Editor: Mary Van Leuven, J.D., LL.M.
The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, made a multitude of changes to the Internal Revenue Code. Although many international tax reform provisions, the Sec. 163(j) business interest expense limitation, and the new Sec. 199A qualified business income deduction garnered much of the attention, businesses and tax practitioners need to be aware of other provisions that may affect their computation of taxable income on 2018 federal income tax returns. This item discusses certain TCJA changes to domestic provisions relevant to tax accounting.
Expansion of the number of small business taxpayers eligible to use the overall cash method of accounting
C corporations, partnerships with C corporation partners, and tax shelters are prohibited from using the cash receipts and disbursements method of accounting under Sec. 448(a). However, a C corporation or a partnership with a C corporation partner may use the cash method if it meets the Sec. 448(c) gross receipts test. The gross receipts test is satisfied for a tax year if a taxpayer's average annual gross receipts for the prior three tax years do not exceed $25 million.
There are a number of special rules for the gross receipts test. Gross receipts are aggregated for entities treated as a single employer under Sec. 52(a) or (b) or Sec. 414(m) or (o). A taxpayer not in existence for the entire three-year period applies the test on the basis of the period during which it, or its trade or business, was in existence. Gross receipts for a tax year of less than 12 months (e.g., due to a change in accounting period, or for an initial year) are annualized by multiplying the gross receipts for the short period by 12 and dividing the result by the number of months in the short period. Additionally, the "taxpayer" referred to in the test includes any predecessor of the taxpayer.
Prior to the TCJA, the gross receipts test was met if the entity had average annual gross receipts not exceeding $5 million; the TCJA increased the number to $25 million for tax years beginning after 2017. Additionally, the $25 million amount is adjusted for inflation for tax years beginning after 2018. For tax years beginning during 2019, the gross receipts test is met if the average annual gross receipts do not exceed $26 million (Rev. Proc. 2018-57).
In addition to increasing the gross receipts limitation, the TCJA exempts small business taxpayers from the requirements to account for inventories, capitalize certain costs, and account for certain long-term contracts using the percentage-of-completion method.
Generally, when the purchase, production, or sale of merchandise is an income-producing factor, the accrual method must be used with regard to purchases and sales. However, a taxpayer that meets the gross receipts test may use the cash method regardless of whether the purchase, production, or sale of merchandise is an income-producing factor. The TCJA exempts these taxpayers from the requirement to keep inventories under Sec. 471 and requires them to either account for inventory as nonincidental materials and supplies (costs are deducted in the tax year the materials and supplies are first used or consumed in the taxpayer's operations) or use a method of accounting that conforms to the taxpayer's financial accounting statement.
The Sec. 263A uniform capitalization (UNICAP) rules apply to taxpayers that maintain inventories. The rules (1) require certain direct and indirect costs allocable to real or tangible personal property produced by a taxpayer to be either included in inventory or capitalized into the basis of the property, and (2) for real or personal property acquired by a taxpayer for resale, require certain direct and indirect costs allocable to the property to be included in inventory. The TCJA exempts any producer or reseller that meets the gross receipts test from the application of UNICAP.
The taxable income from long-term contracts is generally determined under the percentage-of-completion method. In general, a "long-term contract" is for the manufacture, building, installation, or construction of property and is not completed within the tax year during which the contract is entered into (Sec. 460(f)). Small construction contracts may use a completed-contract method, the exempt-contract percentage-of-completion method, or any other permissible method. A "small construction contract" is expected to be completed within the two-year period beginning on the contract commencement date, and the taxpayer must meet the Sec. 448(c) gross receipts test for the tax year in which it entered into the contract. The TCJA thus expands the exception for small construction contracts to taxpayers that do not have more than $25 million in average annual gross receipts (up from $5 million) for contracts entered into in tax years ending after 2017.
The IRS issued Rev. Proc. 2018-40 to provide procedures by which small business taxpayers may obtain automatic consent to change methods of accounting described above. If a taxpayer using an overall accrual method of accounting wishes to use the cash method of accounting, then for tax years beginning after 2017, it must qualify to do so based on revised Sec. 448(c). If it qualifies, an accounting method change, including the changes for inventory, UNICAP, and long-term contracts, can all be made under Rev. Proc. 2018-40. While the change for long-term contracts must be made on a separate Form 3115, Application for Change in Accounting Method, the changes to the cash method, for inventory, and for UNICAP may all be made on one Form 3115. Taxpayers using an overall cash method of accounting may want to confirm that they qualify to use the cash method.
