The Tax Cuts and Jobs Act (TCJA) includes a number of crucial changes to accounting methods for federal income tax purposes. In general, the new law increases gross receipt thresholds and indexes them for inflation.
Taxpayers are required to use the accrual basis accounting, account for inventories, capitalize certain overhead costs as inventory or use the percentage of completion method for long-term contracts once their gross receipts exceed certain thresholds. These requirements often meant growing businesses were burdened with increased costs of compliance. By raising those thresholds, fewer businesses will have to comply with complicated tax provisions and costly accounting method change requests.
Cash Basis Method of Accounting
Prior to the TCJA, corporations and partnerships with corporate partners were prohibited from using the cash method of accounting for tax purposes if their average gross annual receipts were greater than $5 million over the three prior tax years.
For tax years beginning after December 31, 2017, the TCJA increased that threshold to $25 million. This threshold applies regardless of the type of entity or the industry of the taxpayer.
Accounting for Inventories
Under prior rules, taxpayers with inventory were required to use the accrual method of accounting unless they had annual gross receipts of $1 million or less ($10 million or less for certain industries). If below that threshold, the business could account for inventory as non-incidental materials and supplies.
For tax years beginning after December 31, 2017, taxpayers with average annual gross receipts of $25 million or less are permitted to use the cash method of accounting, even if the business has inventory. Therefore, they have the option to treat the inventory as non-incidental materials and supplies or use the method of accounting used for their financial statements.
Uniform Capitalization Requirements
Under the old rules, taxpayers that purchase real or tangible personal property or acquire real or personal property to resell in the ordinary course of business are subject to uniform capitalization rules, requiring the capitalization of certain direct and indirect costs to the property. Higher inventory meant more costs were added to the taxpayer’s balance sheet, resulting in an increase in taxable income. Resellers of personal property were exempt from uniform capitalization requirements if their average annual gross receipts were $10 million or less.
For tax years beginning after December 31, 2017, that $10 million threshold is increased to $25 million.
Percentage of Completion Method for Long-Term Contracts
Before the TCJA, taxpayers with average annual gross receipts of $10 million or less and contracts that were expected to be completed within a two-year period were not required to use the percentage of completion method of accounting. That threshold has been increased to $25 million for contracts entered into after December 31, 2017.
Businesses that now find themselves below the new average gross receipts thresholds for using the cash method of accounting, inventory provisions and exemption from uniform capitalization requirements should be aware that these are considered voluntary accounting method changes, requiring the filing of Form 3115, Application for Change in Accounting Method. If taking advantage of these higher thresholds results in taxable income, the business has the option of recognizing that additional income ratably over a four-year period. If the change results in a loss, it can be recognized immediately.
The exemption from the percentage of completion provision applies on a cut-off basis and would apply only to eligible contracts entered into on or after the year of change. Although it is considered a change in accounting method, the change does not result in recognizing an income adjustment over a four-year period.
The above provisions should be a welcome change for small businesses. Impacted taxpayers should carefully consider switching while keeping in mind there may be other reasons to continue using the accrual basis of accounting or inventory accounting. Making an accounting method change can be a costly and complicated process. If you have any questions about the changes to accounting methods, please contact BSSF today!
ABOUT THE AUTHOR
Randy is a Principal and the Tax Director at Brown Schultz Sheridan & Fritz and is one of the key members of the Firm’s Tax Department. He is responsible for managing tax consulting and compliance services for his clients as well as overseeing the tax department.