Uniform Capitalization Rules

A. Uniform Capitalization

A.1. Introduction

(1) The allocation of project costs in cost segregation studies for self-constructed assets may be impacted by the Uniform Capitalization (UNICAP) rules of IRC § 263A. In addition, the interest capitalization rules of § 263A(f) may also apply. A brief summary of these provisions is presented below.

A.2. Application of the Capitalization Rules Under § 263A

(1) The UNICAP rules require the capitalization of all direct costs and certain indirect costs allocable to real property and tangible personal property produced by the taxpayer. For purposes of the uniform capitalization rules, to “produce” means to construct, build, install, manufacture, develop, improve, create, raise, or grow (See § 263A(g)(1); Treas. Reg. § 1.263A-2(a)(1)(i)). Self-constructed assets and property built under contract are treated as property “produced” by the taxpayer and the rules under § 263A govern.

(2) In addition, § 263A(f) requires the capitalization of interest expense when the taxpayer produces certain property. The interest capitalization rules under Treas. Reg. § 1.263A-8 contain precise definitions of designated property and include inherently permanent structures in the definition of real property. In summary, all real property and certain tangible personal property are subject to the interest capitalization rules. Therefore, any change in the allocation of costs between real and tangible personal property may have an impact on the amount of capitalized interest. Many taxpayers attempt to exclude all § 1245 property from interest capitalization arguing that the § 1245 property is tangible personal property that does not meet the classification thresholds of Treas. Reg. § 1.263A-8(b)(1). Most of the § 1245 property in these situations are inherently permanent structures (real property) subject to interest capitalization without any restrictions.

(3) For tax years beginning after December 31, 2017, a small business taxpayer is not required to capitalize costs including interest under § 263A. A small business taxpayer is a taxpayer that (a) has average annual gross receipts of not more than $25 million for the 3 prior tax years (adjusted annually for inflation), and (b) is not a tax shelter as defined in § 448(d)(3). If the taxpayer has not been in existence for the three-year period mentioned above, § 448(c)(3) provides rules for determining if the taxpayer has met the gross receipts test for the period.

(4) The following text summarizes the capitalization rules of § 263A and the interest capitalization rules of § 263A(f). Further detail and updates can be obtained from the Inventory and § 263A Practice Network (PN). Also, § 263A adjustments generally involve a change in accounting method. Refer to Chapter 6.B. – Change in Accounting Method for more information.

A.3. Capitalization of Costs Under § 263A

(1) How does § 263A identify the costs subject to capitalization? Any cost which (but for § 263A and the regulations thereunder) may not be taken into account in computing taxable income for any taxable year is not treated as a cost properly allocable to property produced or acquired for resale. Thus, for example, any cost (or portion of cost) that is not deductible is not properly allocable to property produced or acquired for resale.

(2) In addition, any cost required to be capitalized under § 263A may not be included in inventory or charged to capital accounts or included in basis any earlier than the taxable year during which the amount is incurred within the meaning of Treas. Reg. § 1.446 1(c)(1)(ii).

(3) What costs are capitalized under § 263A? Except as otherwise provided, direct costs and all indirect costs that are properly allocable to property produced must be capitalized. Indirect costs are properly allocable to property produced when they directly benefit or are incurred by reason of the performance of production activities. For a producer, the direct costs generally include direct material and direct labor. The regulations include examples of indirect costs (See Treas. Reg. § 1.263A-1(e)(3)(ii)). Examples of indirect costs required to be capitalized to the extent they are properly allocable to property produced are:

• Bidding costs
• Capitalizable service costs (including capitalizable mixed service costs)
• Cost recovery allowances (however, remember depletion is only allocated to inventory produced and sold during the year)
• Engineering and design costs
• Employee benefit expenses
• Handling costs
• Indirect labor costs
• Indirect material costs
• Insurance
• Interest (see special rules under § 263A(f))
• Licensing and franchise costs
• Officers’ compensation
• Pension and other related costs
• Purchasing costs
• Quality control
• Rent
• Repairs and maintenance
• Spoilage
• Storage costs
• Taxes
• Tools and equipment
• Utilities

