Editor: Kevin D. Anderson, CPA, J.D.
The IRS and Treasury released final regulations (T.D. 9942) on Jan. 5, 2021, providing guidance to implement several simplification provisions of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. The final regulations generally adopt the proposed regulations published in the Federal Register on Aug. 5, 2020 (REG-132766-18) but with several changes. These simplifying provisions, which apply to small business taxpayers, expand the use of the overall cash method of accounting and grant exemptions from inventory methods under Sec. 471, uniform capitalization (UNICAP) rules under Sec. 263A, and the use of the percentage-of-completion method for certain long-term construction contracts under Sec. 460. A qualifying small business taxpayer is also exempt from Sec. 163(j), which limits the deductibility of business interest expense. The following analyzes these changes and their implications for qualifying small business taxpayers.
Qualification for the small business taxpayer exemptions
These simplified tax accounting rules apply to taxpayers with average annual gross receipts of $25 million (adjusted for inflation) or less for the three-tax-year period ending before the current tax year (the gross receipts test; Sec. 448(c)(1)). The inflation-adjusted ceiling is $26 million for tax years beginning in 2019, 2020, and 2021. Changes to any of these simplified methods generally require filing one or more Forms 3115, Application for Change in Accounting Method, with the IRS. The final regulations generally retain the existing rules related to the computation of the gross receipts test, including the definition of gross receipts, the requirement to aggregate gross receipts with certain other persons (Sec. 448(c)(2)), and the proration of amounts for short tax years.
Tax shelter annual election
Taxpayers treated as tax shelters are prohibited from using the overall cash method and are not eligible to be treated as small business taxpayers, even if they meet the annual gross receipts test. A tax shelter, as defined under Secs. 448(d)(3) and 461(i)(3) and Regs. Sec. 1.448-2(b)(2), is any of the following:
- Any enterprise (other than a C corporation) if the offering of interests is required to be registered with any federal or state agency having the authority to regulate the offering;
- Any syndicate (within the meaning of Sec. 1256(e)(3)(B)); and
- Any tax shelter (as defined in Sec. 6662(d)(2)(C)(ii)).
A syndicate is defined generally as any 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. Whether an entity is a syndicate is determined annually. Although many commenters requested that the definition of a tax shelter or syndicate be modified, the final regulations did not do so, as the IRS and Treasury determined those changes would be contrary to congressional intent.
A cash-method taxpayer that is usually in a taxable income position may experience an unforeseen tax loss for an anomalous year but return to a taxable income position in a subsequent year. If, in the anomalous tax loss year, the taxpayer allocated more than 35% of the tax loss to its limited partners or limited entrepreneurs, then the taxpayer would meet the definition of a syndicate and thus be precluded from using the cash method of accounting under Sec. 448(a)(3). However, the same taxpayer may be permitted to use the cash method in the next tax year if it is in a taxable income position.
Although a taxpayer in this situation would normally have to change to the accrual method for the year in which the loss occurred, the final regulations provide some relief by permitting a taxpayer to make an annual election to use the allocated taxable income or loss of the immediately preceding tax year, instead of the current tax year, to determine whether the taxpayer is a syndicate for purposes of Sec. 448 in the current tax year. This election is more taxpayer-friendly than the election from the proposed regulations, which, once made, applied to all subsequent tax years unless the IRS permitted a revocation. The annual election is made by attaching a statement on a timely filed (including extensions) original federal tax return and is irrevocable once made for a given tax year. However, it will not provide much relief for taxpayers that generate tax losses year after year.
Changes in final regulations under the Sec. 448 requirements to use the accrual method of accounting
The final regulations provide that for purposes of Sec. 448, a taxpayer that uses the cash method for some, but not all, items is considered to be on the cash method of accounting. Accordingly, a C corporation or partnership with a C corporation partner may not account for any of its income or expense items using the cash method if its average annual gross receipts exceed $26 million. Some small business taxpayers may find themselves in a situation where they fail to meet the gross receipts test in a given year and are therefore required to change from the cash method but become eligible to use the cash method again in a subsequent year.
The proposed regulations issued in August 2020 limited the use of an automatic change to switch back to the cash method of accounting if a taxpayer had previously filed a change to use an overall accrual method within a five-year period. However, the final regulations remove the five-year eligibility requirement for a taxpayer changing from the overall cash method as required under Sec. 448. The preamble to the final regulations indicates that future procedural guidance will address accounting method changes for taxpayers that voluntarily choose to switch between the cash and accrual methods and taxpayers that are required to use an accrual method under Sec. 448.
