Section 263A generally requires the capitalization of various costs attributable to inventory, and retail sellers of large and high priced inventory—like motor vehicles—may incur substantial direct and indirect costs associated with their inventory. In Revenue Procedure 2010-44, 2010-49 I.R.B. 811, the Internal Revenue Service (IRS) provides two accounting method safe harbors for auto dealerships with respect to Section 263A. Auto dealerships are broadly defined to include dealers of boats, motorcycles, farm and construction machinery, and other vehicles, and these taxpayers have been an increasingly large area of focus for IRS exam in recent years. Rev. Proc. 2010-44 seeks to provide clarity for these taxpayers with respect to capitalization. Under the guidance a dealership may be considered a retail sales facility, which means that storage and handling costs are not required to be capitalized. Further, a dealership may be treated as a retailer without production activities, which simplifies application of the UNICAP rules.
Treas. Reg. § 1.263A-3(c) requires a taxpayer to capitalize indirect costs, such as purchasing, handling, and storage costs, allocable to property acquired for resale. An important exception exempts handling and storage costs from capitalization if those costs are incurred at a "retail sales facility." This term generally includes portions of a retail site that are (i) customarily associated with and an integral part of operations, (ii) open each business day exclusively to retail consumers, (iii) where retail customers normally and routinely shop, and (iv) adjacent to or in immediate proximity to the retail site.1
The first safe harbor allows a dealership to "treat its entire sales facility from which it normally and routinely conducts on-site sales to retail customers, including any vehicle lot that is an integral part of its sales facility and that is routinely visited by retail customers, as a retail sales facility."2 While it seems innocuous to remove the "adjacent to or in immediate proximity" elements, these costs may be considerable. Consider a car dealer in any urban area. Very few of the cars, whether new, used, or classics, will be in the showroom or the immediate area. Garage costs, maintenance, and other indirect costs otherwise might be capitalized into the costs of the cars. If sales are infrequent, as auto sales have been the last several years given the state of the economy, handling and storage costs make inventory carrying costs more significant. The safe harbor will reduce the amount of costs that dealerships capitalize.
The second safe harbor allows a dealership to treat itself as "a reseller without production activities" for purposes of Treas. Reg. § 1.263A-3 and, thus, allows the dealership to use the simplified resale method.3 The simplified resale method provides an easier allocation method, allowing the taxpayer to simply multiply the inventory costs incurred during the year by an "absorption ratio."4 A de minimis rule generally applies a 10 percent limit on production activities for use of the simplified resale method,5 so the safe harbor allows dealerships that provide repair or mechanic services to qualify more easily.
In addition to the general benefit of using the simplified resale method for capitalizing costs, the safe harbor provides that services performed on dealership-owned or customer-owned vehicles are handling costs that are not required to be capitalized if incurred at a retail sales facility.6 If this safe harbor is elected in conjunction with the first safe harbor of Rev. Proc. 2010-44, dealerships could perform service on vehicles, whether on the immediate premises or at another integral part of its facility, exclude these handling costs from capitalization altogether, and finally be entitled to using a simpler, easier method of capitalizing other costs.
Dealerships may change their accounting methods for either or both of the safe harbors using the automatic change provisions in Rev. Proc. 2008-52,7 as modified by Rev. Proc. 2010-44. They may also apply for a non-automatic change under Rev. Proc. 97-27.8 Dealerships that change their methods will receive audit protection and returns filed before November 10, 2010, that are consistent with the methods will not be challenged as having improper methods.
Importantly, a dealership that uses negative additional Section 263A amounts to adjust its inventory costs may not use the safe harbor methods in Rev. Proc. 2010-44. Taxpayers have used negative additional Section 263A amounts in the simplified resale method to compute their absorption ratios, leading to a negative ratio and to what the IRS fears is a distortion of capitalized amounts.9 If the dealership also changes its method with respect to negative additional Section 263A amounts and no longer includes these negative amounts, then it may use Rev. Proc. 2010-44 to make that change and elect one or both of the safe harbors.
Taxpayers should consider whether they qualify as dealerships under the expansive definition in Rev. Proc. 2010-44 and whether their capitalized costs are covered by one or both of the safe harbors. Accounting method changes may provide immediate tax benefits with respect to these items and additional clarity of treatment going forward.