Producer correctly applies the simplified production method when old inventory carries over

Plain-English summary

A manufacturer that makes products in large batches uses the FIFO (first-in,
first-out) inventory method and the "simplified production method" under
section 263A to figure out how much of its indirect production cost to add to
the value of goods still sitting in inventory at year end. A wrinkle came up:
some of the prior year's inventory did not sell and was still on hand at the
end of the next year. The taxpayer asked whether that carryover changes how it
runs the standard formula. The IRS ruled that it does not. The taxpayer
correctly uses only the current year's additional section 263A costs in the
numerator of its absorption ratio, only the current year's section 471 costs in
the denominator, and only the current year's section 471 costs still on hand at
year end in the multiplicand. It also correctly treats the extra 263A costs
that had been added to last year's ending inventory as recovered through cost
of goods sold this year, because the simplified method allocates those costs as
a lump sum rather than tracking them to specific items. The regulations set no
special rule for inventory that fails to fully turn over, so unsold carryover
items are simply irrelevant to the current-year calculation.

Ruling snapshot

• Question: When some prior-year inventory remains on hand, does a FIFO producer still apply the simplified production method using only current-year costs, and recover the prior year's capitalized 263A costs through cost of goods sold?
• Outcome: approved (both requested rulings granted)
• Key authorities: IRC § 263A; § 471; Treas. Reg. §§ 1.263A-1, 1.263A-2(b)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201848012 [Third Party Communication:
Release Date: 11/30/2018 Date of Communication: Month DD, YYYY]
Index Number: 263A.04-05
Person To Contact:
------------------- ---------------------------------, ID No. ---------
------------------------------------------------------------ ----------
-------------------------- Telephone Number:
---------------------------------------- ----------------------
----------------------- Refer Reply To:
------------------------------ CC:ITA:B06
PLR-111041-18
Date:
August 29, 2018

LEGEND

Year 2 = -------
Year 1 = -------
Taxpayer = -------------------------------------------------------------------------
Type = --------------------------
Purpose = -------------------------------------------------------------------------
-------------------------------------------------------------------------
------

Dear ----------------:

This letter responds to your letter dated March 14, 2018, requesting certain rulings
concerning the application of § 263A of the Internal Revenue Code and the Income Tax
Regulations for a producer that uses the simplified production method and that has
inventory that did not completely turn over during the taxable year. You have requested
the following rulings:

1. For its Year 2 taxable year, notwithstanding the fact that a portion of Taxpayer’s
   Year 1 ending inventory remained on hand in its Year 2 ending inventory,
   Taxpayer, using the first-in, first out (FIFO) method and the simplified production
   method, properly applies the simplified production method by including (1) only
   the additional section 263A costs that it incurred during the Year 2 taxable year in
   the numerator of the absorption ratio of the simplified production method formula,
   (2) only the section 471 costs that it incurred during the Year 2 taxable year in
   the denominator of the absorption ratio of the simplified production method
   formula, and (3) only the section 471 costs that it incurred during the Year 2
   taxable year and that remained in its inventory at the end of the Year 2 taxable

PLR-111041-18 2

   year in the section 471 costs on hand at year end (“multiplicand”) for purposes of
   the simplified production method formula.

2. For its Year 2 taxable year, notwithstanding the fact that a portion of Taxpayer’s
   Year 1 ending inventory remained on hand in its Year 2 ending inventory,
   Taxpayer, using the FIFO method and the simplified production method, properly
   determines the additional section 263A costs capitalized to ending inventory in
   Year 2 by only using the portion of additional section 263A costs incurred during
   Year 2 that are allocable to ending inventory in Year 2 under the simplified
   production method, and Taxpayer properly recovers as cost of goods sold in
   Year 2 the additional section 263A costs that were allocated to ending inventory
   in Year 1 using the simplified production method.

FACTS

Taxpayer develops and commercializes Type products for Purpose. Because of the
complexity of Taxpayer’s manufacturing processes, Taxpayer produces its products in
large batches, and only a limited number of manufacturing facilities can manufacture
Taxpayer’s products. Taxpayer is a calendar-year taxpayer that uses an overall accrual
method of accounting.

For its Year 1 taxable year, Taxpayer used the FIFO method to identify inventory and
the simplified production method without historic absorption ratio election described in
§ 1.263A-2(b)(3) to allocate additional section 263A costs to ending inventory. For its
Year 2 taxable year, Taxpayer continues to use the first-in, first out (FIFO) method to
identify inventory and the simplified production method without historic absorption ratio
election described in § 1.263A-2(b)(3) to allocate additional section 263A costs to
ending inventory. Taxpayer calculates its absorption ratio of the simplified production
method by dividing additional section 263A costs that it incurred during the taxable year
by section 471 costs that it incurred during the taxable year. Taxpayer’s multiplicand of
its simplified production method formula is the section 471 costs that it incurred during
the taxable year and that remained in its inventory at the end of the taxable year.
Taxpayer multiplies this multiplicand by its absorption ratio to determine its additional
section 263A costs allocated to ending inventory.

