by Kathleen Meade, Wendy Landrum, and Patrick Balthazor
Baker Tilly Virchow Krause, LLP is an IMA Member
The Tax Cuts and Jobs Act (the Act) favorably amended certain tax provisions applicable to eligible small business taxpayers to, among other things, increase the “small taxpayer” gross receipts threshold to $25 million. This change enables more taxpayers to use the cash method of accounting and can exempt them from the often costly and onerous requirements of capitalizing costs under section 263A, complying with the section 460 percentage of completion (PCM) rules and accounting for inventories under section 471. On Aug. 3, 2018, the IRS issued Rev. Proc. 2018-40, which permits eligible small business taxpayers to obtain automatic IRS consent to implement the small taxpayer provisions under the Act, generally effective for tax years beginning after Dec. 31, 2017. Key provisions of the four new accounting method changes are highlighted below.
New Automatic Method Changes for Small Business Taxpayers
Section 15.18 – Change to overall cash method: This change applies to a small business taxpayer (defined as a taxpayer that has average annual gross receipts for the three prior taxable years of no more than $25 million) that wants to change its overall method of accounting from an overall accrual method of accounting to the overall cash method of accounting for a trade or business. Note that receipts are adjusted for inflation and, as under prior law, are determined on an aggregate basis for affiliated groups. Taxpayers that are members of affiliated groups should carefully analyze their ownership structures and gross receipts levels to ensure the small taxpayer eligibility threshold is not exceeded.
Ineligible taxpayers: Taxpayers precluded from making this change to the overall cash method include:
- tax shelters described in section 448(d)(3)
- taxpayers otherwise prohibited from using the overall cash method or required under the Code or regulations to use another method of accounting (e.g., sections 475 and 1272)
- certain banks
Note, however, that banks and farmers may be eligible to automatically change to the overall cash/hybrid method or the overall cash method, respectively, under other sections of Rev. Proc. 2018-31. See sections 15.12 (banks) and 15.13 (farmers).
Section 12.16 – Exception from capitalizing section 263A costs: This change applies to a small business taxpayer, described above, that capitalizes costs under section 263A (UNICAP) and wants to change to a method of accounting that no longer capitalizes these costs. Note that the change to discontinue capitalizing UNICAP costs also applies to producers and to self-constructed assets described in section 263A(i). Conversely, this change does not apply to section 460 home construction contracts, which nonetheless may be eligible for the UNICAP exemption method change in new section 19.01, discussed below.
Section 22.19 – Exception from accounting for inventories under section 471: This change applies to a small business taxpayer, described above, that wants to change its section 471 method of accounting for inventory to either:
- treat inventory as non-incidental materials and supplies under Treas. Reg. section 1.162-3 or;
- conform to the taxpayer’s method of accounting used in its applicable financial statements (AFS) or, if the taxpayer does not have an AFS, in the books and records prepared in accordance with the taxpayer’s accounting procedures
No ruling protection: IRS consent granted under this new procedure does not include a ruling that the new method of accounting is permissible. Thus, a change made under this section may be challenged on exam and taxpayers should therefore be prepared to support their new method(s) of accounting with the appropriate legal authority.
Note: The exception from accounting for inventories under section 471 does not mean that inventory can simply be expensed or otherwise not accounted for as an asset unless it is incidental. Nor can it be expensed under the cash method of accounting.
Section 19.01 – Certain long-term contracts exempt from PCM and section 263A: This change applies to a small business taxpayer, described above, that wants to either:
- change its method of accounting for exempt long-term construction contracts from PCM or
- stop capitalizing section 263A costs for section 460 home construction contracts
Cutoff method required: Unlike the other small business taxpayer changes discussed above that are implemented with a section 481(a) adjustment, the changes under this section are affected on a cutoff basis (i.e., only for eligible long-term construction contracts entered into after Dec. 31, 2017, in taxable years ending after Dec. 31, 2017). Conversely, exempt long-term contracts entered into prior to that time continue to be accounted for using the taxpayer’s former method of accounting.
Changes requiring IRS consent: The procedures also clarify when IRS consent (i.e., Form 3115) is required to make the change(s) under this section. Specifically, the procedures provide that only a taxpayer that meets the above described gross receipts test, previously adopted PCM for exempt long-term construction contracts, and wants to change to another permissible exempt contract method of accounting is required to request IRS consent to change its method of accounting for long-term contracts under the new procedures. Likewise, a taxpayer who meets the gross receipts test and enters into a home construction contract that it expects to complete within two years requires consent to change its method of accounting to discontinue capitalizing section 263A costs only if the taxpayer has previously applied section 263A to home construction contracts that are exempt from UNICAP and wants to discontinue capitalizing section 263A costs for those contracts. Conversely, the procedures are inapplicable in the first taxable year that the taxpayer fails the gross receipts test, in which case it must use the PCM to account for nonresidential long-term construction contracts entered into in that year, but must continue to use its exempt contract method of accounting for its existing exempt long-term construction contracts. Similarly, in the taxable year that a taxpayer first meets the gross receipts test, the taxpayer can use a permissible exempt contract method of accounting for long-term construction contracts entered into in that year that it expects to complete within two years. See Rev. Rul. 92-28.
Reduced compliance burden: Rev. Proc. 2018-40 includes several favorable provisions intended to provide flexibility and to simplify and reduce the compliance burden of implementing tax changes related to the new small business taxpayer provisions, including the following:
- Reduced filing requirements: Certain lines of Form 3115 are not required to be completed. A single Form 3115 may be filed for multiple changes requested under the new procedures provided the taxpayer enters the designated automatic accounting method change numbers for the changes on the appropriate line of Form 3115.
- “Same change” eligibility rule temporarily inapplicable: The rule prohibiting the filing of an automatic method change if the same item was changed within the past five tax years (including the year of change) is waived for changes filed for a taxpayer’s first, second or third taxable year ending on or after Dec. 31, 2017.
- Existing section 481(a) adjustments: Taxpayers with section 481(a) adjustments from prior related accounting method changes (e.g., taxpayer filing change from accrual to cash method that has a positive section 481(a) adjustment from a previous change from cash to accrual method) may choose to either account for the prior adjustment separately from the new section 481(a) adjustment or, alternatively, may combine or net the prior adjustment with the new section481(a) adjustment(s) provided they indicate the choice to combine/net adjustments in the Form 3115 disclosure statements for line 26.
- Limited time to convert a non-automatic Form 3115: Taxpayers that filed a non-automatic Form 3115 requesting change(s) covered in the new procedures prior to Aug. 3, 2018, that is still pending with the IRS as of that date, may re-file the application as an automatic change, provided they:
- otherwise meet the automatic change eligibility rules,
- notify the IRS before the later of Sept. 2, 2018, or the issuance date of a ruling letter granting or denying consent for the change (if any), and
- file the automatic Form 3115, along with a copy of the national office letter sent acknowledging the taxpayer’s request to convert, by the earlier of 30 days after the date of the national office’s letter acknowledging the conversion request or the due date of the duplicate copy of Form 3115.
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