Small business taxpayer exemption from Sec. 471
Under Sec. 471 and Regs. Sec. 1.471-1, inventories are required to be used in a tax year in which the production, purchase, or sale of merchandise is an income-producing factor. The TCJA permitted taxpayers that meet the gross receipts test and that are not tax shelters under Sec. 448 to be exempt from Sec. 471 and to use either of the following methods:
- Treat inventory as nonincidental materials and supplies (NIMS inventory method); or
- Conform to the inventory method used in its applicable financial statement (AFS) (AFS Sec. 471(c) inventory method) or to the method in the taxpayer's books and records prepared in accordance with its accounting procedures if it does not have an AFS (non-AFS Sec. 471(c) inventory method).
It is important for small taxpayers to note that being exempted from keeping inventory under Sec. 471 does not necessarily translate to an immediate tax write-off for all inventoriable costs.
For taxpayers that choose to use the NIMS inventory method, the final regulations clarify that even though these amounts are treated as nonincidental materials and supplies, they still retain their character as inventory. The final regulations do not change the position that inventory treated as nonincidental materials and supplies is "used and consumed" in the tax year the taxpayer provides the inventory to a customer, and costs are recovered through costs of goods sold in that year or the tax year in which the costs are paid or incurred (in accordance with the taxpayer's method of accounting), whichever is later. The final regulations retain the general rule from the proposed regulations that the "used and consumed" threshold for NIMS is met only when the taxpayer sells the inventory. As such, manufacturers that convert raw materials into a work in progress or finished goods by year end but have not yet sold the inventory will not be able to deduct the costs under the final regulations.
Some taxpayers that are manufacturers may have taken the position that their raw materials are deductible when first used and consumed in the manufacturing process (e.g., when items enter the work-in-progress stage); these taxpayers will likely need to file a method change to comply with the final regulations. In addition, the final regulations clarify that taxpayers using the NIMS inventory method have to capitalize only direct material costs of the property produced or acquired for resale; hence, direct labor or indirect costs are not required to be capitalized under this method and may be deductible when incurred or paid.
The final regulations clarify that taxpayers may determine the amounts of the costs of inventory by using either a specific identification method, a first-in, first-out method, or an average cost method, but may not use the last-in, first-out, or any other method described in Sec. 471 or the regulations thereunder, including the lower-of-cost-or-market methods. Furthermore, inventory treated as nonincidental materials and supplies is not eligible for the Regs. Sec. 1.263(a)-1(f) de minimis safe-harbor election, since that election specifically scopes out inventory.
With respect to taxpayers that instead choose to follow the AFS Sec. 471(c) inventory method or non-AFS Sec. 471(c) inventory method, the final regulations clarify that costs that are normally required to be capitalized to inventory under Sec. 471(a) but are being expensed in a taxpayer's AFS, or books and records, can also be expensed for tax purposes. This method may be beneficial for taxpayers that currently expense inventoriable costs for book purposes, as tax can generally follow suit. Notably, a taxpayer must ensure that any inventoriable costs capitalized or taken into account for its AFS, or books and records, are paid or incurred under the taxpayer's method of accounting for tax purposes.
For taxpayers without an AFS that decide to follow the non-AFS Sec. 471(c) inventory method, if a physical count is taken but not actually used to capitalize and allocate costs to inventory, then such amounts may be deductible in the year paid or incurred. However, if a taxpayer uses a physical count to allocate costs to inventory and then makes a journal entry to expense these costs in its financial statements, this journal entry would be ignored for tax purposes, thus requiring the taxpayer to capitalize the costs in accordance with the physical count allocation.
Additional simplifying provisions
The TCJA also exempted small business taxpayers from the Sec. 263A UNICAP rules. Furthermore, under Sec. 460(e)(1)(B), for tax years beginning after Dec. 31, 2017, qualifying small business taxpayers are also exempt from using the percentage-of-completion method and can use an exempt contract method for construction contracts estimated to be completed within a two-year period beginning on the contract commencement date. Exempt contract methods are the cash, accrual, and completed-contract methods. Note this exemption applies to long-term contracts involving construction of real property but does not apply to long-term manufacturing contracts.
The rules apply for tax years beginning on or after the date the final regulations were published in the Federal Register, Jan. 5, 2021. A taxpayer can choose to apply the final regulations to tax years beginning after Dec. 31, 2017, and before Jan. 5, 2021, provided that if the taxpayer applies any aspect of the final regulations under a particular Code provision, the taxpayer must follow all the applicable rules in the regulations relating to the Code provision for the current and all subsequent tax years and the administrative procedures in Regs. Sec. 1.446-1(e)(3)(ii) for filing a change in method of accounting. Alternatively, subject to the same restrictions, a taxpayer may rely on the proposed regulations for a tax year in that period.
Kevin D. Anderson, CPA, J.D., is a managing director, National Tax Office, with BDO USA LLP in Washington, D.C.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or firstname.lastname@example.org.
Contributors are members of or associated with BDO USA LLP.