TAM 1030025: Packaging materials had to be capitalized as handling costs

Plain-English summary

The Technical Advice Memorandum addressed an S corporation's treatment of packaging materials used in manufacturing, storing, and shipping its products. The IRS concluded that the cardboard, foam, plastic, and other packaging costs were handling costs that had to be capitalized under section 263A because the same packaging was applied to all products, not only goods prepared for imminent shipment to a particular customer. It also concluded that an earlier letter ruling had permitted the taxpayer to reduce the numerator of its simplified production absorption ratio by those costs, but that the taxpayer had to include them after the new conclusion. Because the taxpayer had relied in good faith on the letter ruling and the change would increase tax liability, the IRS applied the ruling prospectively under section 7805(b). The taxpayer was expected to file Form 3115 to change its treatment for the succeeding taxable year.

Ruling snapshot

• Question: Were the taxpayer's packaging costs deductible pick and pack costs, and if not, would the change apply retroactively?
• Outcome: Mixed, packaging costs had to be capitalized, but the modification applied prospectively
• Key authorities: IRC §§ 263A and 7805(b); Treas. Reg. §§ 1.263A-3(c)(4)(vi)(C) and 601.204(c); Rev. Proc. 2010-1 and Rev. Proc. 2010-2

Full text (IRS public release)

                      INTERNAL REVENUE SERVICE
            NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

Number: 201030025
Release Date: 7/30/2010

                               February 18, 2010


                                      Third Party Communication: None
                                      Date of Communication: Not Applicable

Index (UIL) No.: 263A.01-01
CASE-MIS No.: TAM-138531-09

Attorney
CC:LM:RFP:CHI:2M

  Taxpayer’s Name:                    ------------------------------------------
  Taxpayer’s Address:                 ----------------------
                                      ------------------------------
  Taxpayer's Identification No.       ----------------
  Year(s) Involved:                   ----------
  Date of Conference:                 ------------------------

LEGEND:

Taxpayer = ------------------------------------------
----------------------------
Date One = -------
Date Two = -------
Date Three = -------
Date Four = -------
A = ---
Date Five = ---------------------
Date Six = --------------------------
Date Seven = -------------------------
Letter Ruling = ------------------------------------------------------------------
Date Eight = --------------------------
F = ---------------
TAM-138531-09 2

ISSUES:

(1) Whether Taxpayer’s costs attributable to cardboard boxes, dividers, foam
packaging, plastic wrapping, heavy plastic bags, and other materials (“packaging
material costs”) are required to be capitalized as handling costs under § 263A of the
Internal Revenue Code because these costs are not costs attributable to pick and pack
activities inside a storage or warehousing facility.

(2) Whether Letter Ruling permitted Taxpayer to change its method of accounting for
the packaging material costs by reducing the amount of additional section 263A costs
contained in the numerator of the simplified production absorption ratio in the amount of
the packaging material costs that Taxpayer treated as costs attributable to pick and
pack activities that are not required to be capitalized under § 263A.

(3) If we conclude that Taxpayer’s packaging material costs are required to be
capitalized under § 263A, whether we should apply Ruling (1) prospectively.

CONCLUSIONS:

(1) The packaging material costs are required to be capitalized as handling costs under
§ 263A because the packaging material costs are handling costs and these costs are
not attributable to pick and pack activities inside a storage or warehousing facility.

(2) Letter Ruling permitted Taxpayer to change its method of accounting for the
packaging material costs by reducing the amount of additional section 263A costs
contained in the numerator of the simplified production absorption ratio in the amount of
the packaging material costs that Taxpayer treated as costs attributable to pick and
pack activities that are not required to be capitalized under § 263A.

(3) Taxpayer has satisfied the conditions for § 7805(b) relief, and accordingly, Ruling (1)
will be applied prospectively.

FACTS:

  Taxpayer, an S corporation, is engaged in the business of manufacturing,

wholesaling, and retailing -----------. Taxpayer’s Federal tax returns for the Date One,
Date Two, Date Three, and Date Four taxable years are currently under examination.
Taxpayer’s overall method of accounting is the accrual method.

    Taxpayer owns and operates numerous retail stores from which Taxpayer-

manufactured ----------- is sold. The ----------- that Taxpayer produces, whether or not
built-to-order, is distributed to unrelated retailers, stores owned by third parties but
licensed by Taxpayer, or to stores owned by Taxpayer.
TAM-138531-09 3

     Taxpayer manufactures ----------- by using an assembly-line process. ---------------

-----------------------------is bagged, placed on a cardboard tray, and heat treated to shrink
the bags to better conform to the -----------. Wooden ----------- is boxed, which may
include placing the ----------- in Styrofoam® before boxing it. Once packaged, the --------
----------- goes into a warehouse, located within the manufacturing facility, for storage. If
the ----------- item is preordered, it is stored in the warehouse until the entire order is
completed, at which time the item of inventory is moved to the loading area and placed
in a trailer for shipment.

