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Capitalization and Accounting Methods Update

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1 Capitalization and Accounting Methods Update
Presented by: Sharon Kay – Washington National Tax: Kristine Mora – Washington National Tax:

2 Notice Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code, or applicable state or local tax law provisions These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice

3 Agenda Accounting method changes trends Tangible property regulations
Inventory update

4 Accounting method changes trends

5 Accounting method timeline and procedural considerations
2012 automatic 3115 due1 1 For properly extended corporate and partnership tax returns. 03/31/2013 01/01/2013 12/31/2012 11/13/2012 90 day window period Typical timeline for calendar-year taxpayers 2012 non-automatic 3115 due 2013 non-automatic 3115 due1 09/15/2013 12/31/2013 Automatic Accounting Method Changes Non-automatic Accounting Method Changes Filing Deadline Due date of tax return for year of change Last day of tax year of change Implementation of Change Implement on tax return for year of change; no user fees May not implement on tax return until consent received; user fee required Taxpayers Under Examination may only file (1) Within first 90 days of a tax year if taxpayer has been under examination for at least 12 months; (2) Within 120 days of an examination ending; or (3) With the consent of the Director (4) For automatic changes, taxpayer may file method change if automatic change procedure specifies the change is not subject to audit protection. Things to consider: Information needed to file a Form 3115? How long will it take to document a method change? Implementation impacts timing of section 481(a) adjustment, financial statement reporting and potentially estimated taxes Non-automatic method changes being considered as part of cash tax planning strategy During window period, taxpayers under exam may file with no consent requirement (as long as item not raised during exam) Audit protection for unfavorable changes filed during 90-day window File accounting method changes to mitigate Form UTP disclosure exposure

6 Accounting method changes trends
Top 5 method changes we’ve filed in the past year Accrued bonus liability – typically unfavorable adjustment Depreciation – typically favorable adjustment UNICAP – both favorable and unfavorable adjustments Deferral of advance payments – typically favorable adjustments Repairs – typically favorable adjustments Latest trends Changes for earnings and profits of CFCs Computer software development and ERP implementations Opportunity if there is corporate tax reform Crystal ball for the next year Predict that 9 out of top 10 most commonly filed will be from the 19 tangibles regulations method changes, if IRS does not delay effective date The 10th will be UNICAP BONUSES – continues to be a hot area Is an automatic method change Focus – amount fixed and determinable, and amount paid within 2 ½ months of year-end (economic performance met in most instances) Key – amount must be fixed in taxable year to take deduction in taxable year Problems arise with respect to requirements in place to receive bonus Bonus “pools” ok – allow deduction under 2 ½ month rule DEPRECIATION Automatic depreciation method changes include: Impermissible to permissible method of accounting for depreciation or amortization Permissible to permissible method of accounting for depreciation or amortization Recent trends of taxpayers addressing items such as Recovery periods Missed bonus depreciation Useful for catching-up alternative minimum tax (“AMT”) depreciation deductions to reduce AMT UNICAP -Recent trends of taxpayers: Changing to burden rate methods Non-automatic method change Changing to simplified methods Generally an automatic method change Electing/revoking the historic absorption ratio Lock in a low rate Reduce administrative effort May be an automatic or non-automatic method change Compliance Requirement to be in compliance for many automatic method changes ADVANCE PMTS - To qualify as an advance payment, a taxpayer must have a continuing obligation under the requisite contract. Common categories to consider are: (1)Service agreements; (2)Goods; (3)Guaranty and warranty contracts; (4)Payments for the use of certain intellectual property; (5)Sale, license, lease or maintenance of computer software; (6)Subscriptions; (7)Memberships; (8)Gift Cards Two methods of accounting for advance payments under Rev. Proc : Full inclusion method ;and Deferral method . For advance payments for goods, taxpayers may also consider deferral under Treas. Reg. Sec (BUT Longer deferral period than under and requires advance consent of IRS).

7 Tangible property regulations

8 Materials and supplies Depreciation and dispositions
Overview - tangible property regulations Materials and supplies Acquisitions Improvements Depreciation and dispositions § T §1.263(a)-2T §1.263(a)-3T §§1.168(i)-1T, -7T, -8T §1.263(a)-1T Definition of material and supply Three categories that determine when deductible: Incidental supply Non-incidental supply Rotable spare parts Election to deduct under de minimis rule in acquisition regulations Election to capitalize and depreciate De minimis expensing used for AFS allowed if less than ceiling (applied to each regarded entity) Capitalize costs that facilitate acquisition of property Whether and which test for real property Expense employee compensation and overhead, but may elect to capitalize Capitalize costs to defend or perfect title to property Definition of unit of property is generally functional interdependence except for: Buildings Plant property Leased property Improvement defined: Betterment Restoration New or different use Safe harbor for routine maintenance on property other than buildings Safe harbor for certain regulated entities No plan of rehabilitation Depreciation accounts Single asset accounts Mass asset accounts General asset accounts Dispositions General rules Required to recognize disposition of structural components Reasonable identification methods Capitalize facilitative costs for sales of property by non-dealers Deduct dealer expenses for sales Other issues include: coordination with section 263A, mass asset accounting

9 Transition rules Revenue Procedures 2012-19 and 2012-20
What does compliance with Section 263A (UNICAP) mean? Improvements and other self-constructed property Improvement includes capitalized repairs and is subject to Section 263A Must allocate costs in addition to invoice price such as Allocable portion of the department that negotiates with repairmen and supervises the work performed Allocable portion of support departments such as payroll, HR, legal, etc. that support the above department Probably not eligible under the automatic procedures due to methods typically used Therefore, must file by the last day of the tax year to request advance consent Scope is not waived Inventory May be eligible to file under the automatic procedures, but for now scope is not waived IRS is considering making selected methods automatic and waiving scope

