Upload
others
View
14
Download
0
Embed Size (px)
Citation preview
WHO TO CONTACT DURING THE LIVE EVENT
For Additional Registrations:
-Call Strafford Customer Service 1-800-926-7926 x10 (or 404-881-1141 x10)
For Assistance During the Live Program:
-On the web, use the chat box at the bottom left of the screen
If you get disconnected during the program, you can simply log in using your original instructions and PIN.
IMPORTANT INFORMATION FOR THE LIVE PROGRAM
This program is approved for 2 CPE credit hours. To earn credit you must:
• Participate in the program on your own computer connection (no sharing) – if you need to register
additional people, please call customer service at 1-800-926-7926 x10 (or 404-881-1141 x10). Strafford
accepts American Express, Visa, MasterCard, Discover.
• Listen on-line via your computer speakers.
• Respond to five prompts during the program plus a single verification code. You will have to write down
only the final verification code on the attestation form, which will be emailed to registered attendees.
• To earn full credit, you must remain connected for the entire program.
Mastering Section 263A UNICAP Reporting for Partnerships
and S Corporations: Getting K-1 Disclosures Right Navigating Requirements for Tiered Partnerships, Footnote Disclosures and Interest Capitalization
THURSDAY, SEPTEMBER 8, 2016, 1:00-2:50 pm Eastern
FOR LIVE PROGRAM ONLY
Tips for Optimal Quality
Sound Quality
When listening via your computer speakers, please note that the quality
of your sound will vary depending on the speed and quality of your internet
connection.
If the sound quality is not satisfactory, please e-mail [email protected]
immediately so we can address the problem.
FOR LIVE PROGRAM ONLY
Sept. 8, 2016
Mastering Section 263A UNICAP Reporting for Partnerships and S Corporations
Jolaine L. Hill, CPA, Director
Katz Sapper & Miller, Indianapolis
Gary Markowitz
Chatsworth, Calif.
Notice
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY
THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY
OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT
MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR
RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
You (and your employees, representatives, or agents) may disclose to any and all persons,
without limitation, the tax treatment or tax structure, or both, of any transaction
described in the associated materials we provide to you, including, but not limited to,
any tax opinions, memoranda, or other tax analyses contained in those materials.
The information contained herein is of a general nature and based on authorities that are
subject to change. Applicability of the information to specific situations should be
determined through consultation with your tax adviser.
6
IRC 263A – UNICAP
Objectives: • Determine when and how a taxpayer is required to
allocate IRC 263A costs to inventory;
• Identify which taxpayers are required to apply the
UNICAP rules;
• Define IRC 263A Costs and IRC 471 Costs;
• Define “Additional 263A Costs”;
• Determine what costs a taxpayer is required to
capitalize to inventory under IRC 471;
• Identify the property subject to IRC 263A;
7
IRC 263A – UNICAP
Objectives: • List various special rules and exceptions;
• Identify the types of costs that must be capitalized;
• Discuss and provide an example of the simplified
production method; and
• Explain IRC 481(a) pertaining to the change in
method of accounting.
8
Uniform Capitalization Rules - IRC §263A
IRC §263A outlines the rules for the capitalization
and inclusion in inventory costs of certain expenses.
Known as UCR or UNICAP, this section of the
Internal Revenue Code (Code) was introduced as
section 803 of the Tax Reform Act of 1986 (Public
Law 99-514).
9
Activities Subject to IRC §263A
If you do any of the following in the course of a trade or business or an activity carried on for profit, you are subject to the UNICAP rules:
• Produce real or tangible personal property for use in the business or activity (self-constructed assets),
• Produce real or tangible personal property for sale to customers, or
• Acquire property for resale.
10
IRC §263A Definitions and Concepts
It must be emphasized that this Code section applies to producers whether or not the property produced is held for sale.
This section applies to assets produced for a taxpayer under a contract (see Suzy’s Zoo v CIR, 273 F3d 875 (CA-9 2001)).
• Property produced under a contract for a taxpayer is treated as
produced by that taxpayer to the extent the taxpayer made payments or otherwise incurred costs in connection with the property.
11
IRC §263A Definitions and Concepts
Treas. Reg. §1.263A-2(a)(1)(ii)(B) involves property produced for a taxpayer under a contract.
• In general, property produced for a taxpayer under a contract with another party is treated as property produced by the taxpayer to the extent the taxpayer makes payments or otherwise incurs costs with respect to the property.
• A taxpayer has made payment under this section if the transaction would be considered payment by a taxpayer using the cash receipts and disbursements method of accounting.
12
IRC §263A Definitions and Concepts
Treas. Reg. §1.263A-2(a)(1)(ii)(C) involves home construction contracts.
• IRC §460(e)(1) provides that IRC §263A applies to a home construction contract unless that contract will be completed within 2 years of the contract commencement date and the taxpayer’s average annual gross receipts for the 3 preceding taxable years do not exceed $10 million.
• IRC §263A applies to such a contract even if the contractor is not considered the owner of the property produced under the contract under federal income tax principles.
