is likely to be better if you make the computations and assign costs yourself to production activities. If you have gone through the effort to make a reasonable computation, the IRS agent is unlikely to quibble over the small stuff, in my experience. But if you don’t bother to capitalize costs under Sec. 263A at all, they’ll do it for you, and you won’t care for the results.