IRS Finalizes Simplified Tax Accounting Regulations for Small Businesses

(Parker Tax Publishing January 2021)

The IRS issued final regulations updating various tax accounting regulations to reflect the adoption of the simplified tax accounting rules for small businesses enacted under the Tax Cuts and Jobs Act (TCJA). The final regulations also provide certain special accounting rules for long-term contracts under Code Sec. 460 which implement TCJA changes applicable to corporate taxpayers. T.D. 9942.

Background

The Tax Cuts and Jobs Act of 2017 (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 the gross receipts test under Code Sec. 448(c). 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 2020 and 2021, these simplified tax accounting rules apply to taxpayers having inflation-adjusted average annual gross receipts of $26 million or less.

Under Code Sec. 448(a)(3), taxpayers classified as tax shelters cannot use the simplified rules even if they would meet the gross receipts test. The term "tax shelter" is defined by reference to the definition of a "syndicate" in Code Sec. 1256(e)(3)(B). A syndicate is a partnership or other entity (other than a C corporation) if more than 35 percent of the losses of that entity during the tax year are allocable to limited partners or limited entrepreneurs. Thus, a partnership or other entity (other than a C corporation) may be considered a syndicate under Code Sec. 448 only for a tax year in which it has losses.

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 under Code Sec. 471 to use an inventory method if a taxpayer's inventory is treated as non-incidental materials and supplies, or if the method of accounting for their inventory conforms with the method reflected on their applicable financial statement (AFS). If a business does not have an AFS, it can use its books and records.

In 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 August of 2020, the IRS issued proposed regulations (REG-132766-18) to implement the TCJA's amendments to Code Sec. 263A, Code Sec. 448, Code Sec. 460, and Code Sec. 471.

Final Regulations

Last week, the IRS issued final regulations (T.D. 9942) that adopt the proposed regulations as revised in response to practitioners' comments.

The IRS received several comments concerning tax shelters, including the definition of a syndicate. To address the practical concerns regarding the determination of tax shelter status, the final regulations modify the syndicate election in Prop. Reg. Sec. 1.448-2(b)(2)(iii)(B) to make the election an annual election. The IRS determined that an annual election will allow a taxpayer to elect in the year it has a taxable loss to use the allocated taxable income or loss of the immediately preceding tax year to determine whether it is a syndicate for the current tax year. Under the final regulations, a taxpayer is required to file a statement with the original timely filed federal income tax return (including extensions) to affirmatively make this election for the tax year. The election is valid only for the tax year for which it is made, and once made, cannot be revoked.

Observation: The IRS noted that it intends to issue procedural guidance to address the revocation of an election made under Prop. Reg. Sec. 1.448-2(b)(2)(iii)(B) as a result of the application of the final regulations.

The final regulations also remove the restriction in Prop. Reg. Sec. 1.448-2(g)(3) on making automatic changes in a taxpayer's method of accounting if the taxpayer has previously changed its overall method of accounting from the cash method during any of the five previous tax years. According to the IRS, the proposed five-year restriction could be burdensome for a small business taxpayer that was required to change from the cash method as a result of Code Sec. 448(a)(3) or as a result of not meeting the gross receipts test in a tax year but that becomes eligible to use the cash method in the subsequent tax year. Under the proposed regulations, such a taxpayer would have been required to request IRS consent to change back to the cash method. The IRS said that procedural rules will be provided relating to changes in method of accounting to implement the final regulations using the automatic method change procedures in Rev. Proc. 2015-13.

Under Prop. Reg. Sec. 1.471-1(b)(6), a taxpayer, other than a tax shelter, that does not have an AFS and that meets the gross receipts test was not required to take an inventory under Code Sec. 471(a), and could choose to use the "non-AFS Code Sec. 471(c) inventory method" to account for its inventory. The non-AFS Code Sec. 471(c) inventory method is the method of accounting for inventory reflected in the taxpayer's books and records that are prepared in accordance with the taxpayer's accounting procedures and that properly reflect the taxpayer's business activities for non-tax purposes. The proposed regulations defined "inventory costs" for purposes of the non-AFS Code Sec. 471(c) inventory method generally as costs that the taxpayer capitalizes to property produced or property acquired for resale in its books and records.

Practitioners requested that the final regulations clarify how a taxpayer treats costs to acquire or produce tangible property that the taxpayer does not capitalize in its books and records because the proposed regulations did not specifically address these costs. The final regulations clarify in Reg. Sec. 1.471-1(b)(6)(i) that costs that are generally required to be capitalized to inventory under Code Sec. 471(a), but that the taxpayer is not capitalizing in its books and records, are not required to be capitalized to inventory. The IRS also determined that, under this method, such costs are not treated as amounts paid to acquire or produce tangible property under Reg. Sec. 1.263(a)-2, and therefore, are generally deductible when they are paid or incurred if such costs may be otherwise deducted or recovered notwithstanding Reg. Sec. 1.471-1(b)(4) under another provision of the Code and regulations. Additionally, the final regulations clarify that costs capitalized for the non-AFS Code Sec. 471(c) inventory method are those costs that related to the production or resale of the inventory to which they are capitalized in the taxpayer's books and records.

Effective Date

The final regulations are applicable for tax years beginning on after the date they are published in the Federal Register. However, a taxpayer may apply the final regulations for a tax year beginning after December 31, 2017, 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 contained in the final regulations that relate to that Code provision for the tax year and all subsequent tax years, and must follow the administrative procedures for filing a change in method of accounting in accordance with Reg. Sec. 1.446-1(e)(3)(ii).

For example, a taxpayer that wants to apply Reg. Sec. 1.263A-1(j) to be exempt from capitalizing costs under Code Sec. 263A must apply Reg. Sec. 1.448-2 to determine whether it is eligible for the exemption. The same taxpayer must apply Reg. Sec. 1.448-2 to determine whether it is eligible to apply Reg. Sec. 1.471-1(b) to be exempt from the general inventory rules under Code Sec. 471(a). However, it may choose not to apply Reg. Sec. 1.471-1(b) even though it chooses to apply Reg. Sec. 1.263A-1(j) and Reg. Sec. 1.448-2.

Alternatively, a taxpayer may rely on the proposed regulations for a tax year beginning after December 31, 2017, and before the date the final regulations are published in the Federal Register, provided that if the taxpayer applies any aspect of the proposed regulations under a particular Code provision, the taxpayer must follow all of the applicable rules contained in the proposed regulations that relate to that Code provision for the tax year, and follow the administrative procedures for filing a change in method of accounting in accordance with Reg. Sec. 1.446-1(e)(3)(ii).

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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