10 Developing an implementation plan
Assess current state Assess current state of accounting methods and elections as well as the current processes and available data and systems that support them Understand required/allowed state Understand required state under new regulations as well as elections/optional methods for potential opportunities and how these differ from current state Determine impact on other areas Model requirements/opportunities to determine impact on other federal tax items (e.g., §199 deduction, inventory and PCM computations), state taxable income, E&P, etc., and to evaluate financial statement considerations Develop solutions for implementing changes Prioritize issues and develop solutions for changes to data tracking and business processes/systems, computations and documentation of compliance Success-based fees are amounts paid that are contingent on the successful closing of a transaction Treatment under Treas. Reg. §1.263(a)-5 Amounts paid to facilitate business acquisition or reorganization transactions described in Treas. Reg. §1.263(a)-5(e)(3) (i.e., covered transactions) are required to be capitalized Generally, amounts are paid to facilitate a covered transaction if they are paid in the process of investigating or otherwise pursuing the transaction Success-based fees are presumed to “facilitate the transaction” Presumption may be rebutted by sufficient documentation to establish that a portion of the fee is allocable to activities that do not facilitate the transaction (non-facilitative activities) Determine resources needed to implement Develop workplan for implementation of new methods/elections, computation of §481(a) adjustments, tax return reporting (including Forms 3115 and elections), documentation for potential IRS exam, and financial statement considerations

11 Inventory update

12 Inventory Agenda: Legislative / Regulatory Update
Section 263A (UNICAP) Overview Proposed regulations for negative Section 263A costs Self-constructed assets Other inventory planning

13 Inventory accounting — legislative / regulatory update
Proposed regulations Sales-based royalties Vendor allowances Retail inventory method Negative 263A costs President's Fiscal 2013 budget proposals: Last in, first out (LIFO) repeal Lower of cost or market (LCM) repeal Subnormal goods write-downs repeal

14 Uniform Capitalization (UNICAP) planning: Why now?
Mandatory compliance in order to fall within automatic change procedures for the tangible property regulations Other considerations: Bonus depreciation Reduce taxable income Remediate potential exposure Net operating loss (NOL) companies Newly acquired entities Changes to book inventory costing methods

15 UNICAP planning: Common opportunities
Adopt a burden rate method or new proposed modified simplified production method (if finalized) Embedded costs R&D Deprecation on temporarily idle facilities Warranty and product liability Policy-making/budgeting Elect the historic absorption ratio Lock in a low rate Reduce administrative effort

16 UNICAP planning: Potential exposures
Common exposure areas Book/tax differences are not allocated Absorption ratio has not been updated Operations have changes since last UNICAP study Contract manufacturing for retailers or distributors Service providers (e.g., restaurants) should be treated as producers Following book capitalization for self-constructed assets

17 Other 263A Considerations – Self-constructed assets
Applies to real or tangible personal property produced by the taxpayer and applies to property produced by a company for use in its trade or business (“self- constructed asset”). Definition includes construct, build, install, manufacture, develop, improve Includes capitalizable improvements Applies to taxpayers that have property produced by a contractor The company that contracts to have property constructed for it is treated as self-constructing the asset to the extent it makes progress payments or otherwise incurs cost with respect to the property. Indirect costs incurred by the company (e.g., construction period interest, oversight and general and administrative expenses) for which the property is being produced must be capitalized by that company as a cost of the property Currently most self-constructed asset Section 263A changes are non- automatic and must be filed by the last day of the tax year

18 UNICAP: Negative 263A costs Proposed Regulations
A negative amount generally occurs when a taxpayer capitalizes a cost as a Section 471 cost that is greater than the amount required to be capitalized for tax purposes, which the taxpayer seeks to remove from inventory cost using its 263A formula. In Notice , the IRS stated that, pending the issuance of additional guidance, it would not challenge the inclusion of negative amounts in calculating additional costs under Section 263A or the permissibility of aggregate negative additional Section 263A costs.

19 UNICAP: Negative 263A costs Proposed Regulations
Proposed regulations that generally prohibit the inclusion of negative additional 263A costs subject to a few exceptions: Small taxpayers Simplified resale method Modified simplified production method (discussed on next slide) All other taxpayers must reduce 471 costs using a method that approximates the manner in which the taxpayer originally capitalized the costs The proposed regulations would generally prohibit treating cash or trade discounts under Reg. Section (b) as negative amounts under either simplified method.

20 UNICAP: Negative 263A costs Proposed Regulations
New modified simplified production method Two absorption ratios Preproduction Production Allows negative additional Section 263A treatment Reduce the distortions May be favorable but additional work if currently using SPM Preproduction costs applied to raw material AND raw material content of WIP and finished goods Many of the benefits of burden rate methods but with less work

21 UNICAP: Negative 263A costs Proposed Regulations
Adopt a new definition of Section 471 costs Applies to all taxpayers regardless methods used All costs, other than interest, that a taxpayer capitalizes to its inventory in its financial statements. Must include direct labor and direct material Consistent with what most taxpayers are currently doing in practice

22 Other inventory planning
Reduce taxable income LIFO Automate LIFO computations Adopt LIFO for additional inventory Change from internal to external inflation indexes or vice versa Terminate LIFO for deflationary goods (e.g., pools with debit LIFO reserve) Reconstruct base-year cost if inflationary; do not reconstruct if deflationary Inventory write-downs (non-LIFO taxpayers only) Lower of cost or market Subnormal goods (e.g., expired products, obsolete inventory) Retail inventory method Inventory shrink Charitable contributions of inventory Chargebacks

23 Questions and answers ?

24 Thanks for participating

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