Taxpayer did not sell all of its Year 1 ending inventory in its Year 2 taxable year, and a
portion of its Year 1 ending inventory remained on hand in its Year 2 ending inventory.
In Year 2, Taxpayer recovers as costs of goods sold all of the additional section 263A
costs that were allocated to ending inventory in Year 1 by the simplified production
method.
PLR-111041-18 3

REQUESTED RULINGS

1. Taxpayer Properly Applies the Simplified Production Method Formula in Year 2

Taxpayer’s first requested ruling is that, notwithstanding the fact that a portion of
Taxpayer’s Year 1 ending inventory remained on hand in its Year 2 ending inventory,
Taxpayer, using the FIFO method and the simplified production method, properly
applies the simplified production method in Year 2 by including (1) only the additional
section 263A costs that it incurred during the Year 2 taxable year in the numerator of
the absorption ratio of the simplified production method formula, (2) only the section 471
costs that it incurred during the Year 2 taxable year in the denominator of the absorption
ratio of the simplified production method formula, and (3) only the section 471 costs that
it incurred during the Year 2 taxable year and that remained in inventory at the end of
the Year 2 taxable year in the multiplicand of the simplified production method formula.

Section 1.263A-1(d)(2)(i) provides that section 471 costs are the costs, other than
interest, that the taxpayer capitalized under its method of accounting immediately prior
to the effective date of § 263A.

Section 1.263A-1(d)(2)(ii) provides that, for taxpayers not in existence prior to the
effective date of § 263A, section 471 costs generally are the costs, other than interest,
that the taxpayer would have been required to capitalize under its method of accounting
had it been in existence immediately prior to the effective date of § 263A.

Section 1.263A-1(d)(3) defines additional section 263A costs as the costs, other than
interest, that were not capitalized under the taxpayer's method of accounting
immediately prior to the effective date of § 263A but that are required to be capitalized
under § 263A. For new taxpayers, additional section 263A costs are defined as the
costs, other than interest, that the taxpayer must capitalize under § 263A, but which the
taxpayer would not have been required to capitalize if the taxpayer had been in
existence prior to the effective date of § 263A.

Section 1.263A-2(b) provides a simplified method (the simplified production method) for
determining the additional section 263A costs allocable to ending inventories of property
produced and other eligible property on hand at the end of the taxable year.

Section 1.263A-2(b)(3)(i)(A) provides generally that under the simplified production
method, additional section 263A costs allocable to eligible property remaining on hand
at the close of the taxable year equal the absorption ratio multiplied by the section 471
costs remaining on hand at year end.

Section 1.263A-2(b)(3)(ii)(A) provides that under the simplified production method, the
absorption ratio is the additional section 263A costs incurred during the taxable year
divided by the section 471 costs incurred during the taxable year.
PLR-111041-18 4

Section 1.263A-2(b)(3)(ii)(A)(1) provides that additional section 263A costs incurred
during the taxable year are defined as the additional section 263A costs described in
§ 1.263A–1(d)(3) that a taxpayer incurs during its current taxable year.

Section 1.263A-2(b)(3)(ii)(A)(2) provides that section 471 costs incurred during the
taxable year are defined as the section 471 costs described in § 1.263A–1(d)(2) that a
taxpayer incurs during its current taxable year.

Section 1.263A-2(b)(3)(ii)(B) provides that section 471 costs remaining on hand at year
end means the section 471 costs, as defined in § 1.263A–1(d)(2), that a taxpayer incurs
during its current taxable year which remain in its ending inventory or are otherwise on
hand at year end.

As a general matter, the § 263A regulations provide that a taxpayer that uses the
simplified production method to allocate additional section 263A costs to ending
inventory only includes: additional section 263A costs that it incurs during the current
taxable year in the numerator of the absorption ratio of the simplified production method
formula; only the section 471 costs that it incurs during the taxable year in the
denominator of the absorption ratio of the simplified production method formula; and
only the section 471 costs that it incurs during the taxable year and that remain in
inventory at the end of the taxable year in the multiplicand of the simplified production
method formula. The regulations covering the simplified production method do not
provide any special rules for inventory that does not completely turn over in a taxable
year.

In this case, some of the items in Taxpayer’s Year 1 ending inventory were not sold
during Year 2, and therefore Taxpayer has items from Year 1 in its Year 2 ending
inventory. Regardless, in Year 2, Taxpayer properly determines the numerator and
denominator of its absorption ratio of the simplified production method formula by
including only the additional section 263A costs that it incurred during the Year 2
taxable year in the numerator, and only the section 471 costs that it incurred during the
Year 2 taxable year in the denominator, pursuant to §§ 1.263A-2(b)(3)(i)(A) and -
2(b)(3)(ii)(A). Additionally, Taxpayer properly determines the multiplicand of the
simplified production method formula by including only the section 471 costs that it
incurred during the Year 2 taxable year and that remain in inventory at the end of the
Year 2 taxable year pursuant to §§ 1.263A-2(b)(3)(i)(A) and -2(b)(3)(ii)(B).

