Section 263A is an often misunderstood and misapplied part of the Internal Revenue Code. And it’s one that many construction businesses — particularly homebuilders — should get a handle on to avoid unexpected tax issues and unwanted attention from the IRS. Let’s review the basics.
Sec. 263A, also referred to as uniform capitalization or UNICAP, requires eligible businesses to capitalize — rather than currently deduct — certain direct and indirect costs related to producing, acquiring, improving and holding property to sell. This means these costs must be spread out over time rather than reported as a current expense.
Under the tax code, costs that must be capitalized include direct labor, direct materials and indirect costs that are related to the production process. They must be added to the basis of the property and depreciated over time (or included in inventory costs, as applicable). While marketing, selling, advertising and distribution expenses are indirect costs that generally can be deducted in the current tax period, general, administrative and mixed-service costs such as those related to payroll, legal and accounting must be capitalized.
The tax code rules related to inventory mainly apply to those who are considered “resellers” of inventory or “producers” of inventory and self-constructed assets. Contractors and developers may be subject to Sec. 263A because the IRS defines producers as those who build, install, manufacture, construct or improve on a property. This doesn’t refer only to hammering nails or pouring foundations. Companies that contract out the construction of a property to a third party are also subject to this part of the tax code — in these instances, both parties are considered producers.
Exempt vs. eligible
Not every construction company is required to comply with Sec. 263A. Businesses whose average gross receipts from the previous three tax years are $25 million (adjusted for inflation) or less are exempt from its requirements. Also typically exempt are:
- Costs associated with natural gas or mineral property,
- “De minimis” costs of property treated as incident to the services provided; to qualify, the costs must not exceed 5% of the price charged to the customer for the services provided,
- Projects using long-term contracts under Sec. 460 that don’t involve home and residential construction, and
- Total indirect costs that don’t exceed $200,000.
If your construction company does find itself subject to the Sec. 263A requirements, compliance will generally involve areas such as:
Capitalization of costs. When your construction business produces inventory, you must capitalize the costs of materials, labor and overhead incurred in the production of that inventory. Indirect costs can include indirect labor, insurance and property taxes. Such costs cannot be expensed in the current year. Instead, they must be added to the basis of the inventory and depreciated over time.
Capitalization of interest costs. When your construction company incurs interest costs during a production period, it must also capitalize these costs. Interest costs cannot be expensed in the current year and must be added to the basis of the inventory and depreciated over time.
Long-term contracts. The tax code may require you to use the percentage of completion method to determine your income from long-term contracts — that is, those not completed within the same tax year as they were entered. Under this accounting method, a construction business recognizes income on a contract as it’s being performed, rather than waiting until the contract is completed. Percentage of completion can be more beneficial than the completed contract method because it allows you to recognize income sooner.
It’s also important to note that costs to be capitalized include those incurred during both preconstruction and postconstruction. These may include carrying costs, real estate taxes and zoning request costs related to the holding of the property for future development. Construction or development begins during predevelopment and is deemed to have ended once the property is placed in service or ready for sale. Interest, however, needs to be capitalized only during the construction or development stage.
For construction businesses subject to its requirements, Sec. 263A can give rise to complex tax accounting challenges. If your company must manage compliance in this area, our firm can help you better understand the rules, identify which costs to capitalize for each project and accurately report the costs to the IRS.