Rev. Proc. Addresses Automatic Accounting Method Changes for Small Business Taxpayers

(Parker Tax Publishing August 2018)

The IRS issued guidance which provides the procedures by which a small business taxpayer may obtain automatic consent to change its methods of accounting to reflect changes made by the Tax Cuts and Jobs Act of 2017 that expanded the number of small business taxpayers eligible to use the cash method of accounting and exempts small business taxpayers from the requirements to capitalize costs to account for certain long-term contracts under Sec. 460, and to account for inventories under Sec. 471. The revenue procedure is generally effective for tax years beginning after December 31, 2017, and obsoletes Rev. Proc. 2002-28 and Rev. Proc. 2001-10 for tax years beginning after December 31, 2017. Rev. Proc. 2018-40.

The Tax Cuts and Jobs Act of 2017 (TCJA) amended Code Sec. 448 to expand the number of small business taxpayers eligible to use the cash method of accounting. TCJA also amended the Code to (1) exempt small business taxpayers from the requirements to capitalize costs, including for certain home construction contracts, under Code Sec. 263A; (2) to account for certain long-term contracts under Code Sec. 460; and (3) to account for inventories under Code Sec. 471. This IRS has now issued Rev. Proc. 2018-40, which provides the procedures by which a small business taxpayer may obtain automatic consent to change its methods of accounting to reflect these TCJA changes. The IRS is also requesting suggestions for future guidance under Code Secs. 263A, 447, 448, 460, and 471 on implementing the changes made by TCJA.

Generally, Code Sec. 446(e) and Reg. Sec. 1.446-1(e)(2) require a taxpayer to obtain IRS consent before changing a method of accounting for federal income tax purposes. The IRS has issued certain revenue procedures by which a taxpayer may obtain automatic consent to change its method of accounting for items described in the List of Automatic Changes. Rev. Proc. 2018-31 contains the List of Automatic Changes.

Rev. Proc. 2018-40 modifies Rev. Proc. 2018-31 to provide additional automatic changes and to modify existing automatic accounting method changes to assist taxpayers in conforming to the TCJA changes to Code Secs. 263A, 447, 448, 460, and 471.

A taxpayer that wants to change to one or more of the methods described in Rev. Proc. 2018-40 must, if eligible, use the automatic change procedures in Rev. Proc. 2015-13 and Rev. Proc. 2018-31 (or any successors) as modified by Rev. Proc. 2018-40. Under Rev. Proc. 2018-40, the following automatic accounting method changes are added as new sections to Rev. Proc. 2018-31:

Small business taxpayer changing to overall cash method: A small business taxpayer eligible for this method change is a taxpayer that is not a tax shelter and that has average annual gross receipts for the three prior tax years of $25 million or less (adjusted for inflation). This automatic method change is inapplicable to banks changing to the overall cash/hybrid method and farmers changing to the overall cash method. A small business taxpayer that uses the overall cash method for a trade or business includes amounts attributable to open accounts receivable in income as the amounts are actually or constructively received on the receivables.

Small business taxpayer exception to capitalizing costs under the uniform capitalization rules of Code Sec. 263A: This change applies to a small business taxpayer that capitalizes costs under Code Sec. 263A and wants to change to a method of accounting that no longer capitalizes costs under Code Sec. 263A, including to self-constructed assets, pursuant to Code Sec. 263A(i). A small business taxpayer eligible for this method change is a taxpayer that is not a tax shelter and that has average annual gross receipts for the three prior tax years of $25 million or less (adjusted for inflation). This change does not apply to a small business taxpayer that chooses to no longer capitalize costs under Code Sec. 263A for home construction contracts.

Small business taxpayer exception from requirement to account for inventories under Code Sec. 471: This change applies to a small business taxpayer that wants to change its method of accounting for inventory items to one of the following: (i) treating inventory as non-incidental materials and supplies; or (ii) conforming to the taxpayer's method of accounting reflected in its applicable financial statements with respect to the tax year, or if the taxpayer does not have an applicable financial statement for the tax year, the books and records of the taxpayer prepared in accordance with the taxpayer's accounting procedures.

Small business taxpayer exceptions from requirement to account for certain long-term contracts under Code Sec. 460 or to capitalize costs under Code Sec. 263A for certain home construction contracts: This change applies to a taxpayer that, beginning in the year of change, qualifies as a small business taxpayer and (i) wants to change its method of accounting for exempt long-term construction contracts described in Code Sec. 460(e)(1)(B) from the percentage-of-completion method of accounting to an exempt contract method of accounting, or (ii) chooses to stop capitalizing costs under Code Sec. 263A for home construction contracts defined in Code Sec. 460(e)(1)(A).

Rev. Proc. 2018-40 provides that, if a taxpayer is taking into account a Code Sec. 481(a) adjustment resulting from a prior, but related, change in method of accounting at the time it changes its method of accounting for the changes described above, the taxpayer may account for the prior Code Sec. 481(a) adjustment separately from the Code Sec. 481(a) adjustment required by a change in one of the accounting methods described above. For example, a taxpayer that changed from the cash method to an overall accrual method in a prior year and was required to take the relevant Code Sec. 481(a) adjustment into account over four years could continue to take into account any remaining adjustment over the appropriate number of years even if the taxpayer changes to the cash method in the current year. However, the taxpayer may also choose to combine or net the remaining portion of the prior Code Sec. 481(a) adjustment with the Code Sec. 481(a) adjustment required by the change in method of accounting. Any taxpayer choosing to combine or net the Code Sec. 481(a) adjustments must indicate this choice in the statement required on the Form 3115, Application for Change in Accounting Method, required to be filed to make the change(s) in method of accounting under Rev. Proc. 2018-40.

For a discussion of automatic consent procedures when making an accounting method change, see Parker Tax ¶241,590.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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