On July 29, 2020, the Internal Revenue Service (IRS) issued Proposed Regulations providing additional guidance on the use and implementation of small business accounting methods introduced by the Tax Cuts and Jobs Act (TCJA) in December 2017.
The TCJA introduced several opportunities for small business taxpayers to achieve tax savings and reduce administrative efforts. Generally, a small business taxpayer is defined as a trade or business with average annual gross receipts less than $25 million for the prior three-year period (adjusted for inflation, $26 million for 2020). The small business accounting methods include the following:
- Overall cash method of accounting;
- Exemption from the requirement to capitalize certain costs into the basis of property produced or acquired for resale under Sec 263A;
- Eased requirements on the use of the percentage of completion method of accounting for long term contracts; and,
- simplified methods of accounting for inventory.
The following are select highlights from the Proposed Regulations.
Gross Receipts Test and Small Business Taxpayer Eligibility
- For purposes of the gross receipts test for an individual, inherently personal amounts are excluded from gross receipts – including items such as: Social Security benefits, personal injury awards and settlements, disability benefits and wages received as an employee.
- Under existing law, tax shelters (i.e., certain taxpayers for which more than 35 percent of a taxpayer's losses are allocated to limited partners or entrepreneurs) are not permitted to use the small business taxpayer accounting methods. Making this determination may take significant time and could leave impacted taxpayers with little time to change accounting methods. The Proposed Regulations allow a taxpayer to use its allocated taxable income or loss from the immediately preceding tax year for purposes of determining whether the taxpayer meets the definition of tax shelter.
- Small business taxpayers accounting for inventory as non-incidental materials and supplies deduct those items at the later of when items are "used or consumed" or when the taxpayer pays or incurs the cost associated with those items. There is some uncertainty as to when an item is used or consumed. The Proposed Regulations specify that "used or consumed" means when the item is provided to the customer. This applies to all types of inventory, including raw materials, work in progress, finished goods and goods acquired for resale.
- Inventory items accounted for as non-incidental materials and supplies are not eligible to be deducted under the de minimis safe harbor of Treas. Reg. Sec. 1.263(a)-1(f).
- Small taxpayers accounting for tax inventory by following the method used in an Applicable Financial Statement (AFS) may still have book-to-tax inventory cost differences which must be taken into account.
- Taxpayers following their non-AFS books and records in accounting for tax inventory must determine their ending inventory and cost of goods sold in a manner which fairly reflects the taxpayer's business activities for non-federal income tax purposes. For example, a taxpayer following its non-AFS books and records for tax purposes and performing a physical count to determine inventory in its non-AFS books and records must also use that count to determine its inventory and cost of goods for federal income tax purposes.
- The Proposed Regulations offer refined guidance on how an eligible small business taxpayer may identify and value inventory accounted for as non-incidental materials and supplies.
Uniform Capitalization Under Section 263A
- The Proposed Regulations specify that interest is not required to be capitalized by small business taxpayers under Section 263A.
- Farming small business taxpayers were previously able to elect out of the application of Section 263A. However, a taxpayer making this election was required to use the Alternative Depreciation System in computing its annual depreciation allowance, resulting in slower recovery of depreciable basis. Pursuant to the Proposed Regulations, eligible farming small business taxpayers are able to revoke a prior election out of Section 263A and simultaneously adopt the small business taxpayer exemption from Section 263A.
Percentage-of-Completion / Long-Term Contracts
- The Proposed Regulations clarify that an eligible taxpayer must meet the applicable gross receipts requirements in the year in which a long-term contract is entered.
- Taxpayers subject to Base Erosion Anti-Abuse Tax (BEAT) liability must apply the look-back rules and consider actual total contract price and costs in computing modified taxable income and base erosion minimum tax amount for impacted years.
- The Proposed Regulations also included numerous updates to eliminate obsolete language and apply guidance consistently across all Regulations.
These Proposed Regulations apply to taxable years beginning on or after the date when they are adopted as final and published in the Federal Register. However, taxpayers may rely on the Proposed Regulations before that time, provided the taxpayer follows all the applicable rules contained in the Proposed Regulations for each Internal Revenue Code provision that the taxpayer chooses to apply.
The IRS and the U.S. Department of the Treasury specifically requested comments in several areas of the Proposed Regulations, indicating openness for feedback and possible modifications to the Proposed Regulations.
Tax Savings for Small Businesses
These tax accounting methods have potential to produce significant tax savings for eligible taxpayers. Implementing these opportunities is made through analysis of the current and prior year's taxable income activity and is generally effectuated on a timely filed federal income tax return, including extensions. Amending tax returns is not required.
For assistance or more information about assessing tax savings opportunities that may be available to your business, reach out to us at email@example.com.