13
Inventory Requirement –
Treas. Reg. §1.471-1
In order to reflect taxable income correctly, inventories at the beginning and end of each taxable year are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing factor.
The purpose of maintaining inventories is to assure that the costs of producing or acquiring goods are matched with the revenues realized from their sale. Inventory accounting accomplishes this by accumulating production or acquisition costs in an inventory account as they are incurred instead of allowing an immediate deduction when incurred. When the related goods are sold, these costs are removed from the inventory account and recorded as costs of sale.
14
Recordkeeping Requirement –
Treas. Reg. §1.471-2(e)
Inventory records should be…
• Recorded in a legible manner,
• Properly computed and summarized, and
• Preserved as part of the accounting records of the taxpayer.
Additionally, inventories will be subject to investigation by the district director and the taxpayer must satisfy the district director as to the correctness of the prices adopted.
Inventories Required
• Finished goods
• Work in process (WIP)
• Raw materials (goods for
resale and goods
physically incorporated into
merchandise)
Inventories Not Required
• Materials consumed during
manufacturing
• Supplies used to provide
services
• Miscellaneous supplies
15
Inventory of Goods Under IRC §471
16
Section 471 Costs for Resellers
Treas. Reg. §1.471-3
Invoice price
Less: any discounts
Net invoice price
Plus: acquisition charges
= IRC 471 Costs *
* Doesn’t include §263A costs!
17
Inventories of Manufacturers –
Treas. Reg. §1.471-11
All direct production costs • Reg. §1.471-11(b)(2)
o Direct material costs (see Reg. 1.471-3)
o Direct labor costs
Certain indirect and production costs • Reg. 1.471-11(c)(2)
o Step One – Identify costs
o Step Two – Allocate costs
Costs incident to and necessary for production – see Reg. 1.471-11(c)(3)(i)
• Repair expenses
• Maintenance
• Utilities
• Rent
• Indirect labor
• Indirect
materials/supplies
• Tools & equipment not
capitalized
• Quality control &
inspection costs
18
Category I Costs – Reg. §1.471-11(c)(2)(i) Indirect Costs - Required to be Capitalized
• Marketing expenses
• Advertising expenses
• Selling expenses
• Other distribution exp
• Interest
• Research & experimental
expenses
• Losses under IRC §165
• Pct depletion in excess of
cost depletion
• Excess tax depreciation
• Income taxes re: sale of
inventory
• Pension contributions –
past service costs
• G&A expenses (incidental)
• Officers’ salaries (incidental)
19
Category II Costs – Reg. §1.471-11(c)(2)(ii) Indirect Costs - Not Required to be Capitalized
• Taxes
• Depreciation/depletion
• Employee benefits
• Costs re: strikes
• Costs re: rework labor
• Costs re: scrap
• Costs re: spoilage
• Factory admin expenses
• Officers’ salaries
• Insurance costs
* §471 Costs if capitalized for book
20
Category III Costs – Reg. §1.471-11(c)(2)(iii) Indirect Costs – Dictated by Financial Reports *
21
Allocation Methods
Costs must be allocated by use of a method
which fairly apportions costs among the items
produced:
• Specific identification method;
• Standard cost method;
• Burden rate method;
• Simplified service cost method; or
• Self-developed allocation method.
22
Uniform Capitalization Rules - IRC §263A
Reasons for the enactment:
• Provides for better matching of income and expenses,
• Provides uniform capitalization rules that may be
applied equally to different industries, and
• Provides rules to equalize purchased and self-
constructed assets.
23
Property Subject to IRC §263A
Real and tangible personal property produced by the
taxpayer/client.
Real or personal property the client is holding for resale
in the ordinary course of business of large resellers.
24
IRC §263A Definitions and Concepts
Capitalize – In the case of property that is inventory in
the hands of the taxpayer, capitalize means to include
in the inventory costs, and in the case of other property,
to charge to a capital account or basis. See Treas.
Reg. §1.263A-1(c)(3).
Recovery of capitalized costs – Costs that are
recovered through depreciation, amortization, cost of
goods sold, or by an adjustment to basis at the time the
property is sold, placed in service, or otherwise
disposed. See Treas. Reg. §1.263A-1(c)(4).
25
§263A Definitions and Concepts
§471 Costs – Costs, other than interest, that were
capitalized under the taxpayer’s method of accounting
immediately prior to the enactment of §263A. Includes any
non-inventoriable costs, other than interest, capitalized or
included in acquisition or production costs under the
taxpayer’s accounting method used immediately prior to the
effective date of §263A. (See Reg. §1.263A-1(d)(2)).
Additional §263A Costs – Costs, other than interest, that
were not capitalized under the taxpayers accounting method
immediately prior to the effective date of §263A but are
required to be capitalized under §263A. (See Reg. §1.263A-
1(d)(3)).
26
§263A Definitions and Concepts
Total §263A Costs – All costs that a taxpayer must
capitalize under §263A.
