How the new accounting methods can affect your manufacturing or distribution business
Under the Tax Cuts and Jobs Act (TCJA), there are four tax incentives with accounting methods that are available to many businesses for tax years beginning in 2018; three of which apply to businesses in the manufacturing and distribution industries. Manufacturers and distributors should first determine if they meet the definition of a “small business” to be eligible for one or more of these method changes, and then estimate what the tax benefits of such a change would be. Below, we analyze and provide an overview of these accounting method opportunities.
“Small Business” Defined
Before analyzing the changes in methods of accounting, it is first important to understand how a “small business” is defined in this scenario. A manufacturer or distributor must meet this small business classification in order to make one of the three accounting method changes addressed below.
A small business taxpayer is a taxpayer that meets both of the following provisions:
- Not a “tax shelter.” A tax shelter 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. 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.
Once the manufacturer or distributor has determined it qualifies as a small business for this purpose, it can then analyze each of these accounting methods and determine what the tax savings will be if the change is made.
1. Adoption of Cash Method of Accounting
Change in the overall method of accounting from the accrual method to the cash method
Under IRS rules, the cash method of accounting causes income to be recognized for tax purposes when cash is received for the service or product sold, and results in expenses being deducted when the expense is actually paid. In addition, 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. This could be a favorable method of accounting for a small manufacturer to consider.
2. Removal of Capitalized Costs for Inventory
Inventory cost capitalization provisions (UNICAP) eliminated
For over thirty years, businesses have been required to analyze their general and administrative costs and follow rules that result in a portion of these admin costs being capitalized into their inventory and not currently deducted. The TCJA permits eligible small businesses not to capitalize these administrative overhead costs any longer and to deduct any prior years’ costs that have been capitalized into inventory. Many manufacturers and distributors will be relieved that they no longer need to analyze these costs, and they get to deduct any prior amounts that have been capitalized.
3. 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 resulted in material, labor, and overhead costs being capitalized into inventory. These capitalized costs were then relieved as the inventory was sold. The TCJA allows for small businesses 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. This could be a significant tax benefit to small manufacturers.
How to Change Your Accounting Method
To make a change to one of the accounting methods addressed above, a small business in manufacturing or distribution 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 these accounting method changes. Form 3115 (Application for Change in Accounting Method) must also be properly completed and timely filed with the IRS.