(4) Producers must capitalize costs (other than interest) whether incurred before, during, or after the production period of property. Interest is only capitalized during the production period of property. Pre-production costs are subject to capitalization if the property is held for future production or if it is reasonably likely that the property will be produced at a future date. Thus, costs of storing raw materials and property taxes for real property held for development are required to be capitalized. Some issues may arise in determining the taxpayer’s intent and the taxpayer’s change in intent. Production period costs are costs incurred beginning on the date on which production of the property begins and ending on the date on which the property is ready to be placed in service or is ready to be held for sale. Post-production costs are costs incurred after the actual production and may include storage and handling costs incurred while holding the property produced for sale after production.

(5) Treas. Reg. § 1.263A-1(f) sets forth various detailed or specific cost allocation methods that a taxpayer may use to allocate interest costs to property produced. Under Treas. Reg. § 1.263A-1(f) a taxpayer may use a specific identification method, burden rate method, standard cost method, or any other reasonable method to allocate costs. In addition, in lieu of these methods, producers may use the simplified production methods provided in Treas. Reg. §§ 1.263A-2(b) and (c).

A.4. Capitalization of Interest Under § 263A(f)

(1) Treas. Reg. §§ 1.263A-8 through 1.263A-15 provides guidance with respect to the capitalization of interest under § 263A(f). These regulations are effective for 1995 and after, or at taxpayer’s election, 1994. For years prior to the final regulations, Notice 88-99, 1988-2 C.B. 422, and temporary regulations provide guidance with respect to the capitalization of interest.

(2) For tax years beginning after December 31, 2017, a small business taxpayer is not required to capitalize costs including interest under § 263A. A small business taxpayer is a taxpayer that (a) has average annual gross receipts of not more than $25 million for the 3 prior tax years (adjusted annually for inflation), and (b) is not a tax shelter as defined in § 448(d)(3). If the taxpayer has not been in existence for the three-year period mentioned above, § 448(c)(3) provides rules for determining if the taxpayer has met the gross receipts test for the period.

(3) Interest is capitalized with respect to each unit of designated property. Interest is capitalized during each computation period; the amount of interest that is capitalized is a function of:

• the amount of accumulated production expenditures;
• the amount of outstanding debt(s) on each measurement date; and
• the interest rate of the outstanding debt(s).

(4) In determining the amount of outstanding debt, traced debt is considered first. The excess expenditure amount is the amount (if any) by which the accumulated production expenditures exceed the amount of traced debt.

Interest on non-traced debt, up to the excess expenditure amount, must be capitalized, based upon a weighted average interest rate. Pursuant to Treas. Reg. § 1.263A-9(d), taxpayers may elect not to trace debt. See Treas. Reg. § 1.263A-9.

(5) Designated property is defined in § 263A(f)(1) and Treas. Reg. § 1.263A-8(b)(1). In general, § 263A(f) applies to designated property. Designated property is any property that is produced and that is:

• Real property; or
• Tangible personal property (as defined in Treas. Reg. § 1.263A-2(a)(2)) that meets any of the following classification thresholds:
  • Property with a class life of 20 years or more that is not inventory in the hands of the taxpayer or a related person
  • Property with an estimated production period (as defined in Treas. Reg. § 1.263A-12) exceeding 2 years; or
  • Property with an estimated production period exceeding 1 year and estimated cost of production exceeding $1,000,000

(6) Note: All real property is subject to the rules of § 263A(f); the classification thresholds only apply to tangible personal property.

(7) The classification thresholds are applied individually to each unit of property.

(8) Treas. Reg. § 1.263A-8(c)(1) defines real property. Real property includes land, unsevered natural products of land, buildings, and inherently permanent structures. Any interest in real property, including fee ownership, co-ownership, a leasehold, an option, or a similar interest is real property. Unsevered natural products of land include growing crops and plants (that have a pre-productive period more than 2 years), mines, wells, and other natural deposits. Real property includes the structural components of both buildings and inherently permanent structures.

