Self-Constructed Property Eligible for Simplified Capitalization Methods

A recent ruling clarifies the types of property that qualify for the simplified service cost and simplified production methods, and the circumstances under which a taxpayer’s self-constructed assets are produced on a “routine and repetitive” basis for this purpose.

Law and Analysis

Under Sec. 263A, producers of real or tangible personal property must capitalize the direct costs and a proper share of the indirect costs of such property. Regs. Sec. 1.263A-2(b) allows producers to use the simplified production method to determine the additional Sec. 263A costs properly allocable to ending inventories of produced property and other “eligible” property on hand at the end of the tax year. Additional Sec. 263A costs are the costs (other than interest) that were not capitalized under the taxpayer’s accounting method immediately prior to Sec. 263A’s effective date (1987), but that are required to be capitalized under Sec. 263A; see Regs. Sec. 1.263A-1(d)(3).

Under Regs. Sec. 1.263A-2(b)(2)(i), a taxpayer electing to use the simplified production method generally must use it for all production activities associated with the following eligible property (the categories are identical for the simplified service cost method):

1. Inventory property: Stock in trade or other property properly includible in the taxpayer’s inventory.

2. Noninventory property held for sale: Noninventory property held by a taxpayer primarily for sale to customers in the ordinary course of the taxpayer’s trade or business.

3. Certain self-constructed assets: Self-constructed assets substantially identical in nature to, and produced in the same manner as, inventory or other property produced by the taxpayer and held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business.

4. Self-constructed assets produced on a repetitive basis: Self-constructed assets produced by the taxpayer on a routine and repetitive basis in the ordinary course of the taxpayer’s trade or business.

According to the IRS, these four categories all share common characteristics that make application of the simplified methods appropriate. The simplified methods were designed to alleviate the administrative burdens of complying with the new uniform capitalization rules when mass production occurs on a repetitive and routine basis, with a typically high turnover rate for the produced assets. Thus, the first three categories of eligible property are either mass-produced and/or have a high degree of turnover or are identical to such assets. The fourth category, self-constructed assets produced on a routine and repetitive basis, is similar to these first three categories. It was designed to possess the same characteristics shared by all of the preceding categories of eligible property.

Application

In the ruling, the IRS provided six examples of the application of the rules to self-constructed property.

Situation 1: U, a manufacturer of office equipment, produces numerous identical copiers during the year, using assembly line techniques. U leases the copiers and does not hold them for sale.

U is producing copiers on a routine and repetitive basis, because they are mass-produced.

Situation 2: V, a manufacturer of automobiles, regularly produces molds specifically designed for the production of particular automobile parts. The molds cannot be adapted for a further or different use after changes or improvements are made to the particular part produced by the mold. The molds generally are used for one to three years. Accordingly, the molds have a high degree of turnover.

V is producing molds on a routine and repetitive basis, because they have a high degree of turnover.

Situation 3: W, a telephone company, manufactures numerous identical poles using standardized designs and assembly line techniques for use in its business.

W is producing poles on a routine and repetitive basis for purposes of the simplified methods, because the poles are mass-produced.

Situation 4: X, an electric utility, regularly purchases identical meters and installs them on its customers’ properties. The meters measure the amount of electric current used by X’s customers. X does not manufacture meters. Meters are included in asset class 49.14 under Rev. Proc. 87-56, as clarified and modified by Rev. Proc. 88-22, and have a class life of 30 years.

The meters are not produced on a routine and repetitive basis, because they are neither mass-produced by X nor have a high degree of turnover. Mass production does not include installation of meters and meters do not have a short useful life.

Situation 5: Y, an electric utility, constructs from various components substations that it uses to transmit and distribute electricity. Substations and their components are facilities built on land to house an assembly of equipment designed for switching, changing or regulating the electricity voltage. Each substation is intended to operate for an extended length of time, is custom designed for a specific geographic site and serves a particular function within Y’s electrical grid.

The substations are not produced on a routine and repetitive basis, because they are neither mass-produced nor have a high degree of turnover.

Situation 6: Z, a company that owns and operates a national chain of restaurants, continually constructs new ones each year. Z generally uses a standardized design when constructing them. However, local zoning laws and the physical characteristics of the specific construction site require Z to modify the design for each new restaurant.

The restaurants are not produced on a routine and repetitive basis, because they are neither mass-produced nor have a high degree of turnover.

Conclusion

A taxpayer’s self-constructed assets are produced on a routine and repetitive basis in the ordinary course of its trade or business if they are either mass-produced (i.e., numerous identical goods are manufactured using standardized designs and assembly line techniques) or have a high degree of turnover.

Rev. Rul. 2005-53, IRB 2005-35