The Tax Reform Act of 2017 includes many favorable provisions intending to simplify the accounting methods for small businesses. For these provisions effective for tax years beginning after December 31, 2017, the definition of a small business is one with annual average gross receipts not exceeding $25 million for the three prior tax years. The following information highlights those changes.
Cash Method of Accounting
A taxpayer has to use the accrual method of accounting if inventory is a material income-producing item.
With tax reform, any small business may use the cash method of accounting even if inventory was a material income-producing item. The clear reflection of income requirement is implied to have been met in the fact the legislation allows the exception for small businesses to use the cash method of accounting.
It is possible that changing from the accrual method of accounting to the cash method of accounting may cause a significant decrease in your 2018 taxable income.
Prior to tax reform, taxpayers had to account for inventory if the production, purchase, or sale of merchandise was a material income-producing item. Once inventory was a material income-producing item, the taxpayer had to account for the inventory and use the accrual method of accounting to clearly reflect income.
With tax reform, taxpayers that meet the definition of a small business need not account for inventory. The requirement that income be clearly reflected is treated as met if the method of accounting:
- treats the inventory as non-incidental materials and supplies or
- conforms to the taxpayer’s method of accounting reflected in its audited financial statements prepared under generally accepted accounting principles, its financial statements prepared based on international financial reporting standards and filed with a foreign government or a financial statement filed with any regulatory body or
- if there are no financial statements, the method of accounting used in the taxpayer’s books and records.
Treating the inventory as non-incidental materials and supplies is similar to accounting for the inventory in that the materials and supplies are expensed as consumed or used.
Uniform Capitalization (UNICAP)
The UNICAP rules require certain direct and indirect costs allocable to the production or purchase of real or tangible personal property to be included in the cost of the inventory or the basis of the property.
Prior to tax reform, certain small businesses were exempt from the UNICAP rules.
With tax reform, the definition of small business has expanded to allow them to be exempt from the UNICAP rules.
Income from long-term contracts must be determined under the percentage-of-completion method. A long-term contract is defined as any contract for the manufacture, building, installation, or construction of property if the contract is not completed within the taxable year in which the contract is entered into. There are exceptions for home construction contracts and for small construction contracts from the requirement to use the percentage-of-completion.
Tax reform expanded the definition of small construction contracts not required to use the percentage-of-completion method. Small construction contracts under the exception are those for the construction or improvement of real property if the $25 million average annual gross receipts test is met and the contract:
- is expected to be completed within two years of commencement of the contract and
- is performed by a taxpayer that meets the new definition of small business.
Small construction contracts must still use the percentage of completion method of accounting for the alternative minimum tax. Home construction contracts need not use percentage of completion method of accounting for the alternative minimum tax.
Change in accounting method
Any change in accounting method requires IRS consent. IRS issued a Revenue Procedure to indicate the accounting method changes noted above are treated as initiated by the taxpayer and made with IRS consent. That means the taxpayer need not ask IRS for permission to change the accounting method. The change can be made automatically on a 2018 income tax return by completing a Form 3115.
An adjustment for the provisions above, except for the small construction contract that reduces taxable income is considered all in one year. An adjustment that increases taxable income is taken into income over a four-year period. There is no adjustment from the change for small construction contracts. They will use the new method for contracts entered into after December 31, 2017.
There are many planning opportunities for small businesses allowing them to simplify their filing requirements and save tax dollars. We can assist you by preparing an analysis to determine, which, if any, of these changes will benefit you in 2018. We can also prepare Form 3115. Please contact us at 401-831-0500 with questions or to help your business.