Disallowance of business interest deductions
For tax years beginning after 2017, Sec. 163(j) disallows a deduction for business interest for any year to the extent that net business interest expense exceeds the sum of a taxpayer's business interest income, 30% of adjusted taxable income, plus floor plan financing interest. Business interest expense that is disallowed for a tax year is treated as paid or accrued in the succeeding tax year and may be carried forward indefinitely.
While a full discussion of the business interest expense limitation is beyond the scope of this item, note that small businesses are exempt from the limitation. A small business meeting the Sec. 448(c) gross receipts test for any tax year will not be subject to the interest limitation for that year (see above discussion of the gross receipts test). The small business exemption is not available to a "tax shelter," which is defined in Sec. 448(d)(3) and Temp. Regs. Sec. 1.448-1T(b) to include a partnership or other entity (other than a C corporation) if more than 35% of the losses of the entity during the tax year are allocated to limited partners or limited entrepreneurs. Many partnerships, including real estate funds, may fall under this definition.
Real property trades or businesses or farming businesses may elect to be exempt from the business interest expense limitation. The IRS issued proposed regulations that provide the mechanics for making an irrevocable Sec. 163(j)(7) election to be treated as an electing real property trade or business or an electing farming business. An electing real property trade or business must use the alternative depreciation system (ADS) for all nonresidential real property, residential rental property, and qualified improvement property; an electing farming business must use ADS for all property with a recovery period of 10 years or more, so the property is not eligible for the special allowance for certain property (bonus depreciation).
Rev. Proc. 2019-8, Section 4.02(2), provides guidance to change the depreciation to ADS. In the first year an electing real property trade or business or electing farming business makes the election, it must begin depreciating existing property (placed in service in tax years before the election year) and property placed in service in the election year and subsequent tax years (newly acquired property) under ADS. For existing property, a change in use occurs for the election year, and depreciation for the property beginning for the election year is determined under Regs. Sec. 1.168(i)-4(d). This is not a change in accounting method. Any bonus depreciation that was claimed when the property was placed in service is not redetermined. Newly acquired property is depreciated under ADS beginning with the placed-in-service year.
Sec. 163(j) revisions increased the number of taxpayers that may have interest expense deductions disallowed. To determine small business status, a taxpayer must apply the complex Sec. 448(c) rules, evaluating predecessor history (if any) and its complete structure to determine if gross receipts from certain related entities must be aggregated. The taxpayer should also consider whether it can elect out of the Sec. 163(j) limitation and should understand the consequences of doing so, weighing the benefits of electing not to apply the limitation against the required use of ADS depreciation and the loss of bonus depreciation on qualified property.
Some depreciation provisions changed
Used property acquired and placed in service after Sept. 27, 2017, is eligible for bonus depreciation. Used property is (1) property not used by the taxpayer or a predecessor at any time prior to the acquisition; (2) property that has been acquired by purchase (not from a related party); and (3) property to the extent the cost of the property is not determined by reference to the basis of other property held at any time by the acquiring taxpayer (e.g., like-kind exchange property). Property is treated as used by the taxpayer or a predecessor if the party had a depreciable interest in the property at any time prior to the acquisition, whether or not depreciation was claimed.
Qualified improvement property (QIP) is applicable to certain property placed in service after Jan. 1, 2016. QIP is an improvement to an interior portion of a building that is nonresidential real property placed in service after the date the building was first placed in service. QIP does not include the enlargement of the building or improvements to any elevator, escalator, or the internal structural framework of the building. It appears that QIP acquired and placed in service after 2017 should be depreciated as nonresidential real property. Depreciation as nonresidential real property would require QIP to be depreciated over a 39-year recovery period, and it would not be eligible for bonus depreciation; for ADS, QIP would have a 40-year recovery period. Although the TCJA Conference Report (H.R. Conf. Rep't 115-466, 115th Cong., 1st Sess, p. 367 (Dec. 15, 2017)) described a 15-year recovery period, QIP was not included in Sec. 168(e)(3)(E) as 15-year property. As a result, a technical correction will be needed to provide the 15-year recovery period for QIP and for QIP to be included as qualified property under the bonus depreciation rules. Taxpayers should consider reviewing their records to determine if any used property was acquired and placed in service after Sept. 27, 2017, for which they can claim bonus depreciation and how QIP placed in service after 2017 was depreciated.
