Tax Reform Expands the Definition of “Small” Businesses and their Accounting Method Options by Richard E. Cabrera, JD CPA
Posted on November 13, 2018 by Richard Cabrera
The tax reform law that went into effect beginning in 2018 expands the definition of small businesses that can now qualify to use the cash method of accounting and ultimately defer the recognition of income and payments of tax liabilities to later years. Unlike other changes contained in the Tax Cuts and Jobs Act (TCJA) that are set to expire in future years, these changes are permanent. As a result, more businesses will be able to ease their record-keeping burdens and potentially receive tax benefits from adjustments in when and how they account for income and expenses.
Accounting for Income and Expenses
How a business will account for gross income and expenses is typically among the first decisions an entrepreneur will make when setting up a new company. However, in many instances, the decision is determined for the business owner by the tax code, such as when a business produces inventory, when the taxpayer enters into long-term contracts, or when the company is in a particular industry.
Under the cash method of accounting, a business recognizes income at the point in time that it physically receives payment, and it deducts expenses when it pays money out to cover those costs. Conversely, a business using the accrual method of accounting will record income and expenses when a transaction occurs, such as when it sends out an invoice or ships a product, regardless of whether or not the business actually receives or makes a payment at the time the transaction occurs. The business will adjust the income and expenses in the future when payment is made or performance is complete in full or in part.
Traditionally, the cash method of accounting is preferable for businesses with receivables that exceed their payables, such as professional services firms, because it allows them to recognize income when they actually have payment in hand rather than before they receive payment. Conversely, the accrual method of accounting is more suitable for businesses that buy goods or services on credit from suppliers or that receive payments up front from customers before performing services or delivering goods and, therefore, will most likely have payables that are greater than their receivables.
Changes under Tax Reform
For tax years prior to Dec. 31, 2017, businesses with average annual gross revenue of $5 million or less during the prior three-year period qualified to use the cash method of accounting. However, the TCJA increases this gross receipt threshold to $25 million or less, beginning in 2018, while also carving out exceptions for taxpayers who were previously required to use certain accounting rules related to how to account for inventories, how to capitalize costs and how to treat certain long-term contracts.
In addition, as long as a business falls below the $25 million or less gross receipts test, it may treat inventories as non-incidental materials and supplies or move to a method of accounting that conforms to its “applicable financial statement” method, rather than being required under prior law to follow uniform capitalization rules (UNICAP) and capitalize expenses as part of their inventory costs for tax purposes. As a result, taxpayers that produce real or tangible personal property as inventory for resale may ultimately expense items of inventory in the year of acquisition rather than waiting for it to be sold. When taxpayers qualify, they may deduct non-incidental materials and supplies in the year in which they first use or consume those materials in their operations. In addition to exempting the UNICAP rules to inventory, the new law provides taxpayers with gross revenue below at or below the new $25 million threshold with relief from the other aspects of Section 263A, including with respect to self-constructed assets.
The TCJA’s provisions relating to a change in accounting method also have a significant impact on real estate businesses that now meet the larger gross receipts test of $25 million or less. More specifically, the law expands the universe of developers and home construction businesses that are considered “small contractors” and that are now exempt from using the percentage-of-completion method for accounting for construction contracts that they expect to complete within a two-year period. This change in accounting method provides real estate businesses with the ability to defer income until the point in time that they complete the contract, rather than requiring them to recognize income before construction is finished.
Requesting an Automatic Accounting Change
In an effort to reduce paperwork and ease administrative burdens, the IRS has a streamlined process for eligible taxpayers to request an “automatic” change in the timing of when they may recognize items of income and when they may take deductions. All taxpayers need to do is to complete an application using IRS Form 3115 by the September extended tax-filing deadline for partnerships and S Corporations, or the October extended deadline for C Corporations. There is no fee required for requesting an automatic change from the IRS, and by filing an automatic change in accounting method, taxpayers who meet the income limits do not need to wait for written approval from the IRS.
The expansion of the gross revenue test under the TCJA opens the door for a greater number of businesses to ease their recordkeeping requirements and qualify for an automatic change to the cash method of accounting for federal income tax purposes. The benefits of deferring income, coupled with the tax law’s reduced corporate and individual tax rates, amplify the time value of money that qualifying taxpayers will receive under the new law. However, this provision of the tax reform is not without complexity. As a result, taxpayers should meet with qualified tax advisors and accountants to understand and realize the benefits and potential tax savings they may reap from the new law.
About the Author: Richard E. Cabrera, JD, CPA, is a senior manager with Berkowitz Pollack Brant’s Tax Services practice, where he provides tax planning, consulting, and mergers and acquisition services to businesses located in the U.S. and abroad. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or via email at firstname.lastname@example.org.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.