The cash method can yield tax savings by deferring the recognition of income until cash is received.
The law known as the Tax Cuts and Jobs Act (TCJA),P.L. 115-97, which generally took effect in 2018, provides welcome simplifications for small business taxpayers. This article highlights some of these new provisions compared with prior law and how small business taxpayers are affected.
As with most components of the Code, these new provisions are anything but simple. However, the TCJA generally provides that businesses with less than $25 million in gross receipts can now choose to:
* Use the cash method of accounting instead of the accrual method of accounting (Sec. 448(c));
* Not capitalize additional uniform capitalization (UNICAP) costs to inventory (Sec. 263A(i));
* Treat inventories as nonincidental materials and supplies or use an inventory method that conforms to their financial accounting treatment of inventories (Sec. 471(c)); and
* Not account for long-term construction contracts using the percentage-of-completion method (PCM) of accounting (Sec. 460(e)(1)(B)). Changes to adopt each of these provisions will require a change in accounting method. The procedures for requesting a change in accounting method are discussed later in this article.
WHAT IS A SMALL BUSINESS?
Each of these provisions hinges on whether a business is considered a small business under a gross receipts test provided by Sec. 448. The TCJA amends Sec. 448 by redefining a small business as a corporation or partnership with average annual gross receipts for the prior three-year period (ending with the tax year that precedes the current tax year) that do not exceed $25 million (Sec. 448(c)). This represents a significant increase from the $5 million threshold under prior law. In addition, the rule now takes into account gross receipts only in the three-year period immediately preceding the current tax year, while, previously, a taxpayer was prohibited from using the cash method of accounting if it failed the gross receipts test in any prior year. A business not in existence for the entire three-year period must compute its average gross receipts for the periods it has been in existence. If any of the prior three years were "short years," the business must annualize the gross receipts for the short periods before computing the three-year average.
Example: A business has gross receipts of $20 million in 2015, $25 million in 2016, and $30 million in 2017. For its 2018 tax year, the prior three-year average gross receipts are $25 million. The business's average gross receipts for the prior three-year period do not exceed $25 million, and the business is considered a small business for purposes of Sec. 448(c).
Under previous guidance, Treasury and the IRS anticipated that larger businesses might attempt to meet the former $5 million gross receipts test by separating activities into multiple entities to fall beneath the threshold. To combat these attempts, the Sec. 448 regulations, which remain unchanged by the TCJA, require the gross receipts of related entities to be aggregated for purposes of applying the gross receipts test if the related entities are treated as a single employer. Generally, the aggregation rules apply to entities that are members of a controlled group with more than 50% common control or are considered affiliated service groups (Sees. 52(a) or (b) and 414(m) or (o)).
CASH VERSUS ACCRUAL METHOD
Under the cash method of accounting, items of income are generally included in taxable income when actually or constructively received, and a deduction is allowed when expenses are paid. The accrual method of accounting generally recognizes items of income upon the earlier of (1) when cash is received, or (2) when all the events have occurred that fix the right to receive the income, and the amount of the income can be determined with reasonable accuracy (Sec. 451).Taxpayers using the accrual method generally cannot deduct items of expense before (1) all events have occurred that fix the obligation to pay the liability; (2) the amount of the liability can be determined with reasonable accuracy; and (3) economic performance has occurred (Sec. 461).
In addition, several Code sections work in conjunction with the overall cash and accrual methods to defer expense recognition, such as Sec. 263A (requiring the capitalization of certain costs to property produced or purchased for resale); Regs. Sec. 1.162-3 (requiring capitalization of nonincidental materials and supplies); and Sec. 263(a) (requiring capitalization of improvements to property).
Prior-law limitations on use of the cash method
Under prior law, the availability of the cash method of accounting was relatively limited. A C corporation taxpayer or a partnership with a C corporation partner could not use the cash method if it failed the aforementioned $5 million gross receipts test of Sec. 448(c) for any prior tax year. Even if a taxpayer satisfied the $5 million gross receipts test, it was still prohibited from using the cash method if it was...