The change caused retailers (including dealers) to perform a calculation which included a portion of its handling, storage, and other overhead costs in its inventory.

Previously, these costs were expensed as incurred. The majority of dealerships began using a variation of the simplified retail method allowed by the Uniform Capitalization (UNICAP) rules for IRC 263A(a) to calculate capitalized costs. The result was a very minor adjustment to taxable income based on inventory fluctuations.

Ripple effect?
During a 2006 dealership audit by the IRS, an auditor determined that the method used to calculate capitalized costs was invalid. The auditor requested national IRS involvement and subsequently issued a Taxpayer Advice Memorandum (TAM) to the taxpayer summarizing the position the service would take on the audit. The TAM effectively agreed with the auditor.

The position taken by the TAM invalidated use of the simplified retail method for the dealership. It also required a substantially higher capitalization of expenses for the dealership.

While the TAM only directly affects the taxpayer under audit, and is not official IRS guidance, the positions taken in the TAM will likely be used by future dealership auditors.

Therefore, the lack of official IRS guidance puts virtually all dealerships in the country (20,000+) at risk for significant adjustments if audited on their use of the simplified retail method to calculate capitalized costs.

Guidance
At the AICPA National Auto Dealership Conference in October 2007, Terri Harris, technical advisor with the IRS, said she expects the IRS to provide guidance on this concern next summer. And although she realizes it’s a potentially explosive issue, she said she doesn’t know how or when it will be resolved.

Without guidance from the IRS, dealerships are left with two options:

• Comply with the TAM, which could cause substantially higher capitalization of expenses for dealerships (hundreds of thousands of dollars in some cases)
• Continue using the simplified retail method until additional guidance is issued knowing that if a large dealership is audited, the issue may get litigated

“Dealerships are at risk if audited before the IRS issues guidance; however, we believe the IRS has taken positions in the TAM that could be overturned by the Tax Court if a case is ever litigated,” states Jason Duffner, dealership principal with LarsonAllen.

The National Automobile Dealers Association (NADA) and other interest groups continue to push the IRS on the issue. For answers to basic questions on UNICAP rules for IRC 263A(a), view a white paper published by NADA.