    The taxpayer expenses shipping supplies, such as tape, pallets, and cellophane

rolls used to hold boxes together during shipment, as these supplies are used.

     Approximately A percent of the ------------manufactured by Taxpayer is built-to-

order; that is, the ----------- is manufactured after a customer has ordered the specific ----
-----------. Taxpayer treated only A percent of its packaging material costs as pick and
pack costs. After the ----------- is manufactured, it is packaged using cardboard boxes,
dividers, foam packaging, plastic bags and/or other materials as necessary for
placement on racking in Taxpayer’s warehouses. Generally, Taxpayer’s manufacturing
facilities and warehouses are single integrated facilities. When ready to be shipped,
Taxpayer’s built-to-order ----------- is removed from the racking and loaded onto delivery
trucks.

   ------------ that has been ordered by an individual at one of Taxpayer’s retail

stores is first transported to the retail store. After delivery to the retail store and prior to
delivery to the customer who has ordered the -----------, all packaging materials are
removed from the -----------. The packaging materials are discarded, the ----------- is
loaded onto a delivery truck without the packaging materials, and title to the -----------
passes to the customer after the ----------- has been received, inspected, and accepted
by the customer at the customer’s home.

    ------------ that has been ordered by an unrelated retailer is delivered to the retail

store, operated by the unrelated retailer, and is typically shipped with the packaging
materials remaining on the -----------. When ----------- is shipped to unrelated retail stores
or licensed stores, title to the ----------- does not transfer to Taxpayer’s customer (in this
case, the unrelated retailer) until the ----------- has been received, inspected, and
accepted by the unrelated retailer.

  All ----------- that is manufactured, whether or not preordered, is packaged with

the necessary packaging material. Thus, all ------------is packaged in the same identical
packaging whether or not built-to-order.

 Taxpayer had included the costs that it had capitalized under its standard cost

method in Taxpayer’s section 471 costs for purposes of the simplified production
TAM-138531-09 4

method calculation under § 263A prior to changing its method of accounting (discussed
below).

   During Date Five, Taxpayer filed a Form 3115, Change in Accounting Method, to

change its method of accounting for, among other items, certain packaging and
repackaging costs, beginning with Taxpayer’s 52-53 week taxable year beginning Date
Six. Taxpayer requested permission to change its accounting for these packaging costs
from capitalizing the costs under § 263A to deducting the costs as costs attributable to
pick and pack activities under § 1.263A-3(c)(4)(vi)(C) of the Income Tax Regulations.

    On Date Seven, the Service granted Taxpayer’s request to change its method of

accounting for the items subject to Taxpayer’s Form 3115, including the packaging
costs Taxpayer sought to deduct as pick and pack costs. On Date Eight, the Service
issued Letter Ruling, which superseded the letter ruling issued on Date Seven. Letter
Ruling contained the following representation made by Taxpayer: “the pick and pack
costs [that Taxpayer seeks to deduct] relate to packaging and repackaging material
consisting of heavy plastic bags [that] are designed to protect the goods during the
distribution process and that the pick and pack costs also related solely to goods [that]
have been ordered at the time production is complete.”

    Taxpayer has elected to use the simplified production method without the historic

absorption ratio for computing the additional section 263A costs allocable to eligible
property remaining on hand at the end of the taxable year. As part of Taxpayer’s
simplified production method without the historic absorption ratio for the Date One
taxable year, Taxpayer included packaging material purchases in the amount of $F in
the absorption ratio as a negative additional section 263A cost, resulting in a negative
absorption ratio.

LAW AND ANALYSIS:

Costs attributable to pick and pack activities

  Taxpayer concedes that the packaging material costs are handling costs.

Taxpayer, however, argues that these costs are deductible as costs attributable to pick
and pack activities inside a storage or warehousing facility. Accordingly, we will
address whether the packaging material costs constitute costs attributable to pick and
pack activities under § 1.263A-3(c)(4)(vi)(C). We express no opinion with respect to
whether the packaging material costs are handling costs as defined elsewhere in
§ 1.263A-3(c)(4).

   Section 1.263A-3(c)(4)(vi)(C)(1) provides that, generally, handling costs incurred

inside a storage or warehousing facility must be capitalized. However, costs attributable
to pick and pack activities inside a storage or warehousing facility are not required to be
capitalized. Pick and pack activities are activities undertaken in preparation for imminent
TAM-138531-09 5

shipment to a particular customer after the customer has ordered the specific goods in
question. Examples of pick and pack activities include:

   (i) Moving specific goods from a storage location in preparation for shipment to

the customer;

    (ii) Packing or repacking those goods for shipment to the customer; and

    (iii) Staging those goods for shipment to the customer.