Changes to income recognition standards for accrual-method taxpayers
The general tax rules for income recognition under an accrual method of accounting were changed in the TCJA, which added new Secs. 451(b) and (c). Prior to the TCJA, Sec. 451 required accrual-method taxpayers to include amounts in gross income when all the events occurred that fix the right to receive the income and the amount of income can be determined with reasonable accuracy (the all-events test), unless an exception permitted deferral or exclusion, or a special method of accounting applied. An accrual-method taxpayer is now required to recognize realized income no later than the tax year in which the income is taken into account as revenue in an applicable financial statement (AFS). Sec. 451(b) does not treat the all-events test as being met any later than when an item of income is taken into account in the taxpayer's AFS (to be defined in regulations) for the first tax year beginning after 2017.
While proposedregulations have not yet been issued, the IRS issued Rev. Proc. 2018-60, which provides automatic consent for accrual-method taxpayers with an AFS to make certain accounting method changes to comply with Sec. 451(b), specifically, (1) to recognize income in accordance with the all-events test under Sec. 451(b)(1)(A); and (2) if not adopting the new revenue recognition standards in the year of change, to allocate the transaction price to performance obligations under Sec. 451(b)(4). These automatic changes may be made for tax years beginning after 2017. Until Sec. 451(b) guidance is issued, taxpayers with an AFS will need to do their best to determine whether income needs to be accelerated based on when it is recognized in the financial statements and make any necessary accounting method changes.
Sec. 451(c) requires a taxpayer to include an advance payment in gross income in the tax year of receipt, unless it elects to defer the recognition of all or a portion of the advance payment to the tax year succeeding the year it is received. Sec. 451(c) contains rules similar to Rev. Proc. 2004-34, permitting a limited deferral of an advance payment. As of this writing, the IRS has not issued regulations or other specific guidance on the treatment of advance payments but has issued Notice 2018-35, which permits taxpayers to continue to rely on Rev. Proc. 2004-34 for the treatment of advance payments under the deferral method or full inclusion method until further guidance is issued.
Note that the IRS plans to remove existing Regs. Sec. 1.451-5, relating to the treatment of advance payments for goods and long-term contracts, which would affect accrual-method taxpayers that receive advance payments for goods, including those for inventoriable goods. In general, Regs. Sec. 1.451-5 permitted taxpayers to defer the inclusion of income from advance payments for goods for federal tax purposes until the advance payments were recognized in gross receipts under the taxpayer's method of accounting for financial reporting purposes. New Secs. 451(b) and (c) override the Regs. Sec. 1.451-5 deferral method. Taxpayers that are currently using a method of accounting permitted by Regs. Sec. 1.451-5 will need to make an accounting method change to a permitted method of accounting for advance payments, effective for tax years beginning after 2017. Changes that qualify under Rev. Proc. 2004-34 may be made automatically; any changes that do not qualify under Rev. Proc. 2004-34 are generally nonautomatic method changes.
Reduction or elimination of deductibility of certain meals and entertainment expenses
Amounts paid or incurred after 2017 for entertainment, amusement, and recreation cannot be deducted, even if the expenses are directly related to the active conduct of a taxpayer's trade or business. The TCJA revised Sec. 274(a)(1) and repealed the 50% deduction for entertainment, amusement, and recreation (e.g., golfing, sporting events, luxury box seats).
The 100% deduction for food or beverages — either as a de minimis fringe benefit (e.g., low-value snacks and drinks, de minimis large group meals) or provided to employees through certain employer-operated eating facilities — is being phased out. The TCJA modified Sec. 274(n) and added a new Sec. 274(o) to limit this deduction to 50% for amounts incurred and paid between 2018 and 2025; after 2025 these amounts will not be deductible. Notice 2018-76 provides interim guidance as to the Sec. 274 treatment of expenses for certain business meals.
Taxpayers that have historically applied the 50% reduction to all meals and entertainment expenses should now consider reviewing those accounts in detail to identify potential exposures related to nondeductible entertainment, amusement, and recreation expenses. Fiscal-year-end taxpayers with years overlapping 2017 and 2018 will be subjected to the more stringent Sec. 274 rules for food or beverage expenses paid or incurred after 2017.