• §263A Costs
• Plus: Additional §263A Costs
• Plus: Interest Capitalized Under §263A(f)
• Equals = Total §263A Costs
27
4-Step Approach to §263A Consideration
(1) Identify the client’s production or resale activity. For the year of
tax return preparation:
• Did the client produce property for sale to customers?
• Did the client resell property to customers?
(2) Determine the applicability of any special rules or exemptions.
(3) Identify the costs subject to capitalization.
(4) Allocate all direct and indirect costs that directly benefit or were
incurred by reason of reproduction or resale activities to the
property produced or acquired for resale.
28
Identify Production Personnel
29
Cost Center Allocations
30
Allocating Service Costs
Service costs are a type of indirect costs that may be allocated – generally to specific departments.
There is an election that can be made under Regulation §1.263A-1(g)(4)(ii) called the “De mimimis rule.”
This is an election that can be made for administrative
convenience. It states that, where 90% or more of a mixed service department’s costs are deductible service costs, a taxpayer can elect not to allocate any portion of the service department’s costs to property produced or property acquired for resale.
31
Allocating Costs Attributable to
Purchasing, Handling & Storage
The -3 regulations under IRC 263A cover “property acquired for resale.” The portion of this section that deals with allocating labor costs includes an election that can be made under Regulation §1.263A-3(c)(3)(ii)(A) called the “one-third – two-thirds rule.”
The rule states that (where elected) the costs of the purchasing
department must be capitalized where more than two thirds of the costs are allocated to the purchasing department.
Likewise, if the department costs are less than one-third allocated to purchasing, none of the costs will be capitalized.
32
IRC §263A Definitions and Concepts
Under Treasury Regulation §1.263A-2(a)(1)(i), the term “produce” includes (a) construct, (b) build, (c) install, (d) manufacture, (e) develop, (f) improve, (g) create, (h) raise, or (i) grow.
Examples of producers include:
• Builders
• Manufacturers
• Farmers
• Publishers
• Oil producers
• Miners
• Filmmakers
33
IRC §263A Definitions and Concepts
Treasury Regulation §1.263A-2(a)(1)(ii) provides the general rule involving the term “ownership.” Except as provided in Treas. Reg. §1.263A-2(a)(1)(ii)(B) and (C), a taxpayer is not considered to be producing property unless the taxpayer is considered an owner of the property produced under federal income tax principles.
• Treas. Reg. §1.263A-2(a)(1)(ii)(B) involves property produced for a taxpayer under a contract.
• Treas. Reg. §1.263A-2(a)(1)(ii)(C) involves home construction contracts.
34
§263A Definitions and Concepts
Self-Constructed Assets
• Applies to producers whether or not the property
produced is held for sale.
• Applies to assets produced for the client under a contract.
See Treas. Reg. §§1.263A-1(a)(3)(ii) and 1.263A-1(d)(1).
Capitalizable Costs – Treas. Reg. §1.263A-1(e)(2)(i)
Producers must capitalize direct material costs and
direct labor costs.
• Direct labor costs include the costs of labor that can be
identified or associated with particular units or groups of
units of specific property produced.
Resellers must capitalize the acquisition costs of
property acquired for resale. In the case of
inventory, the acquisition cost is the cost described
in Reg 1.471-3(b).
35
• Indirect labor costs
• Officers’ compensation
• Pension & related costs
• Employee benefit exp
• Indirect material costs
• Purchasing costs Reg. §1.263A-3(c)(3)
• Handling costs Reg. §1.263A-3(c)(4)
• Storage costs Reg. §1.263A-3(c)(5)
• Cost recovery (depreciation)
• Depletion
• Rent
• Taxes
• Insurance
• Utilities
• Repairs/maintenance
• Engineering & design costs
• Spoilage
• Tools & equipment
• Quality control
• Bidding costs
• Licensing & franchise costs
• Interest
• Capitalizable service costs
(including capitalizable mixed)
36
Capitalizable Costs Under IRC §263A –
Indirect Costs – Reg. §1.263A-1(e)(3)
37
Exceptions to the UNICAP Rules
The UNICAP rules do not apply to:
• Resellers of property with average annual gross
receipts of $10 million or less for the 3 prior tax
years;
• Property used for personal or non-business
purposes or for purposes not connected with a
trade or business or an activity conducted for
profit;
• Research and experimental expenditures
deductible under IRC §174;
38
Exceptions to the UNICAP Rules
• Intangible drilling and development costs or any
deduction allowed under IRC §59(e);
• Property produced under a long term contract,
except for certain home construction contracts
described in IRC §460(e)(1);
• Timber and certain ornamental trees raised,
harvested, or grown and the underlying land;
• Qualified creative expenses incurred as a
freelance (self-employed) writer, photographer,
or artist that are otherwise tax deductible;
39
Exceptions to the UNICAP Rules
• Costs allocable to natural gas acquired for
resale, to the extent these costs would
otherwise be allocable to “cushion gas” stored
underground;
• Property produced if substantial construction
occurred before 3/01/1986;
• Property provided to customers in connection
with providing services. It must be “de minimis”
and not be inventory in the hands of the service
provider (see Reg. 1.263A-2(b)(3)(iv));
40
Exceptions to the UNICAP Rules
• Loan originations; and
• The costs of certain producers who use a
simplified production method and whose total
indirect costs are $200,000 or less.
