In Revenue Procedure 2018-40, the IRS outlines the process through which eligible small-business taxpayers — generally those with average gross receipts of $25 million or less in the prior three years — may obtain automatic consent to change certain methods of accounting.

Background

Signed into law in December 2017, the Tax Cuts and Jobs Act (TCJA) increased the gross receipts test amount under Section 448, which effectively expanded the number of small-business taxpayers eligible to use the cash method of accounting and exempted these businesses from certain accounting rules for inventories under Section 471, cost capitalization under Section 263A (for inventory and self-constructed assets), and long-term contracts under Section 460.

Generally, a taxpayer must obtain consent from the Commissioner to change a method of accounting for federal income tax purposes (Section 446(e)). In Revenue Procedure 2015-13, the IRS provides procedures under which a taxpayer may obtain automatic consent to change a method of accounting contained in the list of automatic changes, which is provided in Revenue Procedure 2018-31 and modified by Revenue Procedure 2018-40. (For more on Revenue Procedure 2015-13, see Tax Alert 2015-0204; for more on Revenue Procedure 2018-31, see Tax Alert 2018-1066.)

Revenue Procedure 2018-40 provides guidance that a small-business taxpayer may use to obtain automatic consent to change its methods of accounting to reflect the statutory changes to Section 448 enacted by the TCJA.

Revenue Procedure 2018-40

The new Revenue Procedure modifies existing sections of Revenue Procedure 2018-31 and adds the following new sections to the list of automatic changes:

— Small-business taxpayer changing to overall cash method (Section 15.18)

— Small-business taxpayer exception from requirement to capitalize costs under Section 263A (Section 12.16)

— Small-business taxpayer exception from requirement to account for inventories under Section 471 (Section 22.19)

— Small-business taxpayer exceptions from requirement to account for certain long-term contracts under Section 460 or to capitalize costs under Section 263A for certain home construction contracts (Section 19.01)

Under the new guidance, a small-business taxpayer — having $25 million or less in average gross receipts over the preceding three years — may change to the cash method of accounting effective for tax years beginning after December 31, 2017, using the automatic change procedures. This change generally does not apply to banks (but see Section 15.12 of Revenue Procedure 2018-31) or farming businesses (but see Section 15.13 of Revenue Procedure 2018-31). A special rule provides that a small-business taxpayer using the overall cash method for a trade or business must include in income amounts attributable to open accounts receivable (i.e., any receivable that is due in full in 120 days or less and that is not subject to Section 475) as they are actually or constructively received.

A small-business taxpayer that capitalizes costs under Section 263A and wants to change to a method of accounting that does not capitalize costs under Section 263A (to both inventory and self-constructed assets) may do so using the automatic change provisions. However, the Revenue Procedure provides a separate automatic change for taxpayers wishing to stop capitalizing costs under Section 263A for home construction contracts (as defined in Section 460(e)(1)(A)).

The new Revenue Procedure clarifies that a small-business taxpayer can change its method of accounting for inventories under Section 471 using the automatic change provisions to either: (1) treat inventory as non-incidental materials and supplies under Reg. Section 1.162-3; or (2) conform to the taxpayer's method of accounting reflected in its applicable financial statements with respect to the tax year, or reflected in its books or records if the taxpayer does not have an applicable financial statement.

Revenue Procedure 2018-31 reserved Section 19 for language providing special rules for long-term contracts. Revenue Procedure 2018-40 adds that language, specifying that a small-business taxpayer may: (1) change its method of accounting for exempt long-term contracts described in Section 460(e)(1)(B) from the percentage-of-completion (PCM) method of accounting to an exempt contract method of accounting under Reg. Section 1.460-4(c); or (2) choose to stop capitalizing costs under Section 263A for home construction contracts defined in Section 460(e)(1)(A) (as noted previously).

The new Revenue Procedure waives the eligibility rules under Sections 5.01(1)(e) (for a change in overall method) and 5.01(1)(f) (for a change for a specific item) of Revenue Procedure 2015-13 for a taxpayer's first, second or third tax year beginning after December 31, 2017 (in the case of changes under new Section 19 of Revenue Procedure 2018-31, for a taxpayer's first, second or third tax year ending after December 31, 2017).

The new Revenue Procedure introduces reduced filing requirements for all of the new automatic changes (i.e., by clarifying only certain sections of the Form 3115 need to be completed), and allows a taxpayer that is changing to the overall cash method of accounting under Section 15.18, in addition to making a change under Section 12.16 and/or Section 22.19 for the same year, to file a single Form 3115 for all of these changes.

