By Wendy Landrum, Partner and Practice Leader, National Tax Services – Methods & Credits
The Tax Cuts and Jobs Act (TCJA) includes modifications to certain accounting method provisions resulting in the expansion and simplification of these rules for eligible small businesses. The bill would both increase and align a single gross receipts eligibility limit for qualifying businesses to use several favorable accounting methods, as outlined below.
Cash method of accounting
Current law: The cash method of accounting allows businesses to recognize income and deduct expenses when the cash is received or paid, rather than having to accrue income and expense. Currently, corporations and partnerships (with a corporate partner) may only use the cash method of accounting if its average gross receipts do not exceed $5 million for all prior years.
TCJA impact: The bill would expand the use of the cash method of accounting for small businesses by increasing the $5 million threshold for corporations and partnerships (with a corporate partner) to $25 million. The bill would also repeal the requirement that these businesses satisfy the requirement for all prior years.
Accounting for inventories
Current law: Businesses required to use an inventory method (if the production, purchase or sale of merchandize is a material income-producing factor to the business) must also use the accrual method of accounting. The exception is if its average gross receipts are not more than $1 million (or $10 million for businesses in certain industries), it may account for inventory as non-incidental materials and supplies.
TCJA impact: The bill would increase the gross receipts exception so that businesses with average gross receipts of $25 million or less would be permitted to use the cash method of accounting even if the business has inventories and, therefore, may account for inventory as non-incidental materials and supplies or using its method of accounting reflected on its financial statements.
Current law: The uniform capitalization (UNICAP) rules require certain direct and indirect costs associated with real or tangible personal property manufactured by a business to be included in either inventory or capitalized into the basis of such property. For real or personal property acquired for resale, the UNICAP rules require certain direct and indirect costs associated to the property to be included in inventory. There is an exception with respect to personal property acquired for resale, but not for real and personal property manufactured by a business, under which businesses with $10 million or less of average annual gross receipts are not subject to the UNICAP rules.
TCJA impact: The bill would increase the average gross receipts limitation so that business with $25 million or less of gross receipts would be exempt from the UNICAP rules. The increased average gross receipts limitation would apply to both real and personal property acquired for resale or manufactured, expanding the exception to include producers.
Accounting for long-term contracts
Current law: The taxable income from a long-term contract generally is determined under the percentage-of-completion method. An exception is provided for certain businesses with average annual gross receipts of $10 million or less in the preceding three years. Under this exception, a business may use the completed contract method with respect to contracts that are expected to be completed within a two-year period.
TCJA impact: The bill would increase the $10 million average gross receipts exception to the percentage-of-completion method to $25 million allowing businesses that meet the increased average gross receipts test to use the completed-contract method, therefore the business can deduct costs associated with the construction when they are paid and recognize income when the contract is completed. This provision would be effective for tax years beginning after 2017.
In summary, the TCJA accounting method provisions would allow small businesses greater use of the cash method of accounting, other simplifying accounting method rules and the exemption from complex UNICAP rules.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.