Why Capitalization of Indirect Costs is Important

Why Capitalization of Indirect Costs is Important

Internal Revenue Code (IRC) Section 263A of the Uniform Capitalization (UNICAP) lists what costs to capitalize. Cost capitalization turns cost into a recorded asset with future economic value rather than an expense.

UNICAP’s provisions apply to people who sell real estate or develop properties for business. It also covers people who acquire property for resale. According to the UNICAP, you must capitalize the indirect costs from the properties you produce (develop) or buy for resale.

Indirect costs are those that come from performing property production activities. They do not include direct material and labor costs or acquisition costs.

Depending on the project, you must either capitalize the indirect cost or expense it. Indirect costs that you can capitalize are:

  • Bidding costs
  • Insurance
  • Quality control
  • Rent
  • Capitalizable service costs
  • Cost recovery allowances
  • Interest (but only during the construction or development stage)
  • Licensing and franchise costs
  • Officers’ compensation
  • Pension and other related costs
  • Purchasing costs
  • Engineering and design costs
  • Indirect labor and material costs
  • Employee benefit expenses
  • Handling costs
  • Cost of repairs and maintenance
  • Spoilage and storage costs
  • Taxes
  • Tools and equipment
  • Utilities

Failure to capitalize these costs can muddle up your bookkeeping. On the other hand, capitalizing these costs will have the immediate effect of making your company appear more profitable and increasing stockholder equity.

Allocating Indirect Costs

There are different methods for allocating indirect costs. Depending on the type of property you are constructing and your unique needs, you can use one of the simplified production methods. Most taxpayers prefer simplified methods because they take less time.

Alternatively, you could use a self-developed method. Other methods you might consider include:

  • Specific identification method: This involves tracing costs to a cost objective or a contract. Determining the relationship between the two factors will help you identify whether it’s an indirect cost.
  • Burden rate method: This involves allocating indirect costs according to a ratio, such as labor hours to productivity. You can then use a predetermined rate to approximate the specific amount of indirect cost you have accrued.
  • Standard cost method: You can use pre-established standard allowances (without referencing the actual costs incurred) to determine which costs are indirect or direct.

Contact MKS&H

At MKS&H, we understand it takes more time to fix a mistake than to prevent one. Avoid costly errors when capitalizing and allocating indirect costs by choosing us for all your tax processing. Contact our office today for an initial consultation.

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