The IRS and Treasury Department released proposed regulations (REG-132766-18) that would update small-business tax accounting rules that were changed as a result of the Tax Cuts and Jobs Acts (TCJA). The proposed regulations would implement TCJA amendments that simplified the accounting rules for the cash method of accounting under IRC Section 448, inventories under IRC Section 471, cost capitalization under IRC Section 263A and long-term contracts under IRC Section 460.

The IRS invited the public to submit comments and requests for a public hearing by September 19, 2020.

Background

IRC Section 448 generally limits use of the cash method of accounting. IRC Section 448(c) permits small businesses to use the cash method of accounting (the small-business exception) if their annual average gross receipts fall at or below a certain amount for the three-year period ending immediately before the current tax year (the gross-receipts test).

The TCJA broadened the small-business exception by increasing IRC Section 448(c)'s gross-receipts-test amount to $25 million or less (and indexed the threshold for inflation). The TCJA also applied the higher gross-receipts-test amount to businesses that want to use the simplified accounting rules under IRC Section 471, IRC Section 263A and IRC Section 460.

The IRS subsequently released Revenue Procedure 2018-40, with guidance on how a small business could obtain automatic consent to change its methods of accounting (see Tax Alert 2018-1662). Revenue Procedure 2019-43 was later released and is the current general automatic change procedure addressing automatic cash to accrual method changes (see Tax Alert 2019-2059).

Small-business exception does not apply to tax shelters

Under IRC Section 448(a)(3), a tax shelter cannot use the cash method of accounting. The term "tax shelter" is called a "syndicate" in cross references. "Syndicate" is defined in Treas. Reg. 1.448-1T as a taxpayer that allocates more than 35% of its losses to limited partners or limited entrepreneurs. As a result, a partnership or other entity (other than a C corporation) may be considered a syndicate only for a tax year in which it has losses. The proposed regulations adopt the same definition of syndicate provided in Treas. Reg. 1.448-1T for purposes of determining whether the taxpayer constitutes a tax shelter.

In response to comments, the proposed regulations would permit a taxpayer to elect to use the allocated taxable income or loss of the immediately preceding tax year to determine whether the taxpayer is a syndicate for the current tax year. A taxpayer making this election would have to apply the rule to all subsequent tax years, unless the IRS grants permission to revoke the election.

Small businesses changing to overall cash method under IRC Section 448

The TCJA, as noted, increased the gross receipts threshold to enable more taxpayers to qualify for use of the overall cash method. The proposed rules would update the IRC Section 448 regulations to reflect this threshold. In addition, the proposed rules would clarify that the gross receipts of a C corporation partner are included in the gross receipts of a partnership if the aggregation rules apply to the C corporation partner and partnership.

Under the proposed regulations, taxpayers that want to change to the cash method of accounting on the basis of meeting the gross-receipts test would have to obtain written permission from the IRS if they had changed from the cash method of accounting during any of the previous five tax years.

Small-business exception from requirement to capitalize costs under IRC Section 263A

The TCJA amended IRC Section 263A to add a new general exception for small businesses (excluding tax shelters) meeting the gross-receipts test under IRC Section 448(c), which exempts those taxpayers from applying the rules of IRC Section 263A to inventory and self-constructed assets (including interest capitalization). This new provision was significant for two reasons: (1) the increase in threshold to $25 million expanded the pool of taxpayers exempt from IRC Section 263A; and (2) the exemption for small-business taxpayers from the IRC Section 263A inventory and self-constructed assets (including interest capitalization) requirements changed prior law, under which small taxpayers were only exempt from the rules as they related to resellers and certain producers of inventory.

The proposed regulations would remove the obsolete IRC Section 263A reseller exemption but continue to retain the exemptions from the IRC Section 263A uniform capitalization rules that are not based on gross receipts.

If the taxpayer is not a corporation or partnership, the proposed regulations would apply the IRC Section 448(c) gross receipts test by taking into account the amount of gross receipts derived from all of the taxpayer's trades or businesses. This amount does not include "inherently personal amounts of the individual taxpayer," such as Social Security benefits, personal injury awards and settlements, disability benefits and wages.

The proposed rules would also allow farmers that elected to not apply the IRC Section 263A rules to elect the small-business exception instead (i.e., the farming exception), or to elect the small-business exception if they had elected the farming exception.

Small-business exceptions from requirement to account for certain long-term contracts under IRC Section 460

A contract is a long-term contract if it is: (1) generally for the building, installation or construction of property, or certain manufacturing, and (2) not completed within the tax year in which the taxpayer entered into the contract. Income from a long-term contract must be determined using the percentage-of-completion method (PCM). Under the TCJA, taxpayers that estimate a contract will be completed within two years of its commencement and meet the IRC Section 448(c) gross-receipts test are exempt from using PCM. The proposed regulations would reflect this new rule.

The proposed regulations would also reflect the effect of the base erosion anti-abuse tax (BEAT). For any tax year, the BEAT equals each applicable taxpayer's base erosion minimum tax amount (BEMTA) for that year. Under the proposed regulations, the taxpayer would have to "determine its modified taxable income and BEMTA for each year prior to the filing year that is affected by contracts completed or adjusted in the filing year as if the actual total contract price and costs had been used in applying the percentage of completion method."

Small-business exception from requirement to account for inventories under IRC Section 471

Under IRC Section 471(a) regulations, a taxpayer must take inventory at the beginning and end of each tax year in which the production, purchase or sale of merchandise is an income-producing factor.

