Capitalization and the Cost of Goods Sold

Recent guidance issued by the IRS explains how income from 'qualified' production activities are allocated for tax purposes.

Last year, the Internal Revenue Service issued an advisory from its Chief Counsel’s office to answer a question related to allocating the cost of goods sold (COGS) that includes post-production costs. The IRS concluded that because the costs are properly capitalized to current year production, they must be included when determining COGS. Here is the legal argument behind the IRS decision.

First, the case facts: X Corporation manufactured product A from 1996 through 2004, and manufactured the next generation of product A – called product B — from 2005 through 2008. An employee named Mr. Blue was involved in the company’s production process until he retired in 2000. In 2008, XCorp paid $30 of Mr. Blue’s medical expenses based on an existing medical plan for retired employees. These costs were subject to capitalization under Section 263A of the Internal Revenue Code. (Section 263A provides that taxpayers must capitalize their direct costs and a “properly allocable share” of their indirect costs to inventory.)

A second employee, Ms. Red, had been involved in XCorp’s production process her entire career and was injured in 2004 while manufacturing product A. In 2008, XCorp paid Ms. Red $20 of worker’s compensation payments for her injuries sustained in 2004. These costs were also subject to capitalization under Section 263A.

From 2000 through 2004, XCorp’s production activities discharged hazardous waste at the factory. As a result, in 2008, the company incurred $400 in environmental remediation costs. Again, these costs were also subject to capitalization under the same tax rule, Section 263A.

Allocating Costs

Under the Code’s Section 199, the IRS allows a deduction equal to a specified percentage (the currently applicable percentage is 6%) of income attributable to domestic production activities. Section 199 is effective for taxable years beginning after December 31, 2004. The deduction is limited to a percentage of the lesser of: (1) “qualified production activities income” (QPAI), or (2) taxable income. QPAI is the excess of domestic production gross receipts (DPGR) over the COGS allocable to such receipts, as well as other expenses, losses, and deductions allocable to such receipts.

Willens 10-04-10

According to tax regulations – specifically Regulation Section 1.199-4(b)(2)(ii) – the rules say that if a taxpayer recognizes and reports gross receipts on a federal income tax return for a taxable year, and incurs COGS related to such gross receipts in a subsequent year, then the taxpayer must allocate the COGS to non-DPGR. Indeed, this is the case if the taxpayer recognized the gross receipts (to which the COGS is related) in a taxable year to which Section 199 did not apply. What’s more, the allocation essentially means that the QPAI will be increased

As a result, the issue brought before the IRS was whether the “2008 expenses” were properly allocable to gross receipts of the current year or of a prior year. The IRS concluded in the Chief Counsel’s memo that the expenses were properly allocable to a prior year. (See LTR 200946037, October 26, 2009.)

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