(9) Inherently permanent structures include property that is affixed to real property and that will ordinarily remain affixed for an indefinite time. Examples are swimming pools, roads, bridges, tunnels, paved parking areas and other pavements, special foundations, wharves and docks, fences, inherently permanent advertising displays, inherently permanent outdoor lighting facilities, railroad tracks and signals, telephone poles, power generation and transmission facilities, permanently installed telecommunications cables, broadcasting towers, oil and gas pipelines, derricks and storage equipment, grain storage bins and silos. For purposes of this section, affixation to real property may be accomplished by weight alone. See Treas. Reg. § 1.263A-8(c)(3).

(10) Property may constitute an inherently permanent structure even though it is not classified as a building for purposes of former § 48(a)(1)(B) and Treas. Reg. § 1.48-1. Any property not otherwise described in Treas. Reg. § 1.263A-8(c)(3) that constitutes other tangible property under the principles of former § 48(a)(1)(B) and Treas. Reg. § 1.48-1(d) is treated for the purposes of Treas. Reg. § 1.263A-8 as an inherently permanent structure. See Treas. Reg. § 1.263A-8(c)(3).

(11) A structure that is property in the nature of machinery or is essentially an item of machinery or equipment is not an inherently permanent structure and is not real property. In the case, however, of a building or inherently permanent structure that includes property in the nature of machinery as a structural component, the property in the nature of machinery is real property. A structure may be an inherently permanent structure, and not property in the nature of machinery or essentially an item of machinery, even if the structure is necessary to operate or use, supports, or is otherwise associated with, machinery. See Treas. Reg. § 1.263A-8(c)(4).

B. Change in Accounting Method

B.1. Introduction

(1) A taxpayer may conduct a cost segregation study on used or previously existing property and then re-compute its depreciation deductions for prior years. The underlying incentive for preparing these studies for Federal income tax purposes is the significant tax benefits derived from utilizing shorter recovery periods and accelerated depreciation methods for computing depreciation deductions. Examiners need to be aware of the potential issues relating to these re-computations, including the need for taxpayers to notify the Internal Revenue Service (IRS or Service) that it intends to make a change in accounting method for those items identified in the cost segregation study. This chapter provides a brief overview of the applicable law in this area.

B.2. Historical Service Position

(1) It has been the long-standing position of the Service that a taxpayer adopts a permissible method of accounting in the tax year a depreciable asset is placed in service, relative to the depreciation method, recovery period (but not useful life), or convention for the depreciable property. A taxpayer adopts an impermissible method of accounting relative to depreciable property when it is treated in the same way on two or more consecutively filed returns. Once a method is adopted, a change in depreciation method, recovery period (but not useful life), or convention resulting from a reclassification of such property, results in a change in method of accounting. Such a change requires the consent of the Commissioner (i.e., the taxpayer must generally file a Form 3115, Application for Change in Accounting Method), and the adjustment to taxable income is made pursuant to § 481(a). If a taxpayer has adopted a method of accounting, the taxpayer may not change the method by amending its prior income tax returns. See Rev. Rul. 90-38, 1990-1 C.B. 57. Accordingly, amended returns or claims for adjustment, based on a cost segregation study performed after the original return was filed for the placed-in-service year and the original return for the subsequent tax year, should generally be disallowed on the basis that the taxpayer is attempting to make a retroactive method change. See § 446(e) and IRM 4.11.6.7.5.

(2) The Service’s historical position is that a change in computing depreciation under §§ 167, 168, or 197, or former §§ 168 (ACRS), 1400I, 1400L(b), or 1400L(c) generally is a change in method of accounting under § 446(e) for which the consent of the Commissioner is required. However, this position was successfully challenged by several taxpayers in litigation with respect to depreciable property subject to § 168 (MACRS property). See Brookshire Brothers Holding, Inc. & Subsidiaries v. Commissioner, 320 F.3d 507 (5th Cir. 2003), Green Forest Manufacturing Inc. v. Commissioner, T.C. Memo. 2003-75, and O’Shaughnessy v. Commissioner, 332 F.3d 1125 (8th Cir. 2003); but contrast Kurzet v. Commissioner, 222 F.3d 830 (10th Cir. 2000). Because of these decisions, there was inconsistent treatment of taxpayers with respect to whether a change in computing depreciation under § 168 was a change in method of accounting under § 446(e).

