Tax Accounting-Accounting Methods

By Andrew T. Moon, CPA, Senior Tax Manager and Michele Loretto, CPA, Tax Manager

Have your gross receipts typically been around $25 million or less? 

If so, you may have the ability to take advantage of new accounting methods that may not have been available to you before, or exempt yourself from previously required accounting methods.  The following are a brief list of the most commonly found methods.  See additional information provided later for more specifics on each one.

  • Ability to use the cash method of accounting
  • Exception from the requirement to account for inventories under Code Sec. 471
  • Exception from the requirement to apply UNICAP rules (Code Sec. 263A)
  • Exception from the requirement to use the percentage-of-completion method for small construction contracts 

Previously, a business may not have been able to take advantage of these exceptions unless their gross receipts were under a much lower threshold.  Depending on the industry and/or the type of business entity, the gross receipt threshold allowing them to be exempt from these accounting methods was either $1 million, $5 million or $10 million.  With the new threshold being raised to $25 million and applying to all industries and types of business entities there will be many more taxpayers that can take advantage of these new rules.

What if my gross receipts went over $25 million, can I still qualify?

The gross receipts test is satisfied for the tax year if the average annual gross receipts (net of returns and allowances) for the three immediately preceding tax-year periods is under the prescribed dollar limit.  For tax years beginning after December 31, 2017 the prescribed dollar limit is $25 million and is subject to adjustment for inflation after December 31, 2018.

This means that even though your gross receipts went over $25 million in a prior year you may still qualify.  Below is an example of how this calculation works.

Company T wants to know if, for their upcoming tax year ending December 31, 2018, they can take advantage of the various accounting method changes that were made available in the new Tax Cuts and Jobs Act for companies with less than $25 million in gross receipts. 

Company T’s gross receipts for the past 3 tax years were as follows:

2017 - $28 million

2016 - $24 million

2015 - $20 million

Company T’s average annual gross receipts during the three-year testing period are calculated as follows:

28 + 24 + 20   = $24 million
3                      

Under the new rules instituted by the Tax Cuts and Jobs Act, because Company T’s average gross receipts don’t exceed $25 million it would qualify to take advantage of the various accounting method changes that were made available for companies with less than $25 million in gross receipts

What if I have multiple businesses?  Can they still qualify for these new rules?

Long answer short is, it depends.  If you own multiple businesses then they may need to be looked at as a group when applying the gross receipts test.  Businesses that would be treated as a single employer under IRC Sec. 52(a) or (b) or IRC Sec. 414(m) or (o) must aggregate gross receipts for the gross receipts test. For this purpose, taxpayers are under common control if there is more than 50% ownership. However, intercompany sales do not have to be included.

My business is new and hasn’t been open for 3 years yet.  Can I still qualify?

Yes, if a business has not been in existence for the entire 3 year period then the testing period will be applied on the basis of the period during which the business has been in existence.  Gross receipts for any taxable year of less than 12 months will need to be annualized by multiplying the gross receipts for the short period by 12 and dividing the result by the number of months in the short period.

I have a Schedule C business.  Can I qualify?

Yes, a taxpayer that is not a corporation or partnership is allowed to apply the gross receipts test in the same manner.

Do I need to coordinate my tax returns to my financial statements?

If you are an accrual basis taxpayer, you will need to recognize income on a tax return no later than the tax year that it is recognized on an applicable financial statement or another financial statement as specified by the IRS.  Applicable financial statements include financial statements prepared on the on the basis of Generally Accepted Accounting Principles or International Financial Reporting Standards.

Depending on your specific circumstances this could have an effect on your ability to defer income and lower your taxes in a given year.  It will be important to determine whether or not you have an applicable financial statement, and if so, whether or not you should change your method of accounting for income tax purposes as well as for your financial statements.

How do I take advantage of the ability to use the cash method of accounting and what does this mean to me?

If you are not currently a cash method taxpayer and qualify under the new rules to become one, you must file an application with the IRS in order to begin using the cash method of accounting.  This application will be filed on a Form 3115 “Application for Change in Accounting Method” and will be filed at the time you file your tax return for the first year you use the cash method of accounting.