Repeal of Sec. 199
The Sec. 199 domestic production activities deduction (DPAD) was repealed for tax years beginning after 2017. Taxpayers still have the opportunity, however, to revisit open tax years (with taxable income) to determine whether the full Sec. 199 benefits were claimed. Because Sec. 199 is not a method of accounting, making changes to the DPAD for prior tax years can be done by filing amended returns. When considering this option, note that on Sept. 10, 2018, the IRS Large Business and International Division announced a Sec. 199 compliance campaign addressing businesses that may file claims for additional DPADs. The stated objective of the campaign is to ensure compliance with Sec. 199 through a claim risk review assessment and issue-based examination of claims with the greatest compliance risk.
Modification of ability to deduct fines and penalties under Sec. 162(f)
No deduction was allowed for any fine or similar penalty paid to a government for the violation of any law prior to the TCJA. The TCJA expanded the nondeductibility to amounts paid or incurred to, or at the direction of, a government (or governmental entity) in relation to the violation or potential violation of any law or the governmental investigation or inquiry (Sec. 162(f)(1)). Amounts paid for restitution or to come into compliance may be deductible if identified in a court order or settlement agreement and, in the case of a restitution for failure to pay any tax imposed under the Code, the restitution is treated as if it were that tax and is deductible if a deduction would have been allowed if the tax had been timely paid (Sec. 162(f)(2)). The modification is effective for amounts paid or incurred on or after Dec. 22, 2017, but does not apply to amounts paid or incurred under any "binding order or agreement" entered into before that date.
New information-reporting requirements were added under Sec. 6050X, requiring the government or governmental entity to file a return when the aggregate amount involved with respect to a violation, investigation, or inquiry is $600 or more (the IRS has the authority to adjust this amount to ensure efficient administration). Notice 2018-23 provides transition guidance, announcing that the IRS and Treasury intend to issue proposed regulations to implement these new provisions.
New Form 1098-F, Fines, Penalties, and Other Amounts, for 2019 tax years includes, as required by Sec. 6050X, boxes to provide the total amount required to be paid, the restitution/remediation amount stated in the court order or agreement, and the amount identified in the court order or agreement as required to be paid for coming into compliance with any law. Codes are to be entered showing, among other items, whether full payment was made as of the time the form was filed, whether no payment was received, and whether the payer entered into a deferred prosecution agreement. Governments and governmental entities must file the form with the IRS and the payer by Jan. 31, 2020.
Guidance has not yet been issued to explain the new provisions under Sec. 162(f), including defining a "binding order or agreement." However, taxpayers should consider reviewing amounts paid or incurred on or after Dec. 22, 2017, to determine the proper treatment based on the new language added by the TCJA.
Elimination of local lobbying deduction
Prior to the TCJA, Sec. 162(e)(2)(A) permitted a deduction for expenses incurred in connection with any legislation of any local council or similar governing body (including an Indian tribal government). Effective for amounts paid or incurred on or after Dec. 22, 2017, local lobbying expenses are no longer deductible (Sec. 162(e)(1)). Taxpayers should consider reviewing their local lobbying expenses in light of the new rules.
No more exclusion for certain Sec. 118 contributions
Sec. 118 excludes from gross income contributions to the capital of a corporation. Pre-TCJA, a contribution to capital (and exclusion from gross income) did not include any contribution in aid of construction or as a customer or potential customer. Under amended Sec. 118, a contribution to capital also does not include any contribution by any governmental entity or civic group (other than a contribution made by a shareholder) (Sec. 118(b)(2)). This new treatment applies to contributions made after Dec. 22, 2017, unless the contribution is made by a government entity pursuant to a "master development plan" that was approved prior to the effective date by a government entity. No guidance has yet been issued to define a "master development plan."
The changes to Sec. 118 significantly reduce the ability of a corporation to exclude from gross income grants received from federal, state, or local governments or civic groups to incentivize various corporate investments. Taxpayers should consider reviewing contributions from a government or civic group made after Dec. 22, 2017, to determine whether they are includible in income. Taxpayers may also want to consider alternatives to grants in future dealings with government or civic groups (see "State and Local Location Incentives: Reminder That the Rules Have Changed" on p. 414 for additional information on Sec. 118).
As this item demonstrates, business taxpayers and tax practitioners should determine whether and how the revisions to the Code will affect the computation of taxable income for federal income tax returns now being prepared for 2018 tax years.
Mary Van Leuven, J.D., LL.M., is a director, 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 firstname.lastname@example.org..
Contributors are members of or associated with KPMG LLP. These articles represent the views of the author(s) only, and do 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.