(3) Final regulations under § 446(e), T.D. 9307, 71 F.R. 78066 (December 28, 2006) (final regulations), address the circumstances under which a change in calculating depreciation or amortization is a change in method of accounting under § 446(e). These regulations adopt, with modifications, temporary regulations published in the Federal Register on January 2, 2004. The final regulations provide that the following are changes in method of accounting under § 446(e):

• A change in the treatment of an asset from non-depreciable or non-amortizable to depreciable or amortizable, or vice versa, Treas. Reg. § 1.446-1(e)(2)(ii)(d)(2);
• A correction to require depreciation in lieu of a deduction for the cost of depreciable or amortizable assets that had been consistently treated as an expense in the year of purchase, or vice versa, Treas. Reg. § 1.446 1(e)(2)(ii)(d)(2);
• A change in the depreciation or amortization method, period of recovery, or convention of a depreciable or amortizable asset, Treas. Reg. § 1.446 1(e)(2)(ii)(d)(2)(i); and,
• A change to or from claiming the additional first year depreciation deduction provided by, for example, § 168(k), former § 1400L(b), or former § 1400N(d) under certain circumstances, Treas. Reg. § 1.446-1(e)(2)(ii)(d)(2)(ii).

(4) Treas. Reg. § 1.446-1(e)(2)(iii), Example 9, provides an illustration of a change in accounting method due to changes in depreciation method, recovery period and convention, all resulting from a cost segregation study.

(5) The final regulations clarify that a change in depreciation due to a posting or mathematical error, or a change in underlying facts, is not an accounting method change because the rules in Treas. Reg. § 1.446-1(e)(2)(ii)(a) and (b) also apply to a depreciation change.

(6) In addition, Treas. Reg. § 1.446-1(e)(2)(ii)(d)(3)(i) provides that an accounting method change does not include an adjustment in the useful life of a depreciable or amortizable asset for which depreciation is determined under § 167 (other than under § 168, former § 1400I, former § 1400L(c), former § 168, or an additional first year depreciation deduction provision of the IRC). This rule does not apply if a taxpayer is changing to or from a useful life (or recovery period or amortization period) that is specifically assigned by the Code, regulations, or other guidance published in the Internal Revenue Bulletin.

(7) Treas. Reg. § 1.446-1(e)(2)(ii)(d)(3)(iii) provides that the making of a late depreciation or amortization election or the revocation of a timely valid depreciation or amortization election is not a change in method of accounting, except as otherwise expressly provided by the Code, regulations, or other guidance published in the Internal Revenue Bulletin.

(8) Finally, Treas. Reg. § 1.446-1(e)(2)(ii)(d)(3)(v) provides that any change in the placed-in-service date of a depreciable or amortizable asset is not treated as a change in accounting method.

(9) The final regulations under § 446(e) only apply to a change in depreciation made by a taxpayer for a depreciable or amortizable asset placed in service by the taxpayer in a tax year ending on or after December 30, 2003, regardless of whether the change in depreciation is a change in method of accounting.

B.3. Change in Litigating Position

(1) On January 28, 2004, the Associate Chief Counsel (P&SI) issued a Change in Litigating Position Notice (“Notice”) regarding the application of § 446(e) to changes in computing depreciation. See Notice CC-2004-007, as clarified by Notice CC-2004-024 (July 12, 2004).

(2) The Notice provides that the Service’s position continues to be that a change in computing depreciation under §§ 167, 168, 197, former §§ 1400I, 1400L(b), or 1400L(c), or ACRS, is a change in method of accounting under § 446(e) for which the consent of the Commissioner is required. However, for depreciable or amortizable property that is treated as a capital asset and placed in service in taxable years ending before December 30, 2003, the Service will no longer litigate the issue of whether such a change in computing depreciation is a change in method of accounting under § 446(e).