Under the cash method of accounting you don’t have to recognize income until you actually receive the revenue and you recognize your expenses at the time you pay them.  This can be advantageous as it can provide for more control over how much income a business will have in any given year by allowing the business to defer income recognition by not billing clients until after year end or by accelerating expenses by paying them before year end.

How do I take advantage of the exception from the requirement to account for inventories under Code Sec. 471 and what does this mean to me?

If you are currently required to account for inventories under Code Sec. 471 and qualify under the new rules as exempt from this requirement, you must file an application with the IRS in order to take advantage of this exemption.  This application will be filed on a Form 3115 “Application for Change in Accounting Method” and will be filed at the time you file your tax return for the first year Code Sec. 471 no longer applies to you.

Under these new rules you may no longer need to account for inventories under Code Sec. 471, but rather may use a method of accounting for inventories that either treats inventories as non-incidental materials and supplies (which are expensed when they are used or consumed), or conforms to you financial accounting treatment of inventories either in the taxpayer’s applicable financial statement or, if there isn’t an applicable financial statement, the method of accounting used in the taxpayer’s books and records prepared in accordance with the taxpayer’s accounting procedures.  These new rules provide opportunity to drastically simplify your method of accounting for inventories providing lower administrative expenses related to inventory tracking and accounting that may not provide any value to the business operations.

How do I take advantage of the exception from the requirement to apply UNICAP rules (Code Sec. 263A) and what does this mean to me?

If you are currently required to apply the rules of Code Sec. 263A and qualify under the new rules as exempt from this requirement, you must file an application with the IRS in order to take advantage of this exemption.  This application will be filed on a Form 3115 “Application for Change in Accounting Method” and will be filed at the time you file your tax return for the first year you are exempt from the application of Code Sec. 263A.

Under these new rules you no longer need to allocate direct and certain indirect costs to real or tangible personal property produced by you are acquired for resale.  These new rules provide opportunity to drastically simplify your method of accounting for inventories providing lower administrative expenses related to inventory tracking and accounting that may not provide any value to the business operations.  Additionally they allow more expenses to be deducted in the tax year in which they occur rather than being required to capitalize them in ending inventory or capitalized and depreciated.

How do I take advantage of the exception from the requirement to use the percentage-of-completion method for small construction contracts and what does this mean to me?

If you are currently required to account for construction contracts using the percentage-of-completion method and qualify under the new rules as exempt from this requirement, you must file an application with the IRS in order to take advantage of this exemption.  This application will be filed on a Form 3115 “Application for Change in Accounting Method” and will be filed at the time you file your tax return for the first year you are exempt from the requirement to use the percentage-of-completion method.

This can be advantageous as it can provide for the ability of the business to recognize income using an exempt contract method which could include the completed contract method, the exempt-contract percentage-of-completion method, the percentage-of-completion method, or any other permissible method.  This provides the business with more opportunity to control when income is recognized by, for example, using the completed contract method and waiting to complete a contract until after year end.

What are considered “gross receipts”?

The term gross receipts as used in the $25 million exception means gross receipts in the tax year for which the receipts are properly recognized under the taxpayer's accounting method used in that tax year.  For example, if Company T is trying to determine if it qualifies for the $25 million exception in 2018 it would take the average gross receipts of the 3 years immediately preceding 2018, which would be 2017, 2016 and 2015.  If Company T was required to use the accrual method of accounting in 2017 and 2016, but was allowed to and did in fact use the cash method of accounting in 2015 then the gross receipts used in the calculation would be determined using the accrual method of accounting for 2017 and 2016 and the cash method of accounting for 2015 as these were Company T’s accounting methods used in those tax years.

Gross receipts includes total sales and all amounts received for services.  It also includes any income from investments, and from incidental or outside sources.  For example, gross receipts include interest (including original issue discount and tax-exempt interest under Code Sec. 103), dividends, rents, royalties, and annuities, regardless of whether the amounts are derived in the ordinary course of the taxpayer's trade or business.

