Tax Accounting Methods for Small Businesses

Editor: Mary Van Leuven, J.D., LL.M.

Tax Accounting

Small businesses, like other taxpayers, compute taxable income using an overall accounting method (typically the cash receipts and disbursements method or an accrual method) and accounting methods for specific items (such as inventory or depreciation). Like other areas of tax, accounting methods can be complex and burdensome for many small business taxpayers. Fortunately, there are several simplifying conventions and accounting methods tailored to smaller business entities, including C corporations, partnerships, and S corporations. Using these simplified methods can sometimes result in tax savings and streamline the tax return preparation process and recordkeeping requirements.

While there is no universal definition of “small business” in the Internal Revenue Code or regulations, most, but not all, of the simplifying conventions discussed in this item apply to taxpayers with gross receipts and assets below certain thresholds. For purposes of this item, “small business” taxpayers include corporations and partnerships with gross receipts of less than $10 million.

The discussion below highlights several of the more common simplifying conventions and methods available for small business taxpayers, noting industry-specific methods. This item also briefly discusses simplifying methods relating to the domestic production deduction and accounting period issues applicable to small businesses.

Overall Method of Accounting

Generally, a small business can use either the overall cash method of accounting or an overall accrual method of accounting. Under the cash method (which is typically simpler than the accrual method), a taxpayer can defer income until cash is received; conversely, it must wait to deduct expenses until the amounts are paid. The overall cash method of accounting is available for S corporations, partnerships that do not have a C corporation as a partner, and personal service corporations (PSCs). A PSC performs activities in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting; and substantially all the stock of the corporation is held by employees performing services for the corporation in connection with those activities. C corporations and partnerships with a C corporation as a partner can use the cash method if their average annual gross receipts for the prior three tax years are less than $5 million. For a group of C corporations that files a consolidated return, the gross receipts of all the corporations in the group are aggregated for the $5 million test.

Specific Accounting Methods for Income and Expense Recognition

Several methods available for small business taxpayers allow them to either defer income or exclude certain amounts from income altogether. For example, the nonaccrual-experience method allows certain accrual-basis taxpayers to exclude from income the portion of an amount for services that, based on experience, will not be collected (Sec. 448(d)(5)). The nonaccrual-experience method can be a favorable alternative to the general income and expense recognition rules under Secs. 451 and 461, as it essentially allows taxpayers to exclude amounts from income sooner than the amounts could be written off as bad debt expenses under Sec. 166. To use the method, the taxpayer must provide services similar to those performed by an eligible PSC or have gross receipts of less than $5 million. This exception does not apply to an amount if interest is required to be paid on that amount or there is any penalty for failure to timely pay the amount. Regs. Sec. 1.448-2 and Rev. Proc. 2011-46 provide several safe-harbor nonaccrual-experience methods that a small business could use.

A simplifying accounting method exception also exists for certain taxpayers for income recognition from long-term contracts. Generally, income from a long-term contract (a manufacturing, building, installation, or construction contract that is not completed during the tax year in which it is entered into) must be reported under the percentage-of-completion method, which usually results in the recognition of income at an earlier point in time than under the completed-contract method. However, an exception is available for a small business that engages in home construction contracts or other construction contracts that are expected to be completed within two years from the contract commencement date and that has average annual gross receipts for the prior three tax years that do not exceed $10 million. If a taxpayer meets the requirements of the exception, it may use the completed-contract method of accounting for income recognition (Sec. 460(e)).

In addition to income recognition provisions, several taxpayer-favorable provisions allow businesses to accelerate the recognition of expenses. For instance, when beginning its business, a business may incur startup costs—costs to create or investigate creating or acquiring an active trade or business, operating expenses incurred before the active trade or business begins—and organizational expenses—costs to form the entity (such as the legal expense to draft articles of incorporation or a partnership agreement, or filing fees paid to the state of organization). For startup and organizational costs, if the business incurs $5,000 or less of each type of expense, it can deduct all the expenses in the year the active trade or business begins; any amounts over $5,000 are capitalized and amortized ratably over 180 months beginning with the month in which the active trade or business begins. For each type of expense, the deduction is reduced, but not below zero, by the amount by which the startup expenses or organizational expenses exceed $50,000. A business will be deemed to have made the election to deduct or amortize startup or organizational expenses unless it opts out of this treatment by affirmatively electing to capitalize these expenses.

Additionally, a small business may elect to expense a limited amount of the costs of most types of tangible property that would otherwise be subject to depreciation in the year the property is placed in service under Sec. 179. Eligible property includes tangible property that is depreciable under Sec. 168 and computer software that is depreciable under Sec. 167 (rather than Sec. 197), if the property is described in Sec. 1245(a)(3) (personal property and a few other items). For tax years beginning in 2012 and 2013, a small business may expense up to $500,000. The deduction is reduced (but not below zero) by the amount by which the cost of Sec. 179 property placed in service during the tax year exceeds $2 million. For 2012 and 2013, qualified real property may also be expensed, up to $250,000 (Sec. 179(f)). Note that the amount that may be expensed will revert to a $25,000 limit (with a $200,000 phaseout) for tax years beginning after 2013.

