Small business taxpayers should explore these new accounting methods
When the Tax Cuts and Jobs Act (TCJA) was enacted in December 2017, much of the attention focused on the tax rate reductions, enhanced write offs for capital expenditures, and the wholesale changes within the international tax regime. Nonetheless, there were several lesser publicized provisions as part of comprehensive tax reform that present significant opportunities for small businesses. 2018 is the first year that these changes took effect, so businesses should be aware of whether they can take advantage of these incentives.
Overview of Enhancements
Small business taxpayers can apply one or more of the following new accounting methods for tax years beginning after December 31, 2017. Under tax reform, there now exists:
- Expanded eligibility to use the cash method;
- Elimination of the burdensome cost capitalization rules for inventories;
- Exemption from the requirements to apply certain accounting rules for inventories; and
- Broader use of other accounting methods with long-term contracts.
Small Business Defined
Before we look further at each of these four changes in methods of accounting, we must address the definition of a “small business.” A small business taxpayer is a taxpayer that meets both of the following provisions:
- Not a “tax shelter.” A tax shelter for this purpose has an involved, complicated definition, but can essentially be boiled down to: if more than 35% of the losses of the business are allocated to limited partners or limited entrepreneurs, then the business is treated as a tax shelter. A “limited entrepreneur” is a person who owns an interest in the business, but who does not actively participate in the management of the business.
- If not in a loss situation, then you are not subject to this tax shelter restriction.
- If in a loss situation, then determine if >35% of loss is allocated to those that are limited partners or limited entrepreneurs.
- Satisfies a “gross receipts test.” The gross receipts test is met if a taxpayer has average annual gross receipts of $25,000,000 or less over the prior three tax years. This $25,000,000 level was significantly increased from the prior threshold of $5,000,000. The IRS further describes gross receipts and various adjustments that are needed. For this test, gross receipts are reduced by any returns and allowances (but not for cost of goods sold), and gross receipts include any income from investments, such as interest, dividends, royalties, and rents. Also, with the sale of capital assets or depreciable assets, gross receipts include the amount realized from the sale of the capital assets or depreciable assets, but the sale proceeds are reduced by the adjusted tax basis of the assets sold.
- In addition, gross receipts must be aggregated with other commonly controlled related businesses. Thus, it is important to determine which businesses are commonly controlled and then combine all their gross receipts for this $25,000,000 test. This can be an involved exercise to determine which are the commonly controlled businesses for this purpose.
A. Adoption of Cash Method of Accounting
(Change in the overall method of accounting from the accrual method to the cash method)
According to the IRS, the cash method of accounting causes income to be recognized for tax purposes when cash is received for the service or product, and results in expenses being deducted when the expense is actually paid. The taxpayer must not otherwise be prohibited from using the overall cash method or required to use another overall method of accounting.
The IRS further indicates that income is recognized when paid on accounts receivable, provided the receivable is an “open receivable” that is due and payable within 120 days or less. Many small businesses often prefer the cash method, as it is easier to determine the overall income of the business and it generally provides a tax benefit as taxable income is deferred until receivables are collected.
B. Removal of Capitalized Costs for Inventory
(Inventory cost capitalization provisions [UNICAP] eliminated)
For over thirty years, businesses have been required to analyze their general administrative costs and follow many complicated rules that result in a portion of these admin costs being capitalized into their inventory and not directly deducted. The TCJA permits eligible small businesses: (1) to not capitalize these administrative overhead costs any longer; and (2) to deduct any prior years’ costs that have been capitalized into inventory. Many taxpayers will be relieved that they no longer need to analyze these costs, AND they get to deduct any prior amounts that have been capitalized. This can be a “win-win situation” for any qualifying small businesses that make this change.
C. Revised Treatment of Inventory
(Small businesses no longer need to maintain inventories for tax purposes)
In the past, manufacturers and wholesalers/distributors were required to maintain inventories for tax purposes which capitalized material, labor, and overhead costs into inventory. These capitalized costs were then relieved as the inventory was sold. The TCJA allows for small businesses to change this treatment for inventories to instead treat inventories as “non-incidental materials and supplies.” As non-incidental materials and supplies, the general treatment is that the material cost of the inventory is expensed when the product is sold or disposed of, but there is no need to capitalize labor and overhead into the inventory. This could have a significant tax impact for many small to mid-sized manufacturers.
