This week’s Update covers the pro-taxpayer expansion of the eligibility to utilize certain accounting methods for income tax purposes that are available only to small businesses and are generally “simpler” than the accounting methods required to be used by larger businesses. This Update also covers the pro-IRS new rule that prevents taxpayers from deferring taxable income to a future tax year if that income is being recorded as income on their financial statements in the current tax year.
Cash Method of Accounting
Under the cash method of accounting, eligible taxpayers recognize income and deduct expenses when cash is received or paid, instead of having to accrue income and expenses. Sole proprietorships, partnerships (as long as they do not have a corporate partner), and S corporations can generally use the cash method of accounting. Under prior law, corporations and partnerships with a corporate partner could use the cash method of accounting only if their average annual gross receipts did not exceed $5 million for all prior tax years. Farming C corporations and farm partnerships with a corporate partner could use the cash method of accounting if their gross receipts did not exceed $1 million in any year. Under an exception, certain family farm corporations could still use the cash method of accounting if their average annual gross receipts did not exceed $25 million. Special rules and gross receipts thresholds applied to all taxpayers required to maintain inventories, regardless of entity type.
The new law provides a significantly larger gross receipts threshold of $25 million, eliminates the requirement that the taxpayer not have exceeded this limit for all prior tax years, and allows more taxpayers to use the cash method of accounting. Under the new law, taxpayers other than tax shelters can use the cash method of accounting if their annual average annual gross receipts for the prior three tax years do not exceed $25 million. This higher threshold also applies to any farming C corporation or farming partnership with a C-corporation partner. The threshold for family farm corporations would remain at its prior $25 million limit.
The new law applies to tax years beginning after December 31, 2017, and taxpayers switching from the accrual method to the cash method would be deemed to be making a change in accounting method, requiring the filing of a Form 3115. The IRS has indicated that guidance with respect to this change will be forthcoming.
Prior law required businesses to maintain inventories for tax purposes if the production, purchase, or sale of merchandise was a material income-producing factor. Such businesses generally also had to use an accrual method of accounting for tax purposes, regardless of their level of gross receipts. Under an exception, certain small businesses with inventory that had average gross receipts of not more than $1 million did not have to use an accrual method of accounting. Another exception also exempted businesses with inventories in certain industries from having to use an accrual method of accounting if their annual gross receipts did not exceed $10 million (assuming that the entity was not prohibited from using the cash method of accounting for another reason). Businesses that met either the $1 million or $10 million exception and were thus able to use the cash method of accounting were also allowed to account for their inventory as nonincidental materials and supplies (deducting them in the tax year they are used or consumed) rather than utilizing the inventory rules.
The new law exempts businesses from the requirement to maintain inventories if their annual average gross receipts for the prior three tax years do not exceed $25 million. The new law allows these businesses to either treat inventories as nonincidental materials and supplies or follow the method they used on their financial statements.
The new law applies to tax years beginning after December 31, 2017, and taxpayers switching from the inventory method to the nonincidental materials and supplies method (or financial statement method) of tracking their inventory would be deemed to be making a change in accounting method, requiring the filing of a Form 3115. The IRS has indicated that guidance with respect to this change will be forthcoming.
The uniform capitalization (UNICAP) rules under Section 263A generally require a business to include certain direct and indirect costs associated with real or tangible personal property produced either for sale or for use in the business in the tax basis of that property. For real or personal property acquired for resale, the UNICAP rules require certain direct and indirect costs allocable to that property to be included in the tax basis of the inventory. Section 263A provided several exceptions to the general uniform capitalization requirements. While there was no exception available for taxpayers who produced property for sale or for use in the business, taxpayers who acquired property for resale and had $10 million or less of average annual gross receipts were not required to add Section 263A costs into their inventory. Also, taxpayers who raised, harvested, or grew trees were not required to apply Section 263A to trees raised, harvested, or grown by the taxpayer (other than trees bearing fruit, nuts, or other crops or ornamental trees) or to any real property underlying such trees. In addition, the Section 263A rules did not apply to any plant having a pre-productive period of two years or less or to any animal (unless the taxpayer was required to use an accrual method of accounting). Freelance authors, photographers, and artists were also exempt from Section 263A with respect to any qualified creative expenses.
The new law not only retains the exemptions above that are not based on gross receipts, but also provides that any producer or reseller that meets the $25 million gross receipts test would be exempt from Section 263A.