41
Allocation of Additional §263A Costs
for Producers
The simplified production method is frequently used by
producers to calculate these costs. This method allows
for the determination of the amount of “additional
§263A costs” properly allocable to ending inventory.
This figure is established by applying an absorption
ratio to the current year §471 costs in ending inventory
(aka book inventory).
• The next slide will show how that ratio is determined
under this method.
42
Allocation of Additional §263A Costs
for Producers
Application of Simplified Production Method – see
Treas. Reg. §1.263A-2(b).
• Current year additional §263A costs
• Divided by
• Current year §471 costs
• Equals = Simplified Production Absorption Ratio
43
Allocation of Additional §263A Costs
for Producers
Computation of “additional §263A costs” in ending
inventory – see Treas. Reg §1.263A-2(b)(3).
• Current year §471 costs in ending inventory
• Multiplied by
• Absorption Ratio
• Equals = Add’l §263A costs (to be added to §471 inventory
figure on Form 1125-A)
44
Simplified Production Method Example -
Total Current Year §471 costs
Total Goods Available for Sale
Per Form 1125-A……………$12,500,000
Less: Beginning Inventory*.. 2,500,000
Current Year §471 Costs……….$10,000,000
* This is the ending inventory from the previous year.
45
Simplified Production Method Example - Calculation of Add’l §263A Costs
46
Simplified Production Method Example - Calculation of Ending Inventory Under §263A
Current Year Add’l §263A Costs.. $1,000,000
Divided by: CY §471 Costs…… 10,000,000
Absorption Ratio…………………. 10%
Times CY §471 Costs in EI……… $3,000,000 (a)
§263A Costs in EI…………………. $300,000 (b)
Ending Inventory for tax purposes $3,300,000 (a) + (b)
This is the increase to book inventory to arrive at tax inventory.
47
Accounting Method Change - §481(a) Adjustment
Frequently, producers still file tax returns without
applying UNICAP. In a situation where you prepare a
client’s return and initiate the method change (using
the UNICAP rules), there is generally a 4-year spread
of the increase to the current year’s beginning
inventory (or prior year’s ending inventory).
• See Treas. Reg. §1.263A-7 re: Changing a Method of
Accounting Under IRC §263A.
48
Accounting Method Change - §481(a) Adjustment
Under Reg. §1.263A-7(c), the rules are very specific in
regard to the impact to §481(a).
(1) When a taxpayer changes its accounting method for costs
subject to IRC §263A, the taxpayer generally must, in
computing its taxable income for the year of change, take
into account the adjustments required by §481(a). The
adjustments required by §481(a) relate to revaluations of
inventory property, whether the taxpayer produces the
inventory or acquires it for resale.
49
Accounting Method Change - §481(a) Adjustment
(2) In general, if a taxpayer changes its accounting
method for costs subject to IRC §263A, the taxpayer must
revalue the items or costs included in its beginning
inventory in the year of change as if the new method (the
method too which the taxpayer is changing), had been in
effect during all prior years.
50
Accounting Method Change - §481(a) Adjustment
Using the information shown on the next slide (showing
Form 1125-A) and the example of our $300,000
increase to ending inventory, let’s review what the
impact would be to the affected tax return. Assuming
the beginning inventory was increased by $500,000
after calculating the previous year’s ending inventory,
there would be an additional $125,000 income that
would need to be reported. This is one-fourth of the
$500,000 increase to the original inventory calculated
under IRC §471. This is an allowable automatic
change in accounting method and there would be a
similar “adjustment” in each of the 3 succeeding years.
51
Cost of Goods Sold Under IRC §263A - Costs Allocated Under Reg. §1.263A-1(h)
The beginning inventory includes $500,000 of additional IRC §263A costs while the
ending inventory is recomputed to include $300,000 of additional IRC §263A costs.
52
Accounting Method Change - §481(a) Adjustment
Had the tax return been filed without applying the
UNICAP rules and had the tax return been selected for
examination by IRS, any change in accounting method
would result in a 1-year spread instead of the 4-year
spread. This occurs when IRS initiates the method
change. See Revenue Procedures 2015-13 and 2016-29.
The impact to the taxpayer in our example would be
that an additional $500,000 would be taxed to bring the
client into compliance as if the business had always
been correctly calculating its inventory under §263A.
53
Accounting Method Change - §481(a) Adjustment
54
Comparing Form 1120, Schedule L to
Form 1125-A - Inventory
1 – “Book” beginning inventory 2 – “Book” ending inventory
3 – “Tax” beginning inventory 4 – “Tax” ending inventory
55
IRC §263A Audit Considerations
Small Business audits – SBSE
Large Business audits – LB&I
Likelihood of audits and what to watch for
© 2016 KSM Business Services, Inc.
