New proposed regulations explain how small businesses can use the simplified accounting rules enacted by the TCJA. The 2017 law simplifies the application of the method of accounting rules for businesses (other than tax shelters) with average annual gross receipts that do not exceed $26 million in 2020 as adjusted for inflation, generally allowing use of the cash method. The proposed rules also address special accounting rules for long-term contracts to implement legislative changes applicable to corporate taxpayers.
The TCJA also exempts taxpayers meeting the gross receipts test from the uniform capitalization rules and adds an exception to the requirement to use an inventory method if a business’s inventory is treated as non-incidental materials and supplies or conforms to the method reflected in the business’s applicable financial statement (AFS). If the business does not have an AFS, taxpayers can use their books and records. The proposed regulations implement these statutory changes and provide clarifying definitions.
Gross Receipts Test Examples
The regulations offer several examples of how to apply the gross receipts test to different types of entities.
Example: Taxpayer A, a calendar-year S corporation, is a reseller and maintains inventories. In 2017, 2018 and 2019, S’s gross receipts were $10 million, $11 million and $13 million, respectively. For 2020, Taxpayer A meets the gross receipts test with an average of $11.3 million over the last three years, which does not exceed the $26 million limit.
Example. Taxpayer A, a C corporation, is a plumbing contractor that installs plumbing fixtures in customers’ homes or businesses. A’s gross receipts for the 2017- 2019 taxable years are $20 million, $16 million and $30 million, respectively. A’s average annual gross receipts for the three taxable-year period preceding the 2020 taxable year is $22 million (($20 million + $16 million + $30 million) / 3 = $22 million. Taxpayer A may use the cash method for its trade or business for the 2020 taxable year because its average annual gross receipts for the preceding three taxable years is not more than $26 million.
For a taxpayer other than a corporation or partnership, the test is applied by considering the amount of gross receipts derived from all trades or businesses of that taxpayer.
Example: Taxpayer B is an individual who operates three separate businesses that are reported on Schedule C of B’s Federal income tax return. For 2020, Business X is a retail store with average annual gross receipts of $15 million, Business Y is a dance studio with average annual gross receipts of $6 million and Business Z is a car repair shop with average annual gross receipts of $12 million. B’s gross receipts are the combined amount derived from all three of B’s trades or businesses, $33 million. Therefore, for 2020, X, Y and Z do not meet the gross receipts.
A taxpayer engaged in a farming business and a separate non-farming business is not prohibited from using the cash method for the farming business, even though the taxpayer may be prohibited from using the cash method for the non-farming business.
Materials and Supplies, De Minimis Write-Offs
One important clarification is that taxpayers who elect the option to treat inventory items as materials and supplies cannot use the de minimis election to expense low-cost items–those that cost less than $2,500 or $5,000 for taxpayers with an applicable financial statement. Thus, the election would remove deductions taxpayers could take under the de minimis safe harbor, in return for allowing a simplified inventory method.
Taxpayers may have already begun filing changes in accounting method (forms 3115) to reclassify and deduct former “inventory” items as “de minimis” materials and supplies, based on guidance issued to date. These proposed regulations may require additional (unfavorable) adjustments, or further reliance on a Taxpayers method of accounting under their “Books and records”, for which reliance and restrictions are still mostly undefined.
Taxpayers may determine the amount of their materials and supplies by using either a specific identification method, a first-in, first-out (FIFO) method or an average cost method. Taxpayers may not identify their inventory using a last-in, first-out (LIFO) method and may not value materials and supplies using a lower-of-cost-or-market (LCM) method.
The regulations also provide guidance for small businesses with long-term construction contracts and identify the requirements for exemption from the percentage-of-completion method and the uniform capitalization rules. For taxpayers with income from long-term contracts reported under the percentage-of-completion method, the IRS explains how to apply the look-back method after the repeal of the corporate alternative minimum tax and enactment of the base erosion and anti-abuse tax (BEAT).
Taxpayers may rely on the proposed regulations until the final rules are issued. If you have questions about how the proposed regulations apply to your business, please reach out to a Frazier & Deeter tax professional.