Small businesses should also be aware of Sec. 267(a)(2), which may delay the deduction of expenses. Essentially, if an accrual-method entity owes an expense or interest to a related cash-method entity, the accrual-method entity cannot take the deduction until the cash-method entity recognizes the income (i.e., until it has received the amount). This restriction applies to related entities, which include a PSC and an employee-owner; a partnership and any partner; an S corporation and any person who owns any of its stock; two or more S corporations, or an S corporation and a C corporation, or an individual and a corporation, for which more than 50% in value of the outstanding stock of each corporation is owned by the same person or persons.

Inventory-Related Provisions

Generally, a small business that receives income from producing, purchasing, or selling merchandise must compute its inventory and use the accrual method with regard to purchases and sales. However, Rev. Proc. 2001-10 provides an exception to this general rule and allows a small business with average annual gross receipts of $1 million or less to use the cash method and to account for inventory as nonincidental materials and supplies. In determining whether gross receipts are $1 million or less, the small business’s average annual gross receipts for the prior three tax years is calculated. For a group of C corporations filing a consolidated return, the gross receipts of all the corporations in the group are aggregated for the $1 million test. The cost of otherwise inventoriable items that are treated as nonincidental materials and supplies is deducted in the year the small business sells the merchandise or finished goods, or in the year in which the small business actually pays for the inventoriable items, whichever is later. The uniform capitalization (UNICAP) rules of Sec. 263A do not apply to inventoriable items that are treated as nonincidental materials and supplies.

Note that Rev. Proc. 2002-28 allows a taxpayer engaged in activities (except certain mining, manufacturing, wholesale trade, retail trade, and information industries) with average annual gross receipts of $10 million or less to use the cash method and to account for inventory as nonincidental materials and supplies—if Sec. 448 does not prohibit the taxpayer from using the overall cash method.

With respect to resellers, the UNICAP rules generally require direct costs and an allocable portion of indirect costs of inventory produced or acquired for resale by a taxpayer to be included in inventory costs. The UNICAP rules generally require other property produced or acquired for resale to be capitalized. However, resellers with gross receipts of $10 million or less (Sec. 263A(b)(2)(B)) and producers with $200,000 or less of indirect costs are not required to capitalize costs under Sec. 263A (Regs. Sec. 1.263A-2(b)(3)(iv)(A)).

A small business that is not presently using one of the above-mentioned methods but wishes to do so may need to file an accounting method change on a Form 3115, Application for Change in Accounting Method.

Sec. 199

Simplifying conventions also appear in Sec. 199 (deduction for domestic production activities). Under the general Sec. 199 rules, taxpayers must use a reasonable method (based on all the facts and circumstances) to allocate the cost of goods sold between domestic production gross receipts (DPGR) and non-DPGR. Further, other expenses and deductions (e.g., selling, general, and administrative expenses) must be allocated to DPGR in accordance with Sec. 861 principles (the complex rules for allocating income from sources within the United States). Performing these allocations can be time-consuming and complex, and can often involve a degree of subjectivity. However, under the simplified deduction method, eligible taxpayers may allocate their deductions (other than cost of goods sold) to DPGR using a ratio of DPGR over total gross receipts. For purposes of the simplified deduction method, an eligible taxpayer is defined as a taxpayer with total assets of $10 million or less, or a taxpayer with average annual gross receipts (for the three tax years preceding the current tax year) of $100 million or less.

Additionally, some taxpayers may be able to take advantage of the small business simplified overall method to allocate expenses to DPGR. Under the Sec. 199 regulations, a qualifying small taxpayer is (1) a taxpayer that has average annual gross receipts of $5 million or less; (2) a taxpayer that is engaged in the trade or business of farming that is not required to use the accrual method under Sec. 447; or (3) a taxpayer that is eligible to use the cash method under Rev. Proc. 2002-28 (generally, taxpayers with average annual gross receipts of $10 million or less).

Like the simplified deduction method, the small business simplified overall method allows taxpayers to allocate other expenses to DPGR ratably based on DPGR over total gross receipts. However, the small business simplified overall method also allows qualifying taxpayers to allocate cost of goods sold using the same ratio. Thus, once a qualifying taxpayer has determined its DPGR amounts, it can allocate all expenses based on a simple formula.

Tax-Year Considerations

Finally, it is important to keep in mind that certain small businesses, such as S corporations, partnerships, and PSCs, have required tax year ends. S corporations and PSCs generally must use a calendar year end unless they make a Sec. 444 election, elect to use a 52-53-week tax year that ends with reference to the calendar year or a tax year elected under Sec. 444, or can establish a business purpose for using a fiscal year end. A partnership’s tax year end is determined by its owners’ year ends (a partnership must use the majority partners’ tax year; if none, then the tax year of all its principal partners; or, if neither of these applies, then the tax year that produces the least aggregate deferral of income). A partnership may also be able to make a Sec. 444 election, elect to use a 52-53-week tax year that ends with reference to its required tax year or a taxable year elected under Sec. 444, or establish a business purpose to use a fiscal year end.

EditorNotes

Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington, D.C.

For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.

Unless otherwise noted, contributors are members of or associated with KPMG LLP. This article represents the views of the author or authors only and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.