Tax Reform Series #6: Tax Savings from Accounting Methods

The Internal Revenue Service is working to implement the major tax changes approved by Congress in the Tax Cuts and Jobs Act of 2017 (“TCJA”), including several provisions reforming and simplifying accounting methods for small businesses. Our latest Tax Reform Advisor dives into the details of the eligibility and impact of these accounting method changes.

Accounting Methods & The Gross Receipts Test

Taxpayers use many different accounting methods to maintain their financial records. For tax reporting purposes, however, the methods permitted are much more restrictive and several methods require the user to meet certain gross receipts tests to qualify. The gross receipts tests require taxpayers to have a three-year average of gross receipts to be less than the threshold established for each of the accounting methods. Under the TCJA, the gross receipts threshold has been expanded and unified for many of the accounting methods, now making the threshold $25 million for tax years beginning after December 31, 2017. If a taxpayer becomes eligible for the small business accounting methods due to changes from the TCJA, it may be beneficial for the taxpayer to elect an accounting method change to reduce its taxable income.

Cash Method of Accounting

Generally, the cash method of accounting permits the taxpayer to recognize expenses when they are paid and to recognize the revenue when the income is received. The TCJA now permits this method to be used for businesses with average gross receipts under $25 million, versus the previous threshold of $5 million. The TCJA continues to allow qualified personal service corporations, S-corporations, partnerships without C-corporation partners, and other pass-through entities to use the cash method without regard to whether they meet the $25 million gross receipts test. Controlled group rules will continue to apply when testing for average revenues for certain related entities.

Accounting for Inventories

Taxpayers that manufacture or sell tangible personal property have been historically required to use the accrual method of accounting because they maintain inventories. Under the TCJA, if a taxpayer satisfies the expanded gross receipts test of $25 million (up from $10 million), they are permitted to treat inventories as non-incidental material and supplies and expense them as purchased. This method of accounting would allow taxpayers to accelerate the deductions for inventory immediately upon purchase instead of expensing the inventory when it is sold or disposed.

Uniform Capitalization

Uniform Capitalization (“UNICAP”) requires companies to capitalize direct or indirect costs related to the real or tangible property produced or acquired for resale. Required capitalization of these costs delay the expense from when incurred to when the property is sold. Taxpayers that satisfy the TCJA’s expanded gross receipts test of $25 million (versus the previous $10 million), whether the taxpayer is a manufacturer or reseller, are exempt from the UNICAP rules. Taxpayers that are not subject to UNICAP will be able to expense the related direct and indirect costs as incurred within the tax period.

Accounting for Long-term Constructions Contracts

Historically, the percentage of completion method was required for long-term construction contracts if the contract was not completed within the taxable year the contracted was initiated. Under the TCJA, a taxpayer may use the completed contract method if it satisfies the gross receipts test of $25 million and the long-term contract is to be completed within two years. This is effective for contracts entered on or after December 31, 2017.

Deferring Advance Payments

The TCJA codifies the current method taxpayers use to defer the inclusion of income from certain advance payments to the end of the tax year following the tax year of receipt if the income is deferred on the financial statements also. Taxpayers cannot defer income any later than when it is recognized as revenue on their income statement.

Making the Accounting Method Change

Effective for tax years after December 31, 2017, taxpayers that satisfy the expanded gross receipts test, and naturally any other requirements of a specific accounting method, are permitted to elect an accounting method change. While changes to one or more of the accounting methods listed above will be automatically approved, the taxpayer will be required to complete and file Form 3115, “Application for Change in Accounting Method”, with the taxpayer’s Federal tax return. The completion of the application can be a burden; however, the benefits of making the change can be very favorable by helping taxpayers accelerate expenses to the current tax year or deferring revenue recognition until a later tax period.

Contact us if you would like additional information about these accounting methods or have an interest in making an accounting method change for your tax year after December 31, 2017.