Small business exemption regs. provide surprises for large taxpayers

Editor: Greg A. Fairbanks, J.D., LL.M.

The IRS published proposed regulations (REG-132766-18) on Aug. 5, 2020, regarding the small taxpayer rules under Secs. 263A, 448, 460, and 471, which generally provide that taxpayers meeting the definition of a small taxpayer are not subject to these statutes. Although the small taxpayer rules apply to businesses with aggregate average gross receipts that do not exceed $25 million (indexed for inflation), some of the proposed regulations will affect larger taxpayers as well.

The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, provided several favorable small business provisions under Secs. 263A, 448, 460, and 471 that generally exempt taxpayers from applying the accounting methods under these provisions for tax years beginning after Dec. 31, 2017. Thus, the TCJA expanded the number of taxpayers eligible to use the cash method under Sec. 448, expanded the exception from the uniform capitalization rules under Sec. 263A, exempted certain taxpayers from the requirement to keep inventories under Sec. 471, and expanded the exception for small construction contracts from the requirement to use the percentage-of-completion (PCM) method under Sec. 460. All of the provisions now rely on the same definition of small business found in Sec. 448(c), which provides the aggregate average gross receipts test; for 2020, it has increased to $26 million due to inflation indexing. Additionally, all of the provisions require that the small business not be a tax shelter under Sec. 448(d)(3).

Sec. 448 requirement to use overall accrual method of accounting

Sec. 448(a) generally prohibits C corporations, partnerships with a C corporation as a partner, and tax shelters from using the cash method. Sec. 448(b)(3) provides that the general rule prohibiting the cash method does not apply to C corporations and partnerships with a C corporation as a partner that are small businesses that meet the gross receipts test. The TCJA expanded the definition of small business by permitting a taxpayer (other than a tax shelter) to meet the test if the taxpayer’s average annual gross receipts for the three-tax-year period ending with the year preceding the current tax year does not exceed $25 million (indexed for inflation). The prior rules had an aggregate average gross receipts test limit of $5 million. Other rules in Sec. 448(c), such as the short-tax-year rule and the aggregation rule, were not altered by the TCJA.

The proposed regulations under Prop. Regs. Sec. 1.448-2 generally provide rules similar to the existing regulations under Regs. Sec. 1.448-1 and Temp. Regs. Sec. 1.448-1T for the definition of gross receipts, the aggregation rules, and short-tax-year rules. The proposed regulations add guidance for aggregating gross receipts under Sec. 448(c) for taxpayers other than a corporation or partnership, including gross receipts from flowthrough entities. They also provide a definition of the “mandatory” Sec. 448 year (previously “first” Sec. 448 year), which requires taxpayers that fail the gross receipts test to switch to the accrual method of accounting.

The existing regulations contain automatic procedures to change in the first Sec. 448 year, but these procedures are proposed to be removed by these regulations. Additionally, existing revenue procedures alternatively allow taxpayers to change to the overall accrual method in the “first” Sec. 448 year, but they contain terms and conditions that may prevent a taxpayer from being eligible to use the automatic procedures, including, for example, if the taxpayer previously made an overall method change within the prior five years. This may become an issue for taxpayers whose gross receipts fluctuate back and forth across the threshold and for taxpayers who meet the definition of a tax shelter due to losses in one year.

Tax shelters are not allowed to use the overall cash method of accounting, even if they meet the gross receipts test. A tax shelter is defined as a partnership or any other entity (other than a C corporation) that has at least 35% of its losses allocable to limited partners or limited entrepreneurs. This can be problematic for certain taxpayers because the rule does not account for large one-time deductions or losses, such as favorable Sec. 481(a) adjustments or economic downturns, and because the determination of tax shelter status is based on current-year allocated losses (so that a partnership may not know it is a tax shelter until the last day of the tax year). The proposed regulations provide an irrevocable election that allows taxpayers to make the determination using the prior year’s income, which may give some limited relief for prior planning.

Sec. 263A uniform capitalization rules (UNICAP)

The UNICAP rules of Sec. 263A provide that, in general, the direct costs and the properly allocable share of the indirect costs of real or tangible personal property produced or tangible or certain intangible property acquired for resale must either be capitalized to inventory or, in the case of self-constructed property, into the basis of the property. Prior to the TCJA changes, only certain types of taxpayers were exempt from the capitalization requirements, including certain small resellers. The TCJA added a broader small taxpayer exemption to the rules of Sec. 263A that now includes manufacturers as well as an exemption from interest capitalization. Taxpayers meeting the gross receipts test in Sec. 448(c) may generally discontinue applying the UNICAP rules in their entirety.