The TCJA added an exception for eligible small businesses so they do not have to take inventory for the tax year in which the exception applies. A small business can change its method of accounting for inventories under IRC Section 471 using the automatic change provisions to either: (1) treat inventory as non-incidental materials and supplies or (2) conform to the accounting method reflected in the business's applicable financial statement (AFS) for the tax year, or reflected in its books or records if the business does not have an AFS.

The proposed regulations would clarify that: (1) materials and supplies are used or consumed in the tax year in which the taxpayer provides the item to a customer (consistent with small-business rules in effect before the TCJA) and (2) the cost of the items is recovered in either that year or the tax year in which the taxpayer incurs the cost, whichever is later. The IRS did not adopt a commenter's suggestion to deem raw materials used in the production of finished goods as "used or consumed" when the raw material is used during production instead of when the finished product is provided to a customer. The proposed regulations would treat inventory costs as the direct costs of the property produced or property acquired for sale when taxpayers use the IRC Section 471(c) materials-and-supplies method.

The proposed regulations also specify that non-incidental materials and supplies are not eligible for the de minimis safe harbor election under Treas. Reg. Section 1.263(a)-1(f). In addition, taxpayers could determine the amount of materials and supplies by using either a specific identification method, a first-in, first-out (FIFO) method, or an average cost method, as long as they use the method consistently.

The proposed regulations also include guidance on the definition of an AFS, the types and amounts of AFS costs that can be recovered under IRC Section 471(c) and when such costs may be taken into account.

Special method allocation rule under IRC Section 451(b)(4)

The TCJA added IRC Section 451(b), which requires accrual-basis taxpayers to recognize income at the earlier of when recognized for tax purposes under the historic "all-events test" or when taken into account in an AFS. For a contract containing multiple performance obligations, IRC Section 451(b)(4) provides that the allocation of the transaction price to each performance obligation equals the amount allocated to each performance obligation for purposes of including that item in revenue in the taxpayer's AFS.

In the proposed regulations, the Treasury Department and the IRS asked for comments on a new rule under consideration. Under this rule, if an accrual-method taxpayer with an AFS has a contract with a customer that includes one or more items of gross income subject to a special method of accounting (as defined in Prop. Treas. Reg. Section 1.451-3(c)(5)) and one or more items of gross income subject to IRC Section 451, the allocation rules under IRC Section 451(b)(4) would not apply to determine the amount of each item of gross income that is accounted for under the special method of accounting provision. As a result, the transaction price allocation rules in IRC Section 451(b)(4) and Prop. Treas. Reg. Section 1.451-3(g)(1) (REG-104870-18) would apply to only the portion of the gross transaction price that is not accounted for under the special method of accounting provision (the residual amount) and only to the extent the contract contains more than one performance obligation that is subject to IRC Section 451. If a contract contains more than one performance obligation subject to IRC Section 451, the residual amount would be allocated to each IRC Section 451 performance obligation in proportion to the amount allocated to each such performance obligation for purposes of including that item in revenue in the taxpayer's AFS.

Implications

The proposed regulations are helpful in clarifying the rules added by the TCJA. Most notably, taxpayers that use the IRC Section 471(c) non-incidental materials and supplies method are only required to include the direct costs of inventory items as non-incidental materials supplies. Under this rule, taxpayers have flexibility to deduct indirect costs currently, which could provide a timing benefit if desired.

Taxpayers following their AFS or non-AFS method (as applicable) must consider applicable federal income tax rules to determine when a cost is includible in inventory and when it is recovered (e.g., a cost is not includible in inventory before it is incurred under the taxpayer's overall method of accounting). Therefore, taxpayers may need to reconcile any differences between their AFS/non-AFS treatment and federal income tax treatment for a cost and should note this potential additional administrative effort when choosing which non-IRC Section 471 method to implement.

The proposed regulations would clarify that an eligible small business is not required to apply the IRC Section 263A rules to both inventory and self-constructed assets (including any assets that would have required the capitalization of interest under IRC Section 263A(f)). As noted, these rules are more favorable compared to the more restrictive pre-TCJA rules. Eligible small businesses that stop applying IRC Section 263A will generally want to also change to a non-IRC Section 471 method (as described previously). Otherwise, taxpayers may still need to make tax adjustments to comply with the IRC Section 471 inventory rules (such as making tax adjustments to appropriately treat certain financial statement reserves). Previously issued procedural guidance allows taxpayers to stop applying IRC Section 263A and/or IRC Section 471 under the automatic change provisions (see Tax Alert 2018-1662 for additional details and flexibility offered by such guidance). As a reminder, taxpayers must apply the aggregation rules described in IRC Section 448(c)(2) to determine whether they may use the previously described rules for small businesses.

The proposed rule clarifying that the IRC Section 451(b)(4) allocation rules only apply to the portion of a contract's gross transaction price that is not accounted for under a special method of accounting will be welcome news to many taxpayers whose contracts include items of income subject to both a special method of accounting and IRC Section 451. Many taxpayers were concerned that the new IRC Section 451(b)(4) allocation rules might disrupt the historic tax treatment of contracts with multiple items of gross income and require multiple tax accounting method changes to effectuate new allocation and income recognition methodologies for the income received under these contracts. We understand that the IRS and Treasury are very interested in hearing from taxpayers whose contracts partially account for income under IRC Section 451 and partially under IRC Section 460, IRC Section 467 or another special method of accounting; as such, taxpayers are encouraged to submit comments.

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