An Expanded Universe for Small Business Taxpayers
The New Tax Act Offers Many Favorable Reforms to Small Business Owners Including Drop in Rates and Accelerated Depreciation.
The Tax Cuts and Jobs Act (TCJA or "the Act") of 2017 provides many favorable tax reforms for businesses. Among these reforms is an increase in the small business taxpayer gross receipts threshold from $5 million (or $10 million in certain cases) to $25 million.
Previously, taxpayers that surpassed the $5 million ($10 million) gross receipts threshold were required to use accrual basis accounting, Section 263A inventory capitalization, percentage-of completion method for long-term contracts, and account for inventories. The increased threshold under the TCJA offers relief to more small business taxpayers with respect to accounting method reform and simplification. The TCJA references the existing gross receipts test under section 448(c) of the Internal Revenue Code (IRC or "Code") when determining whether a taxpayer qualifies as a small business taxpayer. However, the TCJA made two modifications to the existing test. First, the gross receipts threshold was increased from $5 million (not adjusted for inflation) to $25 million (adjusted for inflation), and second, the averaging period was changed from all prior years to the three prior taxable years.
It is also important to note that when calculating average gross receipts for these purposes, businesses are subject to the aggregation rules. Under the aggregation rules, the gross receipts from multiple businesses must be aggregated where they meet either a "controlled group" ownership test or an affiliated service group (ASG) test.
This article provides an overview of the simplified accounting method provisions for small business taxpayers under the TCJA, as well as one modified accounting method provision that applies to all accrual basis taxpayers. In addition, it outlines possible benefits and consequences of each accounting method change as well as the effective dates for the changes.
Expanded use of the overall cash method of accounting for small business taxpayers.
Before TCJA: Under Section 448 of the Code, C-corporations and partnerships with corporate partners were prohibited from using the cash method of accounting for tax purposes unless their average annual gross receipts were $5 million or less for the average of the three prior years.
After TCJA: The threshold for average gross receipts increased from $5 million to $25 million and is calculated by averaging the taxpayer’s gross receipts for the three prior taxable years. Effective for years beginning after December 31, 2017, the cash method of accounting may be used by taxpayers, other than tax shelters, that satisfy the $25 million gross receipts test, regardless of whether the purchase, production, or sale of merchandise is an income- producing factor.
- Benefits: The cash method of accounting ensures taxes are not paid on revenues that have not yet been received.
- Effective Date: Applies to taxable years beginning after December 31, 2017.
*Tax Shelters Defined*
The most commonly cited definition of a tax shelter in the Internal Revenue Code is (1) “a partnership or other entity, any investment plan or arrangement, or any other plan or arrangement if a significant purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of Federal income tax.” However, the IRC provides two additional definitions: (2) “Any enterprise (other than a C corporation) if at any time interests in such enterprise have been offered for sale in any offering required to be registered with any federal or state agency having the authority to regulate the offering of securities for sale,” and (3) “Any syndicate.”
The first two definitions conform to the traditional concepts of what constitutes a tax shelter, but the third, “any syndicate,” demands clarification. The IRC defines a syndicate as “any partnership or other entity (other than a corporation which is not an S corporation) if more than 35 percent of the losses of such entity during the taxable year are allocable to limited partners or limited entrepreneurs.” In other words, if more than 35 percent of an entity’s losses are allocated to limited partners or limited entrepreneurs, then the entity is considered a tax shelter.
Expanded Exemption From Requirement To Keep Inventory
Before TCJA: In order to clearly reflect income, a taxpayer had to account for inventories if the production, purchase, or sale of merchandise was an income-producing factor to the taxpayer. Furthermore, taxpayers that were required to account for inventories were also required to use the accrual method of accounting regarding purchases and sales. Two exceptions were provided: (1) taxpayers whose average annual gross receipts did not exceed $1 million, and (2) taxpayers in certain industries whose average annual gross receipts did not exceed $10 million, that treated inventory as non- incidental material and supplies.
After TCJA: Taxpayers with average annual gross receipts of $25 million or less are exempt from the requirement to account for inventories under Section 471 of the Code and have the option to use a method of accounting for inventories that either: (1) treats inventories as non-incidental materials and supplies, or (2) conforms to the taxpayer’s financial accounting treatment of inventories.
- Benefits: The taxpayer is not required to keep an inventory schedule if the $25 million gross receipts test is met.
- Effective Date: Applies to taxable years beginning after December 31, 2017.
Expanded Exemption From Uniform Capitalization (Unicap) Requirements
Before TCJA: The uniform capitalization rules require certain direct and indirect costs allocable to real or tangible personal property produced by the taxpayer to either be included in inventory or capitalized in the basis of such property. Under Section 263A of the Code, resellers of real or personal property were required to include certain direct and indirect costs allocable to such property in inventory. A few exceptions are provided by Section 263A to the general UNICAP rules, such as the exception for resellers of personal property with average annual gross receipts of $10 million or less.
After TCJA: The exception for small taxpayers from the UNICAP rules was expanded under the TCJA. Under the new law, any producer or reseller that meets the $25 million gross receipts test is exempted from the application of section 263A, including the sale of self-constructed assets.
- Benefits: Producers and resellers that are now exempt from the Section 263A adjustment do not need to capitalize the allocable portion of overhead to inventory, allowing them to deduct these costs currently.
- Effective Date: Applies to taxable years beginning after December 31, 2017.
Expanded Exemption From Percentage-Of-Completion Method for Long-Term Contracts
Before TCJA: An exception from the requirement to use the percentage-of-completion method for long-term contracts was provided for certain "small construction contracts." In order for a contract to fall under this category, it had to be a contract for the construction or improvement of real property and both: (1) expected (at the time such contract is entered into) to be completed within two years of commencement of the contract, and (2) performed by a taxpayer whose average gross receipts for the prior three taxable years do not exceed $10 million.
After TCJA: The aforementioned exception was expanded under the new law in that the $10 million gross receipts threshold was increased to $25 million.
- Benefits: By using the completed contract method rather than percentage-of-completion for long-term contracts, an opportunity exists to defer tax due until the job is complete. Under the completed contract method, costs are capitalized into the contract, but net profit is deferred until the contract is substantially complete.
- Effective Date: The changes made to this provision are on a cut-off basis and therefore only apply to long-term construction contracts entered into after December 31, 2017, or taxable years ending after December 31, 2017.
Timing of Revenue Recognition
Before TCJA: An accrual basis taxpayer was required to recognize income when all the events that fix the right to receive such income had occurred and the amount thereof could be determined with reasonable accuracy, more commonly known as the "all events test."
After TCJA: Under the new law, an accrual basis taxpayer subject to the all events test for an item of gross income is required to recognize income no later than the taxable year in which such income is taken into account as revenue in either an applicable financial statement or another statement that Treasury and the IRS identify as applying for this purpose. These new requirements do not apply to income items for which the taxpayer uses another "special method of accounting" provided in the Code, for example, percentage-of-completion for long-term contracts under section 460.
- Consequences: The new provision may require recognition of gross income for tax purposes earlier than the previous law, which consequently may accelerate when income taxes are payable for certain businesses.
- Effective Date: The "all events test" is deemed satisfied when the income is recognized on the financial statement for tax years beginning after December 31, 2017.
Action Steps
On August 3, 2018, the IRS issued a Revenue Procedure 2018-40 which permits eligible small business taxpayers to obtain automatic consent from the IRS when a taxpayer wants to change to one or more of the new TCJA-permitted methods of accounting. Reach out to your local Marcum tax professional to learn more about the opportunities that may exist for businesses under the TCJA.
