January 8, 2021
IRS issues final regulations simplifying tax accounting rules for small businesses to reflect TCJA favorable changes
The IRS has issued final regulations (TD 9942) updating tax accounting rules for small businesses. The new rules finalize underlying proposed regulations (REG-132766-18; see Tax Alert 2020-2114) with few changes. They also implement changes made under the Tax Cuts and Jobs Act (TCJA) that simplified the accounting rules for eligible small business taxpayers, thereby providing important exceptions from the general cash method of accounting limitation under IRC Section 448, the IRC Section 471 inventory rules, the IRC Section 263A cost capitalization rules and the IRC Section 460(e) limitation on the availability of the completed contract method.
IRC Section 448 generally limits use of the cash method of accounting. But IRC Section 448(c) allows small businesses to use the cash method of accounting (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 (gross-receipts test).
The TCJA (1) broadened the small-business exception by increasing the gross-receipts-test amount to $25 million or less, indexed for inflation, and (2) applied the same higher gross-receipts-test amount to businesses that want to use the simplified accounting rules under IRC Sections 471, 263A and 460.
Following enactment of the TCJA, the IRS issued guidance (Revenue Procedure 2018-40; Tax Alert 2018-1662) on how a small business could obtain automatic consent to change its methods of accounting. One year later, the IRS issued the current general automatic change procedure addressing automatic cash to accrual method changes (Revenue Procedure 2019-43; see Tax Alert 2019-2059).
The IRS received numerous comments on the proposed regulations, considered but rejected most, and accepted several that resulted in changes in the final regulations. An overview of the key changes follows.
IRC Section 471 small business taxpayer exemptions are modified
Inventory treated as non-incidental materials and supplies. 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 (NIMS) or (2) conform to the accounting method reflected in the business's applicable financial statement (AFS) for the tax year (AFS IRC Section 471(c) inventory method), or reflected in its books or records if the business does not have an AFS (non-AFS IRC Section 471(c) inventory method). To reduce confusion over use of the word "inventory" in the proposed regulations and the nature of property treated as NIMS under IRC Section 471(c)(1)(B)(i), the final regulations refer to the method under that provision of the Code as the "section 471(c) NIMS inventory method" (referred to, in this Tax Alert, as the "IRC Section 471(c) inventory method"). Under the IRC Section 471(c) NIMS inventory method, the final regulations retain that inventory treated as NIMS is used or consumed when provided to the customer (consistent with prior guidance).
Indirect labor. Some commenters recommended that direct labor costs be excluded from the definition of inventory costs under the IRC Section 471(c) NIMS inventory method. Acknowledging that (1) other guidance (Revenue Procedures 2001-10 and 2002-28) created uncertainty around whether direct labor and overhead costs must be capitalized under the NIMS method and (2) tracking direct labor costs can be burdensome and difficult for many small businesses, the IRS and Treasury decided to exclude direct labor from the costs included in inventory treated as NIMS. Under the final regulations, the only inventory costs includible in the IRC Section 471(c) NIMS inventory method are (1) direct material costs of property produced and (2) costs of property acquired for resale.
Exemption from IRC Section 263A. As previously discussed, 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 because (1) the increased $25-million threshold 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.
Consistent with the proposed regulations, the final regulations remove the obsolete IRC Section 263A reseller exemption but retain the exemptions from the IRC Section 263A uniform capitalization rules that are not based on gross receipts.
Regarding the AFS IRC Section 471(c) method and non-AFS IRC Section 471(c) method. In the preamble to the proposed regulations, the IRS and Treasury requested comments on a "consistency rule" that would require a taxpayer with an AFS that uses the AFS IRC Section 471(c) inventory method "to consistently apply the same mismatched reportable period method of accounting provided in proposed [Treas. Reg. Section] 1.451-3(h)(4) for its AFS [IRC S]ection 471(c) inventory method of accounting that is used for [IRC S]ection 451 purposes." Having received no comments on this proposed rule, the IRS included it in the final regulations.
In addition, the final regulations add some examples to clarify the significance of taking a physical account of inventory under the non-AFS IRC Section 471(c) inventory method. Essentially, if the taxpayer uses the information from the physical count to allocate costs to inventory, this information must be used when applying the non-AFS IRC Section 471(c) method, regardless of whether the taxpayers makes reconciling entries to expense these costs in its financial statements. According to the preamble, these examples "clarify the principle that a taxpayer may not ignore its regular accounting procedures or portions of its books and records under the non-AFS [IRC S]ection 471(c) inventory method."
Finally, in response to requests for clarification, for both the AFS IRC Section 471(c) method and the non-AFS IRC Section 471(c) method, the final regulations clarify that costs do not have to be capitalized to inventory if they are (1) generally required under IRC Section 471(a) to be capitalized to inventory, but (2) are not capitalized in the taxpayer's AFS or books and records (as applicable).