Mastering Section 263A UNICAP
Reporting for Partnerships and S
Corporations
September 8, 2016
Jolaine L. Hill, CPA
57 ksmcpa.com
▪ Calculations related to tiered partnerships
▪ Industry specific issues
▪ Real estate interest capitalization
Agenda
58 ksmcpa.com
Calculations Related to Tiered
Partnerships
59 ksmcpa.com
▪ Aggregation
▫ For purposes of determining whether a retailer has three
year average gross receipts over $10 million, aggregation
rules apply
▫ Section 263A references the rules under Section 448(c),
which in turn references Sections 52(a) or 52(b) or 414(m) or
414(o)
- Section 52(a) – Controlled group of corporations
- Section 52(b) – Partnerships, proprietorships, etc. under
common control
Calculations Related to Tiered Partnerships
60 ksmcpa.com
- Section 414(m) – Affiliated service groups
- Section 414(o) – Separate organization or employee leasing
▫ Section 263A is calculated at each tier where applicable
▫ No specific disclosures, except related to interest
capitalization, are made to the partners or members
Calculations Related to Tiered Partnerships
61 ksmcpa.com
Specific Industry Issues
62 ksmcpa.com
▪ Natural resources
▫ Section 263A applies to the energy and natural resource industries
subject to certain statutory and regulatory exceptions
▫ The following costs are not required to be capitalized:
- Amortization of geological and geophysical expenditures (Section
167(h))
- Costs incurred in complying with environmental protection agency
sulfur regulations (Section 179B)
- Intangible drilling and development costs for oil and gas wells and
geothermal wells (Section 263(c))
- Intangible drilling and development costs incurred outside the United
States (Section 263(i))
Specific Industry Issues
63 ksmcpa.com
- Amortization of intangible drilling costs and mineral exploration and development costs (Section 291(b)(2))
- Section 59(e) costs
▫ Section 263A does not apply to any costs incurred related to natural gas acquired for resale to the extent the cost would be allocable to cushion gas
- Cushion gas is the portion of gas stored in an underground storage facility that is required to maintain the level of pressure necessary for operation of the facility
▫ Section 263A does apply to costs incurred related to natural gas acquired for resale to the extent the cost would be allocable to emergency gas
- Emergency gas is natural gas stored in an underground storage facility that is used during periods of unusually high customer demand
Specific Industry Issues
64 ksmcpa.com
▪ Hard minerals
▫ Section 263A does not apply to mineral exploration and
development expenditures deductible under Sections 616(a),
617(a) or 59(e)
▪ Timber
▫ Section 263A does not apply to the raising, harvesting or
growing of timber or evergreen trees that are more than six
years old when severed from the roots
- Trees bearing fruit, nuts or other crops and other ornamental
trees are treated as farming business
Specific Industry Issues
65 ksmcpa.com
▪ Farming
▫ Applies if first marketable crop is harvested two or more years from the date of planting or acquisition
- Does not apply to livestock and crops harvested in less than two years if the taxpayer is not required to be on the accrual method of accounting
- Crops that have a preproductive period of two or more years are listed in Notice 2013-18
▫ Preproduction costs are capitalized
- Deductible through depreciation expense
▫ Preproduction periods are based on national averages
▫ Preproduction period ends at the time of the first marketable harvest
Specific Industry Issues
66 ksmcpa.com
▫ Election is available to expense preproductive costs
- Must be elected in the first year preproductive costs are incurred
- Allows for costs other than the original cost of the plant to be
expensed
- Requires use of straight line depreciation over longer lives
- Election is not available to taxpayers who are required to use
the accrual method of accounting
Applies if first marketable crop is harvested
two or more years from the date of planting
or acquisition
Does not apply to livestock and crops
harvested in less than two years if the
taxpayer is not required to be on the
accrual method of accounting
Crops that have a preproductive period of
two or more years are listed in Notice
2013-18
Preproduction costs are capitalized
Deductible through depreciation expense
Preproduction periods are based on
national averaes
Specific Industry Issues
67 ksmcpa.com
Real Estate Interest Capitalization
68 ksmcpa.com
▪ Section 263A(f) provides that interest is to be capitalized if it is paid or incurred with the respect to designated property
▫ Designated property
- Real property
- Tangible personal property, other than inventory, with a class life of 20 years or more
- Tangible personal property with an estimated production period of more than two years
- Tangible personal property with an estimated production period or more than one year and an estimated cost of production greater than one million dollars
Real Estate Interest Capitalization
69 ksmcpa.com
▪ Rule One: Interest capitalization begins when production
begins and ends when production ends
▫ For real property, production begins when the physical
activity is first performed (i.e., when dirt is moved for new
construction)
▫ For personal property, production begins when production
expenditures equal or exceed five percent of the total
estimated production costs
Interest Capitalization Rule One
70 ksmcpa.com
▫ Interest capitalization ends when the property is ready to be placed in service or is ready to be held for sale
▫ Examples
- ABC is constructing an office building with two wings. One wing is ready to be placed in service at the end of 2016, while the second wing is still under construction. At the end of 2016, the first wing is considered place in service and interest no longer needs to be capitalized with respect to the first wing.
