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IRS eliminates automatic method change for some UNICAP methods
June 2024
In brief
What happened?
In Rev. Proc. 2024-23, the IRS updated the comprehensive list of method changes to which the automatic procedures apply, modifying Rev. Proc. 2023-24. Most notably, the updated revenue procedure removes a number of Section 263A uniform capitalization (UNICAP) sub-methods from the list of automatic changes, including the direct reallocation method (DRM), the step-allocation method, and the 90-10 de minimis rule for mixed service department costs.
Why is it relevant?
These changes may make it more difficult for taxpayers to change UNICAP sub-methods, which determine the amount and types of expenditures capitalized into the basis of self-constructed assets and inventory. Taxpayers subject to UNICAP now must use nonautomatic procedures (1) to change either to or from the DRM or the step-allocation method or (2) to elect or revoke the 90-10 de minimis rule to allocate a mixed service department's costs to production or resale activities if the taxpayer is currently using the DRM or step-allocation method. Under the nonautomatic procedures, method changes must be filed by the end of the tax year for which they will be effective and are subject to a filing fee. In addition, the IRS has discretion to deny a change from a permissible method and/or to impose different terms and conditions (e.g., different Section 481(a) adjustment spread periods).
Observation: Taxpayers that intend to use the DRM may need to take action before the end of the tax year, and should proceed with caution, as other UNICAP sub-methods (i.e., step-allocation and 90-10 de minimis rule) now also are subject to nonautomatic procedures.
Action to consider
The requirement to use nonautomatic procedures for certain UNICAP sub-methods eliminates much of the flexibility and certainty associated with these methods. Taxpayers that previously changed their UNICAP sub-methods now must obtain permission from the IRS before changing to a different method, which may require action before the end of their tax year. Moreover, it is uncertain how the IRS will administer these nonautomatic changes.
In detail
Background
Under UNICAP, taxpayers that produce property or acquire property for resale generally are required to capitalize the direct and indirect costs that directly relate to, or are incurred by reason of, their production or resale activities (capitalizable activities). Direct and indirect costs are capitalized (1) into inventory and recovered through cost of goods sold or (2) into the basis of property produced for use in the taxpayer’s business (i.e., self-constructed assets) and recovered through depreciation.
Mixed service costs (MSC) are indirect general and administrative (G&A) costs related to both capitalizable and deductible activities. Taxpayers subject to UNICAP may choose one of several sub-methods to allocate MSC to capitalizable and deductible activities – e.g., the simplified service cost method (for inventory and certain self-constructed assets) or a facts and circumstances method. Alternatively, a taxpayer may allocate MSC using the step-allocation method or the DRM. Under the step-allocation method, MSC are allocated to operating and other service departments using a sequential process starting with the service department benefitting the greatest number of departments to the service departments benefitting the least number of departments. Under the DRM, all G&A costs are allocated to capitalizable activities if the costs provide any support to departments engaged in capitalizable activities. Under any method for capitalizing MSC, a 90-10 de minimis rule allows a taxpayer to (1) deduct mixed service department costs if the department is 10% or less allocable to capitalizable activities and (2) capitalize 100% of mixed service department costs if the department is 90% or more allocable to capitalizable activities.
UNICAP method changes
Some taxpayers may have changed to the DRM, which often results in more costs capitalized to self-constructed assets or inventory compared to other methods. These taxpayers may have employed the DRM without the 90-10 de minimis rule, resulting in the capitalization of all MSC. If there is a subsequent desire to capitalize less MSC, then the step-allocation method and/or the 90-10 de minimis rule could be used to decrease the amount of costs capitalized to inventory or self-constructed assets in future years. Historically, both of these method changes could be made under the automatic procedures (unless the five-year eligibility rule applied) and were implemented with Section 481(a) adjustments for which an increase to income was spread over four tax years and a reduction to income was deducted entirely in one tax year.
Rev. Proc. 2024-23 now precludes taxpayers from using the automatic procedures to change either to or from the DRM or the step-allocation method. Likewise, under Rev. Proc. 2024-23, a taxpayer that currently uses the DRM or the step-allocation method must use the nonautomatic procedures to make or revoke an election to use the 90-10 de minimis rule to allocate mixed service department costs to production or resale activities. Rev. Proc. 2024-23 is generally effective for Forms 3115 filed on or after April 30, 2024, for a year of change ending on or after September 30, 2023, that is filed under the automatic change procedures of Rev. Proc. 2015-13, as clarified and modified. However, under Rev. Proc. 2024-23, the due date is modified to the extended due date of the tax return for the taxpayer's last tax year ending before April 30, 2024, for nonautomatic changes that were previously automatic, including the UNICAP changes described above.
Taxpayers now must make these UNICAP method changes under the nonautomatic procedures, which require an earlier filing date (generally by the end of the tax year), a filing fee (currently $11,500), and IRS discretion to approve the change (particularly when the taxpayer is changing from a permissible method). The nonautomatic procedures under Rev. Proc. 2015-13 provide the IRS National Office with discretion to deny a request to change a method if it determines the requested method would not clearly reflect income or would otherwise not be in the interest of sound tax administration. As part of this determination, the IRS National Office will consider whether the change in method would clearly and directly frustrate compliance efforts of the IRS in administering the income tax laws. The IRS National Office also will consider all the facts and circumstances and exercise its discretion in a manner that generally minimizes distortions of income across taxable years, as well as on an annual basis.
Observation: Taxpayers that utilized (or intended to utilize) the DRM can no longer rely on automatic procedures to change to accounting methods that capitalize less (or more) costs and reduce (or increase) taxable income. Affected taxpayers should consider whether to take action before the end of their tax year.
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