By Miranda Aavatsmark
As I sit down to write this, it is a couple of days post-Halloween and I changed out my spring door wreath for my fall one. This year has been the first full year to realize most of the tax reform changes and needless to say, accounting professionals have been quite busy.
But now is not the time to set the cruise control because there are still many tax considerations for business owners and CPAs. As part of the Tax Cuts and Jobs Act of 2017 (TCJA), a new definition of a small business was established as it relates to certain methods of accounting. More specifically, businesses with average annual gross receipts of less than $25 million (more on this shortly) can now choose more favorable accounting methods for tax purposes (other than tax shelters).
For the purpose of the gross receipts test, a “tax shelter” refers to the definition given by IRC §461(i)(3). As the section states, a tax shelter is any enterprise, (other than a C Corp) if at any time interests are offered for sale wherein the offering is required to be registered with any federal or state agency that has the authority to regulate the offering of securities, as well as any syndicate under IRC §1256(e)(3)(B) or any tax shelter under IRC §6662(d)(2)(C)(ii).
The following methods of accounting are worth considering if a business meets the gross receipts tests:
- Cash method of accounting instead of the accrual method (IRC §448(c))
- UNICAP – not required to capitalize additional costs to inventory (IRC §263A(i))
- Allow inventory to be treated as non-incidental materials and supplies, or any method that represents financial accounting treatment of inventory (IRC §471(c)) and,
- Percentage-of-Completion Method not required for long-term construction contracts (IRC §460(e)(1)(B))
Gross Receipts Test
The rules provided by IRC §448 require a business to use the average of their annual gross receipts for the prior three-year period. Circling back to the 2019 year-end considerations for businesses and their CPAs, reviewing this rule annually could prove beneficial if average revenues begin to drop below this threshold. However, keep the aggregation rules in mind if the revenue from related entities needs to be included in the calculator tape. Generally, the aggregation rules apply to two or more businesses that are part of a controlled group with greater than 50 percent common control. A detailed discussion of these rules is beyond the scope of this article.
Application for Change in Accounting Method
In order to use the accounting methods above, a business not previously eligible would need to file Form 3115, Application for Change in Accounting Method. The IRS released Rev. Proc. 2018-40 in early August of 2018 to provide guidance for taxpayers wishing to adopt these newly allowable methods. As laid out in Rev. Proc. 2018-40, all four method changes can be filed under “automatic” procedures as opposed to the more cumbersome (and costly) “advanced consent” procedures. In addition, the IRS waived the “five-year scope limitation” rules (which require advance consent for the same item of change within a five-year period) for taxpayers’ first three tax years beginning after December 31, 2017. If in any future tax years, the taxpayer fails to meet the requirements for an accounting method, they would be required to file Form 3115 to change the method once more. Because of this, carefully consider future revenue projections and tight margins near the threshold.
Calculating the Adjustment
A common adage among CPAs, as it relates to certain IRS friendly rules, is “heads they win, tails you lose.” This describes situations that, regardless of the outcome, the taxpayer receives (potentially) unfavorable treatment. In the case of this change of accounting method though, it’s “heads we win, tails they lose!” This does not happen often, but when it does, a celebration is in order. Under IRC §482(a), method changes one, two, and three above require the taxpayer to compute the difference in taxable income under the old and new methods. If the change is negative (reduces taxable income), then the adjustment is taken all in the year of change (taxpayer win). If the change is positive (increases taxable income), then the adjustment can be spread evenly over FOUR years, starting with the change year (IRS lose). See “Percentage of completion method” below for a discussion on the effects of changing this accounting method.
It is important to understand who qualifies as a small taxpayer, how to make the change of accounting method, and what the effects of doing so could be. Below is a brief summary of each of the relevant accounting methods for business owners to contemplate adopting. Note that the information following is not an in-depth analysis of each method, and many facts and circumstances specific to each taxpayer should be taken into account.
Cash Method of Accounting
The cash method of accounting for computing taxable income is generally thought of as the best matching of a taxpayer’s cash flow with their tax burden. Taxpayers recognize income under the cash method when it has been “constructively received,” meaning the money has been deposited in the bank (or can be). Similarly, expenses are deducted when they are actually paid. Most simply put, the taxpayer “realized” the income to pay their tax, which is why it is usually the preferred method. Under the prior tax laws, the use of the cash method was somewhat limited depending on the type of entity, industry, gross receipts, and whether the business carried inventory. However, as mentioned above, TCJA expanded the availability of the cash method of accounting to any taxpayer meeting the $25M gross receipts test.
Uniform Capitalization (UNICAP)
IRC §263A requires that certain direct and indirect costs incurred by real and personal property producers be capitalized to inventory each year instead of expensed. This is more or less of a timing issue, as when the inventory is sold the costs are deducted. As might be expected, the calculations, tracking, and recordkeeping for this can be very time consuming and tedious. Exceptions to this were available prior to the TCJA if average annual gross receipts were less than $10M. Taxpayers might now take comfort in the new $25M gross receipts test and be free from this obligation.
Accounting for Inventories
Under prior tax laws, taxpayers were required to account for their inventory if the sale of goods was an income-producing factor (IRC §471(a)). If the taxpayer’s gross receipts were less than $1M, or less than $10M of gross receipts for certain industries, then accounting for inventory would not be required. A taxpayer not subject to this would expense purchases, materials, and other costs of goods when paid. The taxpayer that is subject to this rule capitalizes their costs of goods as inventory and expenses the costs when the goods are sold. Under the new TCJA rules, taxpayers that meet the $25M gross receipts test can either expense these costs as non-incidental materials and supplies, or other method used for applicable financial statement purposes.
Percentage-of-completion Method (PCM)
Taxpayers in the construction industry have long been subject to rules regarding the timing of recognizing income related to long-term contracts. These businesses would be required to include in revenue each year a percentage of the gross contract price as determined by the percentage of the project actually completed. This computation is done irrespective of how much of the contract revenue has been collected. The previous tax laws provided an exception for certain small construction contracts for construction or improvement of real property (IRC §460(e)) if the contract is expected to be completed within two years and performed by a taxpayer with average annual gross receipts of less than $10M. The only change to the aforementioned rule with the new law is that the gross receipts test changed from $10M to $25M. Taxpayers who meet the exception can account for the revenue from long-term contracts using the completed contract method. Taxpayers who choose to make a change of accounting method from the PCM method do not make an adjustment under IRC §481(a), since prior year contracts cannot be changed. Instead, the method can be changed for new contracts entered into after December 31, 2017. One caveat here is that the PCM must still be used for computing alternative minimum tax (AMT was repealed for C-Corporations but not individual pass-through owners). Clearly, this could complicate matters and should be taken into consideration.
Accounting and business professionals have spent almost two years learning the new tax laws and continue to seek advantageous ways to apply them. As 2019 approaches the end of its term, new opportunities for tax savings are undoubtedly up for grabs. Determining if a business now qualifies and would benefit from the new small business definition is a definite consideration to put on the books before they close.
This article was originally published in The Kentucky CPA Journal.