Five-year restriction on automatic method changes is removed
Recognizing that the five-year automatic method change restriction under Prop. Reg. Section 1.448-2(g)(3) "could be burdensome for a small business taxpayer that was required to change from the cash method as a result of [IRC S]ection 448(a)(3) or not meeting the [IRC] Section 448 Gross Receipts Test in a taxable year but that becomes eligible to use the cash method under [IRC S]ection 448 in the subsequent taxable year," the IRS eliminates the five-year restriction in the final regulations. The IRS and Treasury intend to issue procedural rules addressing whether a waiver of the five-year overall method eligibility rule in Revenue Procedure 2015-13 "is appropriate for small business taxpayers that were required to change from the cash method in one taxable year but are not subsequently limited by [IRC S]ection 448." Further, the government intends to issue procedural guidance to address similar fact patterns for taxpayers making changes related to the regulations under IRC Sections 263(A)(i) (relating to costing rules for self-constructed assets and inventory), 460(e)(1)(B) (relating to the TCJA expanded exemption from required use of the percentage of completion method) and 471(c) (relating to the AFS inventory and non-AFS inventory methods).
Tax shelter determination may be made annually
IRC Section 448(a) prohibits a tax shelter from using the cash method of accounting. (A "tax shelter" is also referred to as a "syndicate" for these purposes.) A syndicate is defined (Treas. Reg. Section 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 permitted a taxpayer to elect to use allocated taxable income or loss of the immediately preceding tax year to determine whether the taxpayer is a syndicate for the current tax year, but required a taxpayer making this election to apply the rule to all subsequent tax years, unless the IRS granted permission to revoke the election.
Acknowledging that, since the TCJA's enactment, the definition of a tax shelter under IRC Section 448(d)(3) and the practical issues around determining tax-shelter status for a tax year have become increasingly relevant, the IRS explains in the preamble that the final regulations modify the syndicate election in Prop. Reg. Section 1.448-2(b)(2)(iii)(B) to make the election annual. Treasury and the IRS "have determined that an annual election appropriately balances the statutory language with the consistency requirement for use of a method of accounting under [IRC S]ection 446(a) and [Treas. Reg. Section] 1.446-1," the preamble states. Future procedural guidance will address how an election made under Prop. Reg. Section 1.448-2(b)(2)(iii)(B) may be revoked in light of this change in the final regulations.
IRC Section 460
No material changes between the proposed and final regulations were noted with regard to IRC Section 460.
Although the final regulations are generally applicable for tax years beginning on or after January 5, 2021 (the date they were published in the Federal Register), they may be applied for a tax year beginning after December 31, 2017 and before January 5, 2021 under certain circumstances.
The final regulations provide helpful clarifications to the proposed regulations. Most notably, taxpayers that use the IRC Section 471(c) NIMS inventory method are only required to include direct material costs or the costs of property acquired for resale as NIMS (rather than all direct costs, as previously proposed). Under this rule, taxpayers have flexibility to deduct direct labor costs (in the case of producers) and indirect costs currently, which could provide a timing benefit if desired.
If a taxpayer follows its AFS or non-AFS method (as applicable), the final regulations reiterate that taxpayer must consider applicable federal income tax rules to determine when a cost is includible in inventory and when the cost is recovered (e.g., a cost is not includible in inventory prior to when it is incurred under the taxpayer's overall method of accounting). Therefore, a taxpayer may need to reconcile any differences between its AFS/non-AFS treatment and federal income tax treatment for a cost (e.g., by adjusting the amount of a cost capitalized to inventory for book purposes to tax basis) and should note the potential for this additional administrative effort when choosing which non-IRC Section 471 method to implement. In addition, a taxpayer using the AFS IRC Section 471(c) inventory method that has mismatched financial reporting periods with its tax year must apply the same mismatched reporting method used for IRC Section 451 purposes.
The final regulations reiterate that an eligible small business taxpayer is not required to apply the IRC Section 263A rules with respect 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 than the more restrictive pre-TCJA rules. Eligible small business taxpayers that discontinue applying IRC Section 263A will generally want to also change to a non-IRC Section 471 method (as described above). Otherwise, the taxpayer 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 opt to no longer apply IRC Section 263A and/or IRC Section 471 under the automatic change provisions (see Tax Alert 2018-1662 for details, including on flexibility offered by the guidance). New procedural guidance is also expected. As a reminder, a taxpayer must apply the aggregation rules described in IRC Section 448(c)(2) to determine whether it is eligible to use the small business taxpayer rules described above.
Importantly, the final regulations modified the originally proposed tax shelter test election in the proposed regulations from a permanent election to an annual one. This could provide more certainty for taxpayers that have an atypical loss year among, for example, profitable years that would otherwise necessitate a change from the overall cash method. However, the government declined certain commentators' requests to not require an IRC Section 481(a) adjustment for method changes that arise by operation of the tax shelter testing rules of IRC Section 448.
Also, by waiving application of the so-called "five-year rule" proscription on a change in overall method, the final rules generally make any changes to or from the overall cash method automatic. As such, there is no need to obtain a written ruling from the IRS National Office and small taxpayers will not be burdened by the associated costs and waiting period to obtain a non-automatic method change ruling.