(3) The change in the Service’s litigating position does not apply to a change in the treatment of property from a non-capital asset (for example, inventory, materials, and supplies) to a capital, depreciable or amortizable asset (or vice versa), or to a change from expensing the cost of depreciable or amortizable property to capitalizing and depreciating or amortizing such cost (or vice versa). These changes are a change in method of accounting under § 446(e). Accordingly, examiners should consult with their local Chief Counsel attorneys should a taxpayer assert that these changes are not a change in method of accounting.

B.4. Peco Foods Case

(1) In Peco Foods, Inc. v. Commissioner, T.C. Memo. 2012-018, aff’d 522 Fed. Appx. 840 (11th Cir. 2013), the taxpayer purchased two poultry processing plants in applicable asset acquisitions under § 1060. As part of the acquisitions, Peco Foods entered into written agreements with the seller allocating the purchase price among the acquired assets. Peco Foods then hired an outside consulting firm to perform a cost segregation study on the plants and filed a Form 3115 with its return to change its accounting method and reclassify certain property from nonresidential real property to tangible property. Id. At *3. The IRS disputed these changes, arguing that the taxpayer could not modify the purchase price allocations and subdivide them into component assets in a manner at odds with those schedules. The Tax Court held that Peco Foods was bound by the clear and unambiguous terms of the original allocation schedules and could not deviate from its characterization of those assets. Id. At *12. Thus, the taxpayer was not allowed to change its method of accounting for the acquired assets pursuant to its cost segregation study. It is unclear whether the holding in Peco Foods would apply to acquisitions other than applicable asset acquisitions under § 1060.

B.5. Tangible Regulations — Treas. Reg. §§ 1.263(a)-1, -2, -3

(1) The final tangible property regulations under Treas. Reg. §§ 1.263(a)-1, -2, and -3 (final regulations), published on September 19, 2013, are generally effective for taxable years beginning on or after January 1, 2014.

(2) Taxpayers have used cost segregation studies to determine what constitutes § 1245 (personal) or § 1250 (real) property for many years. Historically, these cost segregation studies have resulted in advantageous depreciation deductions for taxpayers. With the issuance of the final tangible property regulations, the demand for cost segregation studies is on the rise.

(3) In many cases, taxpayers who previously decided not to conduct cost segregation studies for depreciation purposes are hiring specialists with engineering expertise to determine units of property for purposes of determining whether certain costs improve a unit of property under Treas. Reg. § 1.263(a)-3. Even taxpayers that conducted these studies in the past are once again hiring specialty firms or CPAs to take another look at their units of property and associated costs.

(4) Cost segregation studies now serve additional purposes. For example, not only do these studies reclassify a building’s components into assets with shorter class lives, but they also identify building systems for purposes of determining whether costs are for an improvement to the building structure or building systems under Treas. Reg. § 1.263(a)-3. These studies are also used to identify functionally interdependent plant property and to determine individual components or groups of components that perform a discrete and critical function under these final regulations. Such items may represent a change in accounting method in which the taxpayer must file a Form 3115 to request consent for the change.

(5) The Examiner should request and review all cost segregation (or similar) studies, past and present and may need to engage the services of an IRS Engineer to determine whether the study was conducted properly.

(6) The Examiner should also consider if the taxpayer’s adjustments due to a cost segregation study represent a change in accounting method and if the changes were implemented properly following the appropriate revenue procedures. See Rev. Proc. 2015-13, 2015-5 I.R.B. 419, (or successor) and Rev. Proc. 2023-24, 2023-28 I.R.B. 1207, (or successor) for current guidance. See the Capitalization of Tangible Property Audit Technique Guide for additional guidance on Treas. Reg. §§ 1.263(a)-1 to -3.