- EFG constructs finished houses. EFG generally paints and finishes the interior of the houses, although this does not occur until a buyer is found. Since EFG expects to undertake this production activity, the production period does not end until these activities are completed.
Interest Capitalization Rule One
71 ksmcpa.com
▫ Suspension of production period
- If production activities cease for at least 120 consecutive days, a
taxpayer may suspend the capitalization of interest with respect
to the designated property
- Interest capitalization resumes when the production activities
resume
- Circumstances causing the cessation period must not be
inherent in the production process, for example, normal adverse
weather conditions
- This is an election treated as an accounting method that must
be applied consistently to all units of designated property that
satisfy the requirements
Interest Capitalization Rule One
72 ksmcpa.com
▫ De minimis exception
- If the production period does not exceed 90 days and the total cost of
production is not more than one million dollars divided by the number
of days in the production period, interest capitalization is not required
- Costs of land, adjusted basis of property to produce property and
interest that would be capitalized except for the de minimis
exception are excluded in testing for the de minimis exception
- Example: XYZ plans to remodel its building. The basis in the
building and land is $500,000. The production period is 40 days. As
long as production costs do not exceed $25,000 ($1,000,000/40
days), interest will not be required to be capitalized
Interest Capitalization Rule One
73 ksmcpa.com
▪ Rule 2: During the production period, interest of
outstanding debt that is directly attributable to production
expenditures must be capitalized first
▫ Traced debt rule
▫ Production expenditures are all costs required to be
capitalized under Section 263A, including costs incurred
before the beginning of the production period
- For real estate, these costs include an allocable portion of the
land, the adjusted basis of any existing structure and all direct
and indirect costs under Section 263A
Interest Capitalization Rule Two
74 ksmcpa.com
▫ Traced debt
- The amount of the taxpayer’s “eligible debt” equal to or less than the property’s accumulated production expenditures
- If accumulated production expenditures are less than eligible debt, the excess debt is not traced debt
- Eligible debt includes all the taxpayer’s outstanding debt, except for:
» Debt bearing interest that is disallowed under Reg. Sec. 1.163-8T(m)(7)(ii)
» Debt that bears no interest, except to the extent the debt is traced debt, for example, accounts payable
» Debt that is borrowed from a related party as defined in Section 267(b) and Section 707(b) that bears an interest rate less than the applicable federal rate
Interest Capitalization Rule Two
75 ksmcpa.com
» Debt bearing personal interest
» Debt bearing qualified residence interest
» Debt incurred by an organization exempt under Section 501(a),
except to the extent debt is related to an unrelated trade or
business
» Reserves, deferred tax liabilities and other similar items
▫ Nontraced debt
- All eligible debt on the measurement date other than traced debt
- Can include debt that was previously treated as traced debt or
may be treated as traced debt in the future
Interest Capitalization Rule Two
76 ksmcpa.com
- Example: On Sept. 8, 2016, HIJ takes out a $5,000,000
construction loan and deposits the amount into a interest-
bearing account to be withdrawn as needed. HIJ incurs
$2,000,000 in construction expenditures as of Dec. 31, 2016. In
2016, HIJ must capitalize interest related to the $2,000,000
expended (traced debt). The remaining $3,000,000 is nontraced
debt.
Interest Capitalization Rule Two
77 ksmcpa.com
▪ Rule 3: Interest is capitalized using the avoided cost
method
▫ Any interest the taxpayer theoretically would have avoided if
the accumulated production expenditures had been used to
repay or reduce the taxpayer’s outstanding debt must be
capitalized
- Based on the assumption that the taxpayer’s debt would have
been repaid without regard to the taxpayer’s subjective
limitations or restrictions against repayment or use of the debt
proceeds
Interest Capitalization Rule Three
78 ksmcpa.com
▫ The avoided cost method requires capitalization of:
- Traced debt
- Excess expenditure amounts
- Interest on other debt to the extent that production
expenditures exceed traced debt
- Calculation:
» Determine average accumulated production expenditures in
excess of traced debt (average excess expenditures)
» Weighted average interest rate is determined
» Average excess expenditures x weighted average interest rate
Interest Capitalization Rule Three
79 ksmcpa.com
- Other items involved in the calculation:
- Average production expenditures = (Accumulated production
expenditures – traced debt computed at each measurement
date in the computation period) / number of measurement
dates in the computation period
- Weighted average interest rate = interest incurred on
nontraced debt during the computation period / average
nontraced debt for the computation period
- Average nontraced debt = Amount of nontraced debt
outstanding on each measurement date during the
computation period / number of measurement dates during
the computation period
Interest Capitalization Rule Three
80 ksmcpa.com
▫ Example : RST acquires land for $1,000,000 on Feb. 1 with
the intent to build a building for its own use. As of April 1, the
preproduction expenditures are $1,200,000. On April 1,
construction begins and is completed on Aug. 31. The
building is occupied on Sept. 1.