   Section 1.263A-3(c)(4)(vi)(C)(2) provides that activities that are not pick and pack

include:

    (i) Unloading goods that are received for storage;

    (ii) Checking the quantity and quality of goods received;

  (iii) Comparing the quantity of goods received to the amounts ordered and

preparing the receiving documents;

    (iv) Moving the goods to their storage location, e.g., bins, racks, containers, etc.;

and

    (v) Storing the goods.

     Taxpayer’s packaging material costs are not costs attributable to pick and pack

activities. First, the packaging materials in question are applied to all ------------------------
----------------------------------------------------------------------------------------------produced by
Taxpayer. All ----------- produced by Taxpayer is packaged in the same identical
packaging whether or not built-to-order. Thus, the packaging material costs are not
undertaken in response to an order from a particular customer.

   This fact argues against Taxpayer’s position that the packaging material costs

are attributable to pick and pack activities. Taxpayer’s packaging activities are not
undertaken in preparation for imminent shipment to a particular customer; the same
packaging material costs are necessary for ----------- produced without a preorder.
Packaging that Taxpayer uniformly applies to all of its manufactured ------------does not
become a pick and pack activity by reason of a customer order.

   The treatment of pick and pack costs as an exception to the general rule in the

§ 263A regulations that handling costs must be capitalized is based on the
determination that such costs are like distribution costs and is illustrated by the following
example: A book reseller stores several hundred books, boxed by title, in its warehouse.
A particular customer places an order for several different titles. Upon receipt of the
TAM-138531-09 6

order, an employee of the book reseller retrieves the requested titles from several boxes
stored in the warehouse, applies plastic wrap to the books, and places the books in a
shipping box. The labor and materials used within the reseller’s warehouse upon
receipt of the customer order constitute pick and pack activities that are not required to
be capitalized under § 263A.

    Accordingly, Taxpayer’s packaging material costs are required to be capitalized

as handling costs under § 263A because: (1) Taxpayer concedes that the packaging
material costs are handling costs; and (2) Taxpayer’s packaging material costs are not
attributable to pick and pack activities inside a storage or warehousing facility.

Negative amounts included in additional section 263A costs

   The second issue is whether Letter Ruling permitted Taxpayer to change its

method of accounting for the packaging material costs by reducing the amount of
additional section 263A costs contained in the numerator of the simplified production
absorption ratio in the amount of the packaging material costs that Taxpayer treated as
costs attributable to pick and pack activities that are not required to be capitalized under
§ 263A. We find that it did. In light of our conclusion, however, that the packaging
material costs are required to be capitalized under § 263A because these costs are not
the result of pick and pack activities inside a storage or warehousing facility, Taxpayer
must include these amounts in the numerator of the simplified production absorption
ratio.

Section 7805(b) relief

   The third issue is whether Taxpayer should be granted relief under § 7805(b)

with regard to the treatment of packaging materials as pick and pack costs rather than
as costs that must be capitalized under § 263A.

   Section 7805(b)(8) provides that the Secretary may prescribe the extent, if any,

to which any ruling (including any judicial decision or any administrative determination
other than by regulation) relating to the internal revenue laws shall be applied without
retroactive effect.

    Section 13.02 of Rev. Proc. 2010-2, 2010-1 I.R.B. 90, 106, provides that a

technical advice memorandum (“TAM”) may be used to seek revocation or modification
of a private letter ruling (“PLR”). See section 11.03 of Rev. Proc. 2010-1, 2010-1 I.R.B.
1, 49, with respect to revocation or modification of PLRs. Under section 601.204(c) of
the Statement of Procedural Rules, the written permission by the national office to a
change in a taxpayer's accounting method is a letter ruling. Generally, a TAM that
revokes or modifies a letter ruling will not be applied retroactively if: (1) the applicable
law has not changed; (2) the taxpayer directly involved in the letter ruling relied in good
faith on it; and (3) revocation or modification would be detrimental to the taxpayer.
TAM-138531-09 7

However, the TAM will be applied retroactively to the taxpayer whose tax liability was
directly involved in the letter ruling if: (1) controlling facts have been misstated or
omitted; or (2) the facts at the time of the transaction are materially different from the
controlling facts on which the letter ruling was based.

    In the instant case, the applicable law has not changed since issuance of Letter

Ruling. Moreover, no evidence has been presented to suggest that Taxpayer failed to
rely on Letter Ruling in good faith, that Taxpayer misstated or omitted controlling facts,
or that the facts at the time of the transaction are materially different from the controlling
facts on which Letter Ruling was based. Finally, modification of Letter Ruling would
result in increased tax liability for Taxpayer’s Date One through Date Four taxable
years. Accordingly, Ruling (1) will be applied prospectively. However, the Service may
exercise its authority to modify the year of change if Taxpayer does not file a Form 3115
to change its treatment of the packaging materials for the taxable year immediately
succeeding the taxable year in which the § 7805(b) relief ends.

  A copy of this technical advice memorandum is to be given to Taxpayer. Section

6110(k)(3) of the Code provides that it may not be used or cited as precedent.