2. Taxpayer Properly Determines Costs Allocated to Ending Inventory and Properly
   Recovers Certain Costs as Cost of Goods Sold in Year 2

Taxpayer’s second requested ruling is that, notwithstanding the fact that a portion of
Taxpayer’s Year 1 ending inventory remained on hand in its Year 2 ending inventory,
Taxpayer, using the FIFO method and the simplified production method, properly
PLR-111041-18 5

determines the additional section 263A costs capitalized to ending inventory in Year 2
by only using the portion of additional section 263A costs incurred during Year 2 that
are allocable to ending inventory in Year 2 under the simplified production method, and
that Taxpayer properly recovers as cost of goods sold in Year 2 the additional section
263A costs that were allocated to ending inventory in Year 1 using the simplified
production method.

Section 1.263A-1(c) provides that section 263A costs are generally allocated to the
items of property produced or property acquired for resale during the taxable year and
capitalized to the items that remain on hand at the end of the taxable year.

Section 1.263A-1(f)(1) allows taxpayers to use the simplified method provided in
§§ 1.263A-2(b) (the simplified production method) to allocate additional section 263A
costs properly allocable to property produced or acquired for resale to property that is
on hand at the end of the taxable year.

Section 1.263A-2(b) provides a simplified method (the simplified production method) for
determining the additional section 263A costs allocable to ending inventories of property
produced and other eligible property on hand at the end of the taxable year.

Section 1.263A-2(b)(3)(i)(A) generally provides that under the simplified production
method, additional § 263A costs allocable to eligible property remaining on hand at the
close of the taxable year equal the absorption ratio multiplied by the section 471 costs
remaining on hand at year end.

Section 1.263A-2(b)(3)(i)(B) provides generally that the absorption ratio of the simplified
production method is multiplied by the section 471 costs remaining in ending inventory
or otherwise on hand at the end of each taxable year in which the simplified production
method is applied. The resulting product is the additional section 263A costs that are
added to the taxpayer's ending section 471 costs to determine the section 263A costs
that are capitalized.

As a general matter, the § 263A regulations provide that the simplified production
method only treats the additional section 263A costs incurred during the current taxable
year as allocable to ending inventory. As described above, those are the only costs that
are properly included in the numerator of the absorption ratio of the simplified
production method formula. Additionally, the simplified production method allocates
additional section 263A costs as a lump-sum to ending inventory (in lieu of allocating
those costs to specific items of property, which is generally otherwise required under the
§ 263A regulations). The regulations covering the simplified production method do not
provide any special rules for inventory that does not completely turn over in a taxable
year.
PLR-111041-18 6

In this case, some of the items in Taxpayer’s Year 1 ending inventory were not sold
during Year 2, and therefore Taxpayer has items from Year 1 in its Year 2 ending
inventory. Regardless, none of the additional section 263A costs allocated to
Taxpayer’s Year 1 ending inventory by the simplified production method are allocable to
Taxpayer’s Year 2 ending inventory, and all of the additional section 263A costs
allocated to Taxpayer’s Year 1 ending inventory are properly recovered as cost of
goods sold in Year 2. The simplified production method allocates additional section
263A costs to ending inventory as a lump-sum, and not to specific items in ending
inventory, and for purposes of determining the additional section 263A costs allocated
to Taxpayer’s Year 2 ending inventory, it is irrelevant that some of the items in
Taxpayer’s Year 1 ending inventory are also in Taxpayer’s Year 2 ending inventory.

RULINGS

1. For its Year 2 taxable year, notwithstanding the fact that a portion of Taxpayer’s
   Year 1 ending inventory remained on hand in its Year 2 ending inventory,
   Taxpayer, using the FIFO method and the simplified production method, properly
   applies the simplified production method by including (1) only the additional
   section 263A costs that it incurred during the Year 2 taxable year in the
   numerator of the absorption ratio of the simplified production method formula, (2)
   only the section 471 costs that it incurred during the Year 2 taxable year in the
   denominator of the absorption ratio of the simplified production method formula,
   and (3) only the section 471 costs that it incurred during the Year 2 taxable year
   and that remained in its inventory at the end of the Year 2 taxable year in the
   section 471 costs on hand at year end (“multiplicand”) for purposes of the
   simplified production method formula.

2. For its Year 2 taxable year, notwithstanding the fact that a portion of Taxpayer’s
   Year 1 ending inventory remained on hand in its Year 2 ending inventory,
   Taxpayer, using the FIFO method and the simplified production method, properly
   determines the additional section 263A costs capitalized to ending inventory in
   Year 2 by only using the portion of additional section 263A costs incurred during
   Year 2 that are allocable to ending inventory in Year 2 under the simplified
   production method, and Taxpayer properly recovers as cost of goods sold in
   Year 2 the additional section 263A costs that were allocated to ending inventory
   in Year 1 using the simplified production method.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.
PLR-111041-18 7

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to Taxpayer’s authorized representatives.

                                   Sincerely,



                                   W. Thomas McElroy Jr.
                                   Senior Technician Reviewer, Branch 6
                                   (Income Tax & Accounting)