If a taxpayer is taking into account a positive Section 481(a) adjustment from a prior similar method change (e.g., a change in overall method from the cash method to an accrual method) at the time it changes its method under one of the new sections discussed previously, the new Revenue Procedure also allows the taxpayer either to: (1) continue to account for the prior Section 481(a) adjustment separately over four years; or (2) combine the remaining portion of the Section 481(a) adjustment from the prior change with the adjustment required by one of the new automatic changes previously referenced.

Regarding the existing sections in Revenue Procedure 2018-31, which allowed a taxpayer to conform to the small-business taxpayer rules under pre-TCJA law, the new Revenue Procedure modifies those sections to clarify those changes do not apply to a taxpayer's tax year beginning after December 31, 2017.

Transitional rule

If a taxpayer requested a change in accounting method by properly filing a Form 3115 under the non-automatic change procedures of Revenue Procedure 2015-13 and the request is pending with the IRS National Office as of August 3, 2018, the taxpayer may choose to utilize the automatic change procedures in Revenue Procedure 2015-13 as long as the taxpayer is otherwise eligible to use Revenue Procedure 2018-40 and the automatic procedures in Revenue Procedure 2015-13. To make this change, the taxpayer must notify the National Office contact person for the Form 3115 before the later of: (1) September 2, 2018, or (2) the issuance of a letter ruling granting or denying the change request. If the taxpayer timely notifies the National Office that it chooses to convert the Form 3115 to the automatic change procedures in Revenue Procedure 2015-13, the National Office will send a letter to the taxpayer acknowledging its request and will return the user fee submitted with the Form 3115.

Comment request

Treasury and the IRS invite suggestions for future guidance under Sections 263A, 447, 448, 460 and 471, focusing particularly on:

1. How the Section 448(c) gross receipts test applies to each trade or business of a taxpayer that is not a corporation or partnership

2. How to interpret "books and records of the taxpayer prepared in accordance with the taxpayer's accounting procedures" in Section 471(c)(1)(B)

3. How to interpret Section 460(e)(2)(B) in the context of Revenue Ruling 92-28

Implications

This Revenue Procedure provides simplified procedures under which taxpayers may receive automatic consent when changing their methods of accounting to conform to the expanded small-business taxpayer exceptions implemented by the TCJA. Allowing taxpayers to obtain automatic consent, waving certain scope limitations in Revenue Procedure 2015-13, providing reduced filing requirements, and allowing taxpayers to transition previously filed non-automatic changes to automatic changes for the same year is consistent with the IRS's general intent to lessen the burden on taxpayers when complying with the new law. The waiving of the "five-year" scope limitation is particularly important now that a taxpayer can qualify under the new small-business rules even if it failed to qualify in a prior year.

One trending question is whether a taxpayer that previously did not apply Section 263A for inventory or self-constructed assets (impermissibly) and now qualifies to be exempt from Section 263A under the new small-business rules would be able to file an automatic change (to continue not applying Section 263A, albeit permissibly) and obtain audit protection for prior years through any guidance issued by the IRS. Based on new Section 12.16, it appears such taxpayers are scoped out of such section (i.e., the taxpayer must presently be capitalizing such costs under Section 263A to qualify). Taxpayers would need to file a non-automatic change under the procedures of Revenue Procedure 2015-13 to comply with the new rules and obtain audit protection.

While Revenue Procedure 2018-40 allows an eligible small-business taxpayer to obtain automatic consent to change its method for exempt long-term contracts to an exempt long-term contract method, this change only applies to taxpayers presently accounting for such contracts using PCM. Therefore, a taxpayer that had to use PCM in previous tax years, but impermissibly used another method (such as an accrual method), may not rely on the automatic provisions of Revenue Procedure 2018-40 to change its method of accounting and obtain audit protection. That taxpayer must file the method change under the non-automatic change provisions of Revenue Procedure 2015-13.

Taxpayers should also be aware of the flexibility in treating positive Section 481(a) adjustments for prior similar changes. While it generally would not be beneficial to combine a remaining positive Section 481(a) adjustment with a negative Section 481(a) adjustment (negative adjustments are generally expected to result from the new changes), to the extent the taxpayer is looking to increase income, this new rule could be one way to achieve that objective.

Taxpayers affected by the TCJA's changes to Sections 263A, 447, 448, 460, or 471 should consider submitting comments in response to the IRS and Treasury's request for suggestions on future guidance in that area. Submitting comments ensures a taxpayer's concerns are heard and considered as the IRS and Treasury draft this future guidance.

Taxpayers with less than $25 million in gross receipts (new businesses, certain partnerships, certain s corporations, etc.) should review their methods of accounting to determine whether they may now benefit from the new expanded exceptions.

———————————————