Simplified accounting methods for small business taxpayers

Small business taxpayers can see significant tax savings by using the favorable tax accounting methods provided by the Tax Cuts and Jobs Act of 2017 (TCJA). In January, the Treasury Department published final regulations related to these small business taxpayer accounting methods. Under these rules, qualified small business taxpayers have opportunities to potentially accelerate deductions, defer income, and simplify their tax accounting methods.

Who qualifies as a small business taxpayer?

Businesses are considered small business taxpayers if their average annual gross receipts for the preceding three years are below the gross receipts threshold, which is presently $26 million and indexed for inflation. The expansion of the gross receipts threshold from its previous level of $5 million provides many businesses new opportunities to optimize their tax accounting methods.

However, some taxpayers with less than $26 million of gross receipts may still not be eligible for these methods:

• Taxpayers with related businesses: In evaluating the gross receipts of the Company, taxpayers are required to aggregate their receipts with those of related businesses. In some cases, this determination is obvious, but in more complicated ownership structures, this may require some analysis. 
• Flow-through businesses with losses allocated to passive investors: Taxpayers who are considered tax shelters are not eligible for the small business taxpayer accounting methods. For this purpose, a tax shelter includes any flow-through entity that allocates 35% or more of losses to limited partners or those not actively participating in management. This only applies in a year when tax losses actually exist. Additionally, taxpayers who typically generate income may still qualify as small business taxpayers if they encounter a single year of taxable losses. Under the final regulations, taxpayers can make an election to use their prior year income to make the tax shelter determination, protecting their favorable tax accounting methods in a loss year.

Small business taxpayer accounting methods

With the increase of the gross receipts threshold, qualified small business taxpayers have the opportunity to take advantage of simplified accounting methods that often defer income and accelerate deductions.

Overall cash method

Small business taxpayers can adopt the overall cash method of accounting. The cash method of accounting has many advantages compared to the accrual method. One advantage of the cash method of accounting is its simplicity. Taxpayers only account for cash paid or received, which lessens the administrative burden of a business’s overall accounting.

Under the cash method of accounting, taxpayers defer the recognition of income until cash is received. For taxpayers where accounts receivable exceeds their accounts payable and accrued expenses, revenue isn’t taxed until received and the expenses are paid. This can create a semi-permanent deferral so long as receivables continue to exceed unpaid expenses.

Accounting for inventories

Small business taxpayers also have more flexibility in accounting for their inventory by accounting for inventory as non-incidental materials and supplies (NIMS), which can be deducted in the year that they are used or consumed in the taxpayer’s business. Alternatively, taxpayers can account for inventory by conforming to their financial statements or books and records.

Under the TCJA, it was relatively clear that the NIMS method did not require the capitalization of labor and overhead costs to inventory — even if they were capitalized for book purposes — creating an ability to accelerate deductions. However, in the case of manufacturers, the timing for the deduction of materials was not clear. Many practitioners and taxpayers had originally interpreted the NIMS method to provide for a deduction of inventory when it was first used in a taxpayer’s business. For example, raw materials inventory would be deductible when it first entered the production process, providing taxpayers a deduction for all work-in-process and finished goods inventory. The final regulations clarify that under the NIMS inventory method, direct materials cannot be deducted until they are sold.

The final regulations also provide some clarity for taxpayers that adopt a book conformity method for inventory, rather than the NIMS method. Many small taxpayers do not fully capitalize inventory costs for book purposes, due to more limited processes compared to larger taxpayers. To preserve the intended simplification for small taxpayers, if inventory is not capitalized for books and records, the taxpayer is not required to capitalize the inventory for book purposes. However, taxpayers maintaining records of inventory, particularly if they are reporting these records to lenders or other third parties, will be required to capitalize that inventory.

The final regulations also provide that taxpayers using the book conformity method may also need to address book-tax differences on capitalized inventory costs, which in some cases can create some additional complexity.  For example, a taxpayer using the accrual method on its books and records but the cash method for tax purposes would need to defer the deduction for cost of goods sold until the underlying cost has been paid.

Uniform capitalization

Historically, even small taxpayers with inventory were often required to capitalize additional expenses into inventory under the Uniform Capitalization (UNICAP) rules under Section 263A. The TCJA expanded the gross receipts exception for small business taxpayers who were previously required to apply UNICAP. Small business taxpayers can elect off of UNICAP, reducing capitalized expenses and eliminating the burdensome UNICAP calculation.

Percentage of completion method

Eligible small business taxpayers are not required to use the percentage-of-completion method on long-term contracts entered into after Dec. 31, 2017 for construction contracts with an estimated completion of less than two years. It should be noted that manufacturing contracts are not eligible for this exemption and home construction contracts remain exempt regardless of gross receipts or construction period.

Small business taxpayers who currently use the percentage-of-completion method for their construction contracts should consider whether other methods of accounting may be more beneficial, such as the cash method or completed contract method.

Case Study: Manufacturer

WidgetCo is a small business taxpayer with gross receipts less than $26 million. They have historically used the accrual method for both book and tax purposes. They worked with their accountant to evaluate the ability to benefit from the more favorable small business taxpayer methods.

Cash method: WidgetCo’s receivables were $3 million while their accounts payable and accrued expenses were only $2 million. By adopting the cash method, they were able to accelerate $1 million of deductions.

Inventory: WidgetCo capitalizes direct materials, direct labor, and overhead to its inventory for book purpose, resulting in the following capitalized expenses:

• Direct materials: $900,000
• Direct labor: $500,000
• Overhead: $400,000
• Total inventory: $1,800,000

By adopting the nonincidental materials and supplies method, they were able deduct capitalized labor and overhead of $0.9 million.

UNICAP: WidgetCo had applied Section 263A to its inventory for tax purposes and capitalized $0.2 million of costs. Under the small taxpayer methods, WidgetCo was able to deduct these costs and will no longer be required to complete a UNICAP calculation.

As a result of these favorable methods, WidgetCo was able to accelerate $2.1 million of deductions for tax purposes. They also expect this deferral to continue to grow as the business continues to grow, at least until they exceed the gross receipts threshold in 5 years or so. Once WidgetCo is no longer a qualified small business taxpayer, they can change their methods back to the larger taxpayer methods and are able to recognize the income resulting from the method change over four tax years.

Changes in accounting method

In order to adopt these small business taxpayer accounting methods, taxpayers must file a Form 3115, Application for Change in Accounting Method. Taxpayers who have already adopted these accounting methods after TCJA, but whose approach to these methods differ from the final regulations will also need to file an accounting method change. Taxpayers will typically be required to comply with these new rules starting in 2022, but they choose to rely upon them sooner if they wish.

Generally, the small business taxpayer accounting method changes are filed automatically, meaning they can be filed with a timely filed tax return and do not require a separate user fee payable to the IRS. The IRS has commented that they intend to issue procedural guidance related to changes in methods of accounting related to the final regulations. As of the date of this article, no procedural guidance has been issued.

How we can help

Our team of specialists will work with you to identify accounting methods opportunities. Specifically, we’ll help you:

• Determine if you’re an eligible small business taxpayer
• Evaluate the accounting methods and their impacts on other business strategies
• Navigate the complex procedural rules in implementing a tax accounting method change
• File the accounting method change forms with the IRS

Please contact your Plante Moran advisor for more information.