In addition, the rules for non-incidental materials and supplies were updated by the IRS in 2014 under the “tangible property regulations” (TPR or the “repair regs”). One of the changes introduced was the new “de minimis safe harbor” election (DMSH). The DMSH election permits a company on an annual basis to deduct when paid the cost of smaller, non-incidental materials and supplies provided it: (1) had a policy in place for the year that it would expense these items; (2) followed this same policy on the company’s books as it did for tax purposes; (3) applied this expensing treatment on all such qualifying items; and (4) included a DMSH election in its tax return for the year. The threshold for the DMSH election was $5,000 per item for a company with applicable financial statements (AFS) and $2,500 per item for a company without applicable financial statements.
Thus, a company could elect a change of accounting method for its inventory to treat this as a non-incidental supply. It would reduce the amount of costs that are capitalized; then as a non-incidental supply, the product cost could be deducted as paid under the DMSH election. This combination could provide significant tax benefits to any small business that now maintains or carries inventory. Remember, the DMSH election must also be made for book purposes, and this could present some challenges. Your Sikich tax advisor can help you analyze all the issues, potential savings, and implications of such a change with inventories.
D. Opportunities for Accounting Methods with Long-Term Contracts
(How contractors account for “long-term contracts”)
Prior to the TCJA, contractors were required to use the percentage-of-completion method (PCM) on any long-term contract (a contract that is not completed in the year it begins) if their average annual gross receipts over the prior three years was less than $10,000,000 AND the expected length of the contract at the beginning of the contract was two years or less. Thus, contractors with less than $10,000,000 of average gross receipts could use various methods, such as the completed contract method or cash method to account for their long-term contracts. But once they exceeded $10,000,000 in average gross receipts, they needed to use the PCM which recognizes revenues and expenses on a contract as the work is performed and costs are incurred.
The TCJA greatly expanded this limitation—the threshold for long-term contracts was raised to $25,000,000. This hike could allow contractors to use more tax-favorable methods for their long-term contracts. For those contractors eligible to make this change, it applies for long-term contracts entered into after December 31, 2017 (so contractors must continue to use prior methods on older long-term contracts until those are completed).
One word of caution – while the threshold to force contractors on to the percentage-of-completion method was increased to $25,000,000, this applies only for regular tax purposes. For alternative minimum tax (AMT) purposes, the PCM applies for all long-term contracts regardless of the contractor’s gross receipts. Thus, there is a difference—an AMT adjustment—that must be determined each year between the method used for regular tax and the PCM method used for AMT. AMT only applies to individual taxpayers (as there is no longer any corporate AMT), and thus owners of contractors operating as S Corporations, partnerships, or sole proprietorships will need to factor this AMT adjustment into their analysis. Again, your Sikich tax advisor can assist in this analysis.
Bonus for Small Businesses – Relief from New Limitation on Interest Expense Deduction
Another TCJA provision that is not-so-friendly to all businesses, regardless of entity type, is a new limitation on the deductibility of interest expense (click here for more information). This change has a two-fold impact on businesses: (1) for those subject to this new interest deduction limitation (interest expense that exceeds 30% of “adjusted taxable income”), some interest expense will not be deductible; and (2) for many other businesses that, even if not limited, the business must still deal with the recently issued IRS proposed regulations which created a web of complexity and new compliance and reporting burdens. Certain industries can elect out of these interest limitations. In addition, some interest expense is not limited, such as floorplan financing interest.
Eligible small businesses are exempted from this new limitation on deducting their interest expense. Note that the same two-part definition of a small business outlined above applies for purposes of the relief from this new restriction on deducting interest expense.
How A Small Business Makes a Change of Accounting Method
To make a change to one of the accounting methods addressed above, the small business must follow the corresponding guidance issued by the IRS. Rev Proc 2018-40, released by the IRS on August 3, 2018, spells out the requirements businesses must follow to make any of the four accounting method changes:
- Taxpayers must file IRS Form 3115, Application for Change in Accounting Method.
- Rev Proc 2018-40 provides that these small business accounting method changes will be treated as an “automatic change in accounting method.” Thus, no fees are involved, but the business/taxpayer must still gather the materials and answer the specified questions for the requested change as spelled out in the Form 3115 Instructions and Rev Proc 2018-40.
- With the previously mentioned relief from the new interest deduction limitation for qualifying small businesses, there is no need to change any accounting methods. If the business meets the small business definition, then the business interest expense is deductible without limitation and there is no need to file any change of accounting method.
Small business taxpayers should explore these new accounting methods to see if they qualify to make one or more of these changes, and what the tax benefits of such a change would be. Small businesses should also explore whether they will be subject to the new interest expense limitation rules. There are tax incentives available, but many issues and complexities to consider. Your Sikich tax advisor can assist you in identifying these tax savings opportunities and how to get started. Contact us for more information.