B.6. Revenue Procedures Involving Method Changes

(1) To file a Form 3115 with the Service, a taxpayer needs to follow the procedures outlined in the applicable revenue procedure. Although taxpayers generally argue that they are simply reclassifying property placed in service in prior years to “correct” class lives, this reclassification results in a change in recovery period, depreciation method and/or convention.

(2) Taxpayers who have adopted an impermissible method of accounting for depreciation (or amortization) and have either (1) claimed no depreciation, or (2) claimed less than or more than the allowable amount of depreciation and are making a change described in Treas. Reg. § 1.446-1(e)(2)(ii)(d), are generally required to file a Form 3115 under either the automatic change or non-automatic change procedures (i.e., the voluntary method change procedures) to change the method of accounting. A taxpayer cannot change an adopted accounting method by filing an amended return unless specific guidance allows for an exemption.

(3) The general voluntary method change procedures are found in Rev. Proc. 2015-13 (or successor) with the list of automatic changes found in Rev. Proc. 2023-24 (or successor). As provided in Rev. Proc. 2015-13, Section 6, for an automatic change, the original Form 3115 must be attached to the taxpayer’s timely filed (including extension) original federal income tax return implementing the change in method of accounting for the year of change. Also, a duplicate copy of the Form 3115 must be filed with the IRS office in Ogden, UT no earlier than the first day of the year of change and no later than the date the taxpayer files the original Form 3115 with the federal income tax return for the year of change. If the automatic change procedures of Rev. Proc. 2015-13 (or successor) do not apply to a taxpayer’s situation, the non-automatic change procedures should be followed.

(4) The following is a list of the more common compliance issues involving accounting method changes:

Compliance issues for non-automatic method changes:

• Was the ruling letter granting consent to the change followed?
• Is the method the taxpayer implemented consistent with the facts presented and the representations made in the consent agreement?
• Is the § 481(a) adjustment correct?
• Exam may perfect the method change as an examination adjustment when deemed appropriate.
• A TAM is required to revoke or modify the ruling letter.

Compliance issues for automatic method changes:

• Did the taxpayer fully comply with the provisions in the voluntary method change procedure (Rev. Proc. 2015-13 or successor)?
• Is the method the taxpayer implemented consistent with the automatic method change provisions described in Rev. Proc. 2023-24 (or successor) for the designated change number?
• Is the § 481(a) adjustment correct?
• Exam may perfect the method change as an examination adjustment when deemed appropriate.
• A TAM is necessary if the taxpayer made the method change in compliance with the applicable procedures, but the examiner wants to revoke or modify the method change.

(5) If after reviewing the taxpayer’s cost segregation study and its implementation, the Examiner determines (1) the taxpayer is using an accounting method that does not clearly reflect income or is improper under § 446(b); or (2) the taxpayer changed its method of accounting without obtaining the consent of the Commissioner under § 446(e), the Examiner should use the involuntary method change procedures in Rev. Proc. 2002-18, 2002-1 I.R.B. 678, to resolve these accounting method issues. See IRM 4.11.6.7.

B.7. Summary

(1) A change in the recovery period, depreciation method, and/or convention for depreciable property is a change in accounting method. Once a method of accounting is adopted, a taxpayer is required to obtain the consent of the Commissioner through the timely filing of a Form 3115 to change the accounting method. Pursuant to Rev. Proc. 2015-13, a taxpayer may request automatic or non-automatic consent for the change. Although a Form 3115 may be subject to National Office review, it is generally the responsibility of the examiner to verify the propriety of the revised method of accounting for depreciation and the accuracy of the § 481(a) adjustment at the time of the examination. The examiner should evaluate the need to review the cost segregation study that formed the basis for the depreciation re-computations and the resultant change in accounting method.

(2) The issue regarding a change in accounting method with respect to the re-computation of depreciation (e.g., those based on cost segregation studies) can be quite complex. Examiners should consult Treas. Reg. § 1.446-1(e) for further guidance. Examiners should also contact the Methods of Accounting and Timing Practice Network for assistance regarding ongoing developments in this area, as well as determining the taxpayer’s compliance with the proper procedures for changing the accounting method and computing the adjustment pursuant to § 481(a).