Interest Capitalization Rule Three
Production Expenditures
May $1,400,000
June $1,800,000
July $2,000,000
August $2,400,000
September $3,200,000
81 ksmcpa.com
- Steps to determine amount of interest to capitalize:
- Determine the production period
» April 1 to Aug. 31 = five months
- Determine the average production expenditure for each
production period
» Production period is subdivided into time periods not exceeding
one month
Interest Capitalization Rule Three
82 ksmcpa.com
Month Beginning
Production
Expenditure
Ending
Production
Expenditure
Average
Production
Expenditure
April 1,200,000 1,400,000 1,300,000
May 1,400,000 1,800,000 1,600,000
June 1,800,000 2,000,000 1,900,000
July 2,000,000 2,400,000 2,200,000
August 2,400,000 3,200,000 2,800,000
Total 9,800,000
Average Production
Expenditures
1,960,000
Real Estate Interest Capitalization
83 ksmcpa.com
- Determine the average outstanding balance of traced debt
(OTDB) for the production period
Real Estate Interest Capitalization
Month Beginning OTDB Ending OTDB Average OTDB
April 800,000 900,000 850,000
May 900,000 1,200,000 1,050,000
June 1,200,000 1,400,000 1,300,000
July 1,400,000 1,500,000 1,450,000
August 1,500,000 1,800,000 1,650,000
Total 6,300,000
Average OTDB 1,260,000
84 ksmcpa.com
- The interest rate is then applied to the average outstanding
balance of traced debt
- If the interest rate is ten percent, the annual interest would be
$126,000. For a production period of five months, the amount
of interest on traced debt to be capitalized would be $52,500
($126,000 x 5/12).
- The taxpayer can also use the actual interest paid or incurred
on the traced debt
Real Estate Interest Capitalization
85 ksmcpa.com
- Determine the average avoided cost debt: average production
expenditures exceed the average outstanding traced debt
Real Estate Interest Capitalization
Month Beginning ACD Ending ACD Average ACD
April 400,000 500,000 450,000
May 500,000 600,000 550,000
June 600,000 600,000 600,000
July 600,000 900,000 750,000
August 900,000 1,400,000 1,150,000
Total 3,500,000
Average ACD 700,000
86 ksmcpa.com
- The weighted average interest rate for nontraced debt is then applied
to the avoided cost debt.
- If the interest rate is 12 percent, the annual interest would be
$84,000. For a production period of five months, the amount of
interest on avoided cost debt to be capitalized would be $35,000
($84,000 x 5/12)
- The excess expenditure amount is capitalized from the following
sources in the following order:
- Interest incurred on nontraced debt
- Interest incurred on amounts borrowed from related parties if the
interest rate is less than the applicable federal rate
- For a partnership, guaranteed payments for the use of capital that
would be deductible if the interest capitalization rules did not apply
Real Estate Interest Capitalization
87 ksmcpa.com
- When the excess expenditure amount exceeds the sum of the
interest available for capitalization, the excess expenditure
amount is capitalized to the extent of interest available for
capitalization
- As an alternative, a taxpayer can elect to treat all debt as
nontraced debt
- This is an election and applies to all designated property
Real Estate Interest Capitalization
88 ksmcpa.com
▪ Rule Four: a taxpayer may select a computation period
corresponding to its full tax year or divide its tax year into
two or more measurement periods of equal length
▫ The same measurement period must be used for all
designated property produced in a single tax year
▫ The last day of the measurement period is the measurement
date
Interest Capitalization Rule Four
89 ksmcpa.com
▪ Application to pass-through entities
▫ Interest capitalization is first applied at the entity level and
then at the partner, member or shareholder level
▫ Applied at the partner, member or shareholder level only to
the extent the pass-through entity has insufficient debt to
support the construction expenses
Interest Capitalization Rule Four
90 ksmcpa.com
▫ Deferred asset method - The remaining amount of the pass-through entity’s production
expenditures (excess of the accumulated production expenditures of the entity over its traced debt and avoided cost debt) is allocated to partners, members or shareholders based on their respective share
- The partner, member or shareholder would capitalize interest during the production period of the designated property
- Example J owns 40 percent in partnership JB Partnership. JB is constructing a building. Section 263A(f) applies. The production period is six months and the average monthly balance of the building’s production expenditures reduced by traced and avoided cost debt allocable to the expenditures is $800,000. J must capitalize any interest incurred by J on J’s eligible debt with respect to J’s 40 percent share ($320,000).