The proposed regulations remove the old $10 million small reseller exception, including all related definitions, and replace it with the rules of Sec. 448. The definition of gross receipts under Sec. 448 has historically been much broader than the gross receipts definition under the small reseller exception in Sec. 263A. This change in definition of gross receipts may impact certain producers when considering whether they meet the $50 million gross receipts test for using the simplified production method in conjunction with the alternative method and negative additional Sec. 263A costs under Regs. Sec. 1.263A-1(d)(3)(ii)(B).

The proposed regulations also modify Regs. Secs. 1.263A-7 and -8 to reflect the exemption for small taxpayers from the requirement to capitalize interest.

Sec. 460 PCM for long-term contracts

Sec. 460(a) provides that income from a long-term contract must be determined using the PCM and includes both long-term construction contracts and long-term manufacturing contracts. Prior to the TCJA, certain long-term construction contracts were exempt from applying the PCM for taxpayers that met a $10 million threshold. The TCJA increased the exception for taxpayers that meet the small taxpayer exemption under Sec. 448(c). The proposed regulations modify the existing regulations relating to the small contractor exemption by referencing the Sec. 448(c) gross receipts test for the tax year in which the contract is entered into. The proposed regulations clarify that a contract continues to be exempt even if the taxpayer fails the gross receipts test in a year subsequent to the contracting year but prior to the year in which the contract is completed. The exemption does not apply, however, to long-term manufacturing contracts.

The proposed regulations also affect certain non-small business taxpayers by modifying the lookback rules. They clarify that a taxpayer with a contract that begins in a pre-TCJA year and ends in a post-TCJA year must only compute the alternative minimum tax (AMT) lookback component for the pre-TCJA year(s). The lookback calculation must also take into account changes to a taxpayer’s base-erosion and anti-abuse tax (BEAT) as if the actual total contract price and costs had been used in computing the taxpayer’s modified taxable income and base-erosion minimum tax amount (BEMTA), if applicable.

Sec. 471 inventories

Sec. 471(a) requires inventories to be taken by a taxpayer when, in the opinion of the Treasury secretary, taking an inventory is necessary to determine the income of the taxpayer. Regs. Sec. 1.471-1 requires the taking of an inventory at the beginning and end of each tax year in which the production, purchase, or sale of merchandise is an income-producing factor. The TCJA provided that small taxpayers do not need to follow the rules of Sec. 471 for valuing or identifying inventories and allowed two options: (1) follow the book inventory method, or (2) treat inventory as nonincidental materials and supplies.

In what is perhaps the most surprising portion of these new proposed regulations, the IRS proposes that taxpayers must effectively still follow certain (but not all) rules for inventory under Sec. 263A and Sec. 471 despite the plain language of the statute that exempts the taxpayer from following those capitalization rules.

For taxpayers that choose to follow their book inventory method, the proposed regulations would only allow taxpayers to follow the types of costs capitalized for book purposes but not the amount. The proposed regulations require certain adjustments to be made to the book inventory method, including, for example, adjustments to remove the Sec. 274 nondeductible meals and entertainment expenses. The regulations are silent as to the treatment of certain inventory reserves and whether a taxpayer may follow the book accounting for those valuation items.

If a taxpayer chooses to treat inventory as nonincidental materials and supplies, the proposed regulations provide that the items are deductible when used or consumed in the taxpayer’s trade or business but retain their character as inventory. For resellers, goods would be considered used or consumed when the products are sold. For producers, raw materials would not be considered used and consumed, generally, until the title to the finished goods passes to the customer. Additionally, taxpayers would be required to capitalize all direct costs, for example, direct labor, during the production process. Therefore, the proposed regulations appear to require taxpayers to continue to follow some of the capitalization rules under Secs. 263A and 471 to identify the amount of costs to be capitalized to inventory, even if they are not identified or capitalized for book purposes.

Effective date

The rules will be effective beginning on or after the final regulations are published in the Federal Register. However, for tax years beginning after Dec. 31, 2017, and before the final regulations are published, a taxpayer may early-adopt the proposed regulations provided the regulations are applied in their entirety.

EditorNotes

Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

Contributors are members of or associated with Grant Thornton LLP.