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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

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Sept. 8, 2016

Mastering Section 263A UNICAP Reporting for Partnerships and S Corporations

Jolaine L. Hill, CPA, Director

Katz Sapper & Miller, Indianapolis

[email protected]

Gary Markowitz

Chatsworth, Calif.

[email protected]



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.

5

UNICAP Overview Gary Markowitz, Enrolled Agent

Contact me at:

[email protected]

September 8, 2016

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


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


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


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


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


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


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


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


• 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


• 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


• 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


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


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


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


(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


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


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


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))


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


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


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


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


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


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.


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


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


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


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


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- 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.


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▪ 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

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▫ 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


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- 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


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▫ 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.


Production Expenditures

May $1,400,000

June $1,800,000

July $2,000,000

August $2,400,000

September $3,200,000

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- 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


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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


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- Determine the average outstanding balance of traced debt

(OTDB) for the production period


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

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- 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


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- Determine the average avoided cost debt: average production

expenditures exceed the average outstanding traced debt


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

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- 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


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- 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


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▪ 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

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▪ 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


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▫ 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).


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- 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


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- 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


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- 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


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▫ 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


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- 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:


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» 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


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» The amount of the remaining production expenditures subject to

the deferred asset method and pass-through entity avoided cost

debt is $136,842


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

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▫ 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


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- 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


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▫ 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:


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July 434,707

August 839,055

September 1,057,237

October 1,140,178

November 1,135,128

December 1,135,128


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- 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.


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Questions? Contact Jolaine

Jolaine L. Hill, CPA

Tel: 317.580.2446

Fax: 317.805.2372

E-mail: [email protected]

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