Interest Capitalization Rule Four
91 ksmcpa.com
- If the entity has a different tax year than the owner, the owner can apply the lagged year convention or a facts and circumstances method can be used
- This is considered a method of accounting
- Under the lagged year convention, the partner, member or shareholder will capitalize interest incurred in his or her taxable year based on the accumulated production expenditures of the entity outstanding during the taxable year of the entity ending within the partner, member or shareholder’s taxable year
- Interest is capitalized on the partner, member or shareholder’s eligible debt outstanding during each month of his or her taxable year with respect to the corresponding balance of accumulated production expenditures outstanding during each month of the entity’s taxable year
Interest Capitalization Rule Four
92 ksmcpa.com
- Under the facts and circumstances method, the partner,
member or shareholder must capitalize interest incurred in his
or her taxable year by using the actual production
expenditures of the entity for each month of the partner,
member or shareholder’s taxable year
- If the production expenditures of more than one pass-through
entity become subject to the deferred asset method, the partner,
member or shareholder must adopt a pro-rata ordering rule
based on the ratio of his or her share of each entity’s remaining
production expenditures to the total amount of his or her share
of all the entities remaining production expenditures
Interest Capitalization Rule Four
93 ksmcpa.com
- Recovery of the deferred asset
- Each partner, member or shareholder creates on its books an
asset consisting solely of the capitalized interest attributable
to his or her share of the production expenditures of the pass-
through entity
- The partner, member or shareholder would then account for
the capitalized interest in the same manner as the entity, for
example, depreciation or cost of goods sold
- If the partner, member or shareholder sells his or her share in
the pass-through entity, the remaining capitalized interest
goes into the calculation of any gain or loss on disposition
Interest Capitalization Rule Four
94 ksmcpa.com
▫ Substitute cost method
- Election
- The producing taxpayer shall capitalize certain substitute costs
during the production period in lieu of the partners, members or
shareholders of the pass-through entity being required to
capitalize interest on their avoided cost debt
- Substitute costs consist of a pro-rata amount of all the taxpayer
costs that would otherwise be deductible, for example,
marketing, advertising, general and administrative costs not
otherwise required to be capitalized, and interest on eligible
debt outside the production period
Interest Capitalization Rule Four
95 ksmcpa.com
- Amount of substitute costs to be capitalized
- Capitalize costs up to an amount equal to the additional interest that would have been capitalized by the taxpayer had the taxpayer’s eligible debt been equal to the average balance of its accumulated production expenditures during the production period
- The interest rate is the average federal long-term rate in effect during the production period
- If the taxpayer has insufficient substitute costs, i.e. substitute costs are less than or equal to the amount of interest that would be capitalized had the taxpayer’s eligible debt been equal to the average balance of its accumulated production costs, the following formula applies:
Interest Capitalization Rule Four
96 ksmcpa.com
» The amount of the entity’s substitute costs capitalized for the
taxable year / the average federal long-term rate in effect for the
period
- This amount is subtracted for the entity’s remaining
production expenditures
» This difference is then subject to the deferred asset method
- Example
» One million dollars in production expenditures
» An allocation of $600,000 of traced and avoided cost debt to such
expenditures
» Federal long-term rate in effect for the period of nine and a half
percent
» $25,000 of substitute costs
Interest Capitalization Rule Four
97 ksmcpa.com
» The amount of the remaining production expenditures subject to
the deferred asset method and pass-through entity avoided cost
debt is $136,842
Interest Capitalization Rule Four
Substitute Costs 25,000
Federal long-term rate /.095
263,158
Average production expenditures 1,000,000
Average traced debt 600,000
Average excess production period
expenditures
400,000
263,158
Amount subject to deferred asset
method
136,842
98 ksmcpa.com
▫ De minimis rule for pass-throughs
- Partners, members or shareholders of a pass-through entity are
not subject to the avoided cost rules with respect to the
production expenditures of the entity if:
- The partner, member or shareholder owns 20 percent or less
of the entity during the year and
- The partner, member or shareholder’s respective aggregate
share in the production expenditures of all designated
property being produced by the pass-through entity during the
production period reduced by the entity’s traced and avoided
cost debt allocable to such expenditures is less than or equal
to $250,000 calculated no less than monthly
Interest Capitalization Rule Four
99 ksmcpa.com
- Interest expense of the pass-through entity will not require
capitalization if:
- The partner, member or shareholder owns 20 percent or less
of the entity during the taxable year and
- The total partner, member or shareholder’s distributive share
of deductible interest expense for the partner, member or
shareholder’s taxable year is less than $25,000
Interest Capitalization Rule Four
100 ksmcpa.com
▫ Sample K-1 footnote to a partner, member or shareholder
- Pursuant to IRS Notice 88-99 and IRC Section 263A(f)(2)(c), the
interest capitalization requirements of Section 263A(f) shall be
applied first at the partnership level to the extent of its traced
and avoided cost debt allocable to its production expenditures
and then at the partner level
- Following is a schedule of your allocable share of the
partnership’s 2016 monthly average excess production
expenditures during the production period:
Interest Capitalization Rule Four
101 ksmcpa.com
July 434,707
August 839,055
September 1,057,237
October 1,140,178
November 1,135,128
December 1,135,128
Real Estate Interest Capitalization
102 ksmcpa.com
- If you capitalized interest with respect to the excess production
period expenditures reported to you on your 2015 K-1, you may
expense 77.456 percent of that interest in 2016. This interest
may be expensed due to the sale of lots in 2016.
Real Estate Interest Capitalization
103 ksmcpa.com
Questions? Contact Jolaine
Jolaine L. Hill, CPA
Tel: 317.580.2446
Fax: 317.805.2372
E-mail: [email protected]