The new law applies to tax years beginning after December 31, 2017, and taxpayers switching away from the use of UNICAP would be deemed to be making a change in accounting method, requiring the filing of a Form 3115. The IRS has indicated that guidance with respect to this change will be forthcoming.
Percentage-of-Completion Method of Accounting
Generally, taxable income from a long-term contract was required to be calculated by using the percentage-of-completion method, which requires businesses to take deductions and recognize income based on the percentage of the contract completed at the end of each tax year. A "long-term contract" is any contract for the manufacture, building, installation, or construction of property if that contract is not completed within the same tax year the contract is entered into by the taxpayer. An exception to the percentage-of-completion method applied to certain businesses with average annual gross receipts of $10 million or less in the preceding three years. Under this exception, a business could use the completed-contract method (or any other permissible exempt contract method) instead of the percentage-of-completion method for any contracts that were expected to be completed within two years. Under the completed-contract method, a taxpayer does not recognize taxable income or loss from the contract until the contract is completed, even though the taxpayer might have billed and received payments on the contract in years prior to completion.
The new law exempts small construction contracts from the requirement to use the percentage-of-completion method if the contract (1) at the time it is entered into, is expected to be completed within two years of the commencement of the contract and (2) is performed by a taxpayer that meets the $25 million gross average annual gross receipts test for the prior three years. If these requirements are satisfied, the contracts may be accounted for using the completed-contract method (or any other permissible exempt contract method). The TCJA’s repeal of corporate Alternative Minimum Tax (AMT) and changes made for individuals that limit the number of individuals subject to AMT make the ability to change to a method other than the percentage-of-completion method even more beneficial, since contractors must use percentage-of-completion method for AMT purposes regardless of their tax accounting method for regular tax purposes.
The new law applies to tax years beginning after December 31, 2017, and taxpayers switching from the percentage-of-completion method would be deemed to be making a change in accounting method, requiring the filing of a Form 3115. The IRS has indicated that guidance with respect to this change will be forthcoming.
Book-Tax Conformity: Special Rule for Tax Year of Income Inclusion
A taxpayer using the cash method of accounting was required to include an amount in taxable income when the amount was actually or constructively received. A taxpayer generally was in constructive receipt of an amount if the taxpayer had an unrestricted right to demand payment. An accrual-basis taxpayer was required to include an amount in income when all the events that fixed the taxpayer’s right to receive the income (generally when received, due, or earned) had occurred and the amount could be determined with reasonable accuracy, unless a specific exception allowed deferral or exclusion. Under these rules, income could be accrued for tax purposes in a later tax year than it was accrued for financial statement purposes.
The new law requires a taxpayer, absent a specific exception, to recognize income for income tax purposes no later than the tax year in which the income is reported as income on an applicable financial statement or another financial statement under rules provided by the Treasury. Thus, this new rule under Section 451 will result in an earlier recognition of taxable income to the extent amounts are accrued earlier for financial statement purposes than was previously required for tax purposes. It is therefore important that taxpayers consider this new tax law in conjunction with their adoption of the new revenue recognition standard under ASC 606, since the potential for the acceleration of taxable income exists. The IRS has just published a new automatic tax accounting method change procedure (Revenue Procedure 2018-29) for taxpayers to use in changing their financial statement accounting methods to conform with ASC 606. Also, in the case of a contract that has multiple performance obligations, the new law requires the taxpayer to allocate the transaction price in accordance with the allocation made in the taxpayer's applicable financial statement. An exception to this new law is available for special methods of accounting such as long-term contract income, to which Section 460 applies, or installment sales, to which Section 453 applies. In addition, the new law codifies the deferral method of accounting for advance payments for goods and services contained in Revenue Procedure 2004-34 and provides that this rule is now the exclusive method for deferral of advance payments. Under that method, taxpayers are permitted to defer the inclusion of income associated with certain advance payments to the end of the tax year following the tax year of receipt if the income is deferred for financial statement purposes. This exception is important, since it is widely used by taxpayers.
The new law applies to tax years beginning after December 31, 2017. Taxpayers whose income is accelerated under this new Section 451 provision would be deemed to be making a change in accounting method, requiring the filing of a Form 3115. The IRS has indicated that guidance with respect to this change will be forthcoming.