Gross receipts are not reduced by costs of goods sold or by the cost of capital assets sold (unless the property is a depreciable business asset described in Code Sec. 1221(a)(2)).  However, gross receipts can be reduced for any returns and allowances made during the year.  With respect to sales of capital assets or depreciable business assets, gross receipts are reduced by the taxpayer's adjusted basis in the property.

Gross receipts do not include:

  • The repayment of a loan or similar instrument (e.g., a repayment of the principal amount of a loan held by a commercial lender).
  • Amounts received by the taxpayer with respect to sales tax or other similar state and local taxes which, under the applicable state or local law, is legally imposed on the purchaser of the good or service. If, in contrast, the tax is imposed on the taxpayer under the applicable law, then gross receipts include the amounts received that are allocable to the payment of the tax.

My business has large losses.  I heard I may no longer be able to fully deduct these, is this true?

For taxpayers other than a C Corporation, the new Tax Cuts and Jobs Act adds limitations to your ability to deduct business losses for tax years beginning after December 31, 2017.  Any losses limited under this new rule are called excess business losses.  In essence, a taxpayer is not allowed to deduct aggregate business losses in excess of $250,000; or $500,000 if filing a joint return.  Any loss that is disallowed as an excess business loss is treated as an NOL carryover to the following tax year under Code Sec. 172.

This essentially limits the ability of taxpayers to use trade or business losses to offset a taxpayers other non-business income for that year.  However, it should be noted that if married taxpayers file a joint return, the losses (up to the $500,000 limit) of one spouse can be used to offset the other spouse’s non-business income.  If a husband and wife have separate businesses and they file a joint return, then the income/loss from all of the couple’s businesses must be aggregated.

For partnerships or S Corporations, the excess business loss limitation rules apply at the partner or shareholder level.

The excess business loss rules are also applied after the application of the passive loss rules of Code Sec. 469.

For tax years beginning after December 31, 2018 the $250,000 and $500,000 threshhold amounts will be adjusted for inflation.

I’m a brewer/distiller/vintner, are there any special changes in the tax reform that I need to know about specific to my business?

Yes!  Under the new Tax Cuts and Jobs Act the application of the UNICAP interest capitalization rules will no longer apply to the aging period for beer, wine and distilled spirits (except those spirits that are unfit for use for beverage purposes).  These new rules are effective for interest paid or accrued in calendar years 2018 and 2019.

The practical impact of this exclusion is that beer, wine, and distilled spirits won't be considered “designated property” if the production period (without taking into account any aging period) doesn't exceed two years (one year if it has a cost in excess of $1 million dollars). Thus, the UNICAP rules won't apply and these producers will be able to deduct their interest expenses instead of capitalizing them under the UNICAP rules.  However, if the beer, wine, or distilled spirits has a production period that exceeds two years (one year if it has a cost in excess of $1 million) even without taking into consideration the aging period, that property will still be considered “designated property” and the producer will have to capitalize interest in accordance with the UNICAP rules, albeit possible over a shorter time period.

Am I still able to deduct all of my R&D expenses?

There were some changes related to R&D expenses, however these do not take effect until tax years beginning after December 31, 2021.  In essence the new rules still allow you to deduct all of your R&D expenses, however you will no longer be able to deduct them in the year in which they are incurred.  Under the new rules, R&D expenses will now need to be capitalized and amortized over a period of 5 years (15 years for expenditures attributable to foreign research).

The good news here is that due to the effect of this change not taking place until 2022 there is still time to plan for this change.  Every business should take time to review their planned projects and see if there is any opportunity to accelerate these projects to take place before these new rules take effect, or at the very least understand what the financial effect of these new rules will be on future projects.

For more information, please contact Andy Moon, CPA, Senior Tax Manager (amoon@tsacpa.com, or Michele Loretto, CPA, Tax Manager (mloretto@tsacpa.com); or call 716.633.1373.

 


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