IRS Simplifies Tax Accounting Rules for Small Businesses

(Parker Tax Publishing August 2020)

The IRS issued proposed regulations updating various tax accounting regulations to adopt the simplified tax accounting rules for small businesses as enacted under the Tax Cuts and Jobs Act (TCJA). The proposed regulations, which taxpayers may rely on immediately, also address certain special accounting rules for long-term contracts under Code Sec. 460 that are applicable to corporate taxpayers. REG-132766-18.

Background

The Tax Cuts and Jobs Act of 2017 (Pub. L. 115-97) (TCJA) amended Code Sec. 263A, Code Sec. 448, Code Sec. 460, and Code Sec. 471 to simplify certain tax accounting rules for small business taxpayers that meet a gross receipts test. Prior to the TCJA, certain taxpayers could determine whether they were eligible to calculate taxable income under the cash method of accounting by meeting a gross receipts test. That gross receipts test was met if the taxpayer's average annual gross receipts for all prior taxable years did not exceed $5 million. After the TCJA, a taxpayer meets the gross receipts test and can use the cash method if average annual gross receipts for the three-taxable year period ending immediately before the current tax year are $25 million (adjusted for inflation) or less. For tax years beginning in 2019 and 2020, these simplified tax accounting rules apply for taxpayers having inflation-adjusted average annual gross receipts of $26 million or less. Taxpayers classified as tax shelters cannot use the simplified rules even if they would meet the gross receipts test.

The TCJA also exempted taxpayers meeting the gross receipts test from the uniform capitalization rules under Code Sec. 263A, including the requirement to capitalize interest under Code Sec. 263A(f). Tax reform also added an exception to the requirement to use an inventory method if a taxpayer's inventory is treated as non-incidental materials and supplies, or in accordance with the applicable financial statement (AFS). If a business does not have an AFS, it can use its books and records.

Additionally, in August of 2018, the IRS issued Rev. Proc. 2018-40, which provided procedures for a small business to obtain consent to change its method of accounting to a method of accounting permitted by Code Sec. 263A, Code Sec. 448, Code Sec. 460, or Code Sec. 471, as amended by TCJA. In September of 2019, the IRS published proposed regulations under Code Sec. 451(b) (REG-104870-18) in which comments were requested on the allocation of the transaction price for contracts that include items of income subject to Code Sec. 451 and items of income that are attributable to long-term contract activities subject to Code Sec. 460.

Proposed Regulations

Last week, the IRS issued proposed regulations (REG-132766-18) that provide guidance under Code Sec. 263A, Code Sec. 448, Code Sec. 460, and Code Sec. 471 to implement the TCJA's amendments to those provisions. Taxpayers generally may rely on the proposed regulations for tax years beginning after December 31, 2017, and before the date the regulations are published as final regulations in the federal register.

The proposed regulations provide that, in the case of a taxpayer other than a corporation or partnership, the Code Sec. 448(c) gross receipts test is applied by taking into account the amount of gross receipts derived from all trades or businesses of the taxpayer. In addition, amounts not related to a trade or business of the taxpayer, such as inherently personal amounts of an individual taxpayer, are generally excluded from gross receipts. For an individual, excluded amounts include items such as social security and disability benefits, personal injury awards and settlements, and W-2 wages. However, the proposed regulations provide that the exclusion for wages does not extend to guaranteed payments, which are not generally equivalent to salaries and wages. The proposed regulations also modify Reg. Sec. 1.263A-7 and Reg. Sec. 1.263A-8 to add new provisions which implement the small business taxpayer exemption for purposes of the requirement to capitalize interest.

The proposed regulations update the rules regarding the restrictions on the use of the cash method of accounting by C corporations and partnerships with C corporation partners to reflect the post-TCJA Code Sec. 448(c) gross receipts test. The proposed regulations clarify that the gross receipts of a C corporation partner are included in the gross receipts of a partnership if the aggregation rules of Code Sec. 448(c)(2) apply to the C corporation partner and the partnership. In addition, in light of the increased relevance of the definition of "tax shelter" under Code Sec. 448(d)(3) after enactment of the TCJA, Prop. Reg. Sec. 1.448-2(b)(2)(iii)(B) permits a taxpayer to elect to use the allocated taxable income or loss of the immediately preceding tax year to determine whether the taxpayer is a syndicate for purposes of Code Sec. 448(d)(3) for the current tax year. Under the proposed regulations, a taxpayer that makes this election must apply the rule to all subsequent tax years, and for all purposes for which status as a tax shelter under Code Sec. 448(d)(3) is relevant, unless the IRS permits a revocation of the election.

Prop. Reg. Sec. 1.448-2(g)(3) requires a taxpayer that meets the Code Sec. 448(c) gross receipts test in the current tax year to obtain written consent before changing to the cash method if the taxpayer has previously changed its overall method from the cash method during any of the five tax years ending with the current tax year. The IRS states in the preamble to the proposed regulations that a taxpayer that makes multiple changes in its overall method of accounting within a short period of time may not be treating items of income and expense consistently from year to year, and a change back to the cash method within the five-year period may not clearly reflect income, even if Code Sec. 448 otherwise does not prohibit the use of the cash method.

The proposed regulations contain amendments to the existing regulations under Code Sec. 460, which provides special accounting rules for long-term contracts, to implement TCJA amendments applicable to corporate taxpayers, including the repeal of the corporate alternative minimum tax under Code Sec. 55 and the addition of the base erosion anti-abuse tax under Code Sec. 59A.

The proposed regulations also provide guidance relating to the small business taxpayer exemption to the requirement under Code Sec. 471 that inventories be taken if necessary to clearly reflect income. Finally, the proposed regulations provide a proposed rule regarding the allocation of transaction prices for contracts that include both income subject to Code Sec. 451 and income subject to a special method of accounting provision.

For a discussion of the small business exception to the uniform capitalization rules under Code Sec. 263A, see Parker Tax ¶242,420. For a discussion of the gross receipts test under Code Sec. 448(c), see Parker Tax ¶241,640. For a discussion of the accounting rules for long-term contracts under Code Sec. 460, see Parker Tax ¶245,630. For a discussion of taxpayers that are exempt from keeping inventories under Code Sec. 471(c), see Parker Tax ¶242,315. For a discussion of the income inclusion rule under Code Sec. 451, see Parker Tax ¶241,715.

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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