Publications

• 30 Second Ideas
• Accounting Updates
• Alerts
• Articles
• Business Surveys
• Construction Edge
• Healthcare Edge
• Insurance Edge
• Legal Talent
• Manufacturing Edge
• Not-for-Profit Edge
• Quick Links & Good Ideas
• SEC Edge
• Strategy Insights Blog
• Surviving the Upturn
• Tax Highlights

Article Author:

Excess Capacity - Tax Advantage or Disadvantage?

In the December 2009 Manufacturing Edge, Brian Wiedenhoeft wrote the article “Excess Capacity: Accounting, Pricing and Production Issues,” which discussed the accounting implications of allocating overhead when production is below normal.  A capacity-based fixed overhead allocation allows, for book purposes, some overhead costs to be charged to expense as a production volume variance when production is below normal.

What are the Tax Implications of Excess Capacity Accounting?

Tax accounting rules allow taxpayers discretion in computing the allocation of inventoriable costs and place great reliance on financial accounting techniques and procedures.
Under a practical-capacity concept, a portion of fixed indirect production costs is treated as a period expense that is fully deductible in the period incurred. This portion is not allocable to inventory or otherwise treated as an inventoriable cost. The portion of costs that can be treated in this manner is the amount attributable to the under-utilization of plant capacity.

So does this means that the period costs computed for book purposes are deductible for tax purposes? Not quite.

Additional Inventoriable Costs for Tax Purposes

Manufacturers are subject to complex rules surrounding the costing of their inventories. Inventoriable costs are broken down into three categories for manufacturers and producers: (1) direct material costs, (2) direct labor costs, and (3) indirect production costs or overhead. “Indirect production costs” are defined to include those costs that are incident to and necessary for production or manufacturing operations or processes but that are not direct material costs or labor costs.  Costs included in indirect production costs depend on the book treatment of such costs.

In addition to the above indirect production costs, there is another layer of costs that must be inventoried for tax purposes, known as 263A costs (also referred to as UNICAP). Prior to the enactment of Code Sec. 263A in the 1986 Act, there was more ambiguity in the tax law for accounting for inventoriable costs. As a result of this added costing layer for tax purposes, a number of costs that were previous a period costs [does this make sense?] are now required to be capitalized. These costs are defined as all costs (other than direct costs) that “benefit or are incurred by reason of the performance of a production or resale activity”.

Beware of Sec. 263A

Regulations under Sec. 263A specifically disallow the use of a practical-capacity concept, as do the old tax accounting rules. Under the Regulations, practical capacity is defined as a method in which fixed costs are not capitalized due to the relationship between the actual production at the taxpayer’s facility and the practical capacity.  Since this method of accounting for inventoriable costs is specifically disallowed, costs included in a period expense for book purpose must be capitalized into inventory for tax purposes. There are specific costs that are required to be included in the 263A calculation and other costs that are specifically excluded from that calculation.

Timing is Everything

The additional costs that will be required to be capitalized into inventory due to the use of an excess or practical-capacity method for book purposes will be added to book income as a timing difference. As inventory levels fluctuate [or level fluctuates] and/or costs go up or down, these 263A costs may increase or decrease your taxable income in the future.

Questions about excess capacity for tax purposes or 263A? Please contact Michael Calahan at 312-980-2996 or Cara Hoffman at 312-980-3274 or your Blackman Kallick representative.

 

Sources:

• http://www.blackmankallick.com/articles/2009/12/excess-capacity-accounting-pricing-and-production-issues/
• Treasury Reg. §1.471-11(b)(3)
• Temporary Reg. §1.263A-1T(b)(2)(ii)
• Treasury  Reg. §1.263A-2(a)(4)

 
 

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.