The IRS and the Treasury released the final regulation (TD9942) on January 5, 2021, guiding the implementation of the various simplifying provisions of the law, known as the Tax Cuts and Jobs Act (TCJA). The final regulations generally adopt the proposed regulations published in the Federal Register on August 5, 2020, but with various modifications. These simplification provisions, which apply to small business taxpayers, extend the use of the general cash method of accounting and grant exemptions to inventory methods in accordance with Section. 471, and the use of the percentage of completion method for certain long-term construction contracts in accordance with Sec. 460. A qualified small business taxpayer is also exempt from Section 163(j), which limits the deductibility of expenses with commercial interest. These changes and their implications for the classification of small business taxpayers are discussed below.
Qualification for small business taxpayer exemption
These simplified tax accounting rules apply to taxpayers with an average gross income of $25 million (adjusted for inflation) or less for the three-year tax period ending before the current fiscal year (gross test income; section 448 (c)(1)). The inflation-adjusted limit is $26 million for fiscal years beginning in 2019, 2020, and 2021. Changes to any of these simplified methods typically require the submission of one or more Forms 3115 with the IRS. The final regulations generally maintain the existing rules on the calculation of the gross income test, including the definition of gross income, the obligation to add gross income to certain other persons (Section 448 (c)(2)), and the prorated amounts for short tax years.
Tax haven annual election
Taxpayers treated as tax havens are prohibited from using the cash method of accounting and cannot be treated as small business taxpayers, even if they meet the annual gross income test. A tax shelter, as defined in Section. 448 (d)(3) and 461 (i)(3) and Reg. Sec. 1.448-2 (b)(2), is one of the following:
• Any company (except C Corps) if the offering of interest is required to be registered with a federal or state body that has the power to regulate the offering;
• Any syndicate (per article 1256 (e)(3)(B));
• Any tax shelter (defined in article 6662 (d)(2)(C)(ii)).
A syndicate is generally defined as any partnership or other entity (other than a C corporation) if more than 35% of the entity's losses during the year are attributed to limited partnerships or owners of limited liability companies. It is determined annually whether an entity or a syndicate. While many commentators have called for changes to the definition of syndicate or tax shelter, the final regulation did not establish it as the IRS and Treasury ruled such changes would be contrary to congressional intent.
A cash-method accounting taxpayer who typically has taxable income may suffer an unexpected tax loss in an abnormal year but return taxable income in a subsequent year. For example, if the taxpayer attributes more than 35% of the tax damage to his limited partners or limited entrepreneurs in the year of the abnormal tax damage, the taxpayer would comply with the definition of a syndicate and therefore would not be able to use the cash method of accounting according to the Sec. 448(a)(3). However, the same taxpayer may be authorized to use the cash method during the following fiscal year if he is in a situation of taxable income.
Although a taxpayer in this situation would generally have to switch to the accrual method for the year in which the loss occurred, the final regulation provides for some exemption, allowing the taxpayer to make an annual election to use the allocated taxable income or loss of the immediately previous fiscal year, instead of the current fiscal year, to determine whether the taxpayer is a syndicate within the meaning of Section 448 of the current fiscal year. This election is more favorable to the taxpayer than the proposed regulation choice, which, when made, applied to all subsequent years unless the IRS permits a revocation.
The annual election is made by attaching a timely return to the original federal income tax return (including any extensions) and is irrevocable once it has occurred for a given fiscal year. However, it will not be too much relief for taxpayers who suffer tax losses year after year.
Amendments to final regulations in accordance with Section 448 Requirements for the use of the accrual method of accounting
The final rules provide that for the purposes of section 448, a taxpayer who uses the cash method of accounting for some items, but not all, are considered to be on the cash method of accounting. Therefore, a C corporation or a partnership with a C corporation partner cannot recognize any of its income or expense using the cash method if its average annual gross income exceeds $26 million. As a result, some small business taxpayers may find themselves in a situation where they fail the gross income test in a given year and then have to change their cash method of accounting but may again be eligible to use the cash method in a year.
The proposed regulation released in August 2020 limited the use of an automatic switchover to revert to the cash method of accounting if a taxpayer has already filed a switch over to using a general accrual method over five years. However, the final regulation removes the five-year eligibility requirement for a taxpayer to switch from the general cash method of accounting, as required by section 448. The preamble to the final regulation indicates that future guidelines procedures will deal with changes in accounting policy for taxpayers that voluntarily choose to switch from cash methods to accrual methods and taxpayers who are required to use an accrual method according to section 448.
Small Business Taxpayer Exemption from Section 471
In accordance with section 471 and Reg. Sec. 1.471-1, the inventory must be used in a fiscal year during which the production, purchase, or sale of goods is an income-generating factor. The TCJA has allowed taxpayers who have passed the gross income test and who are not tax havens within the meaning of Section 448 to be exempt from Section 471 and to use one of the following methods:
Treat stocks as non-incidental materials and goods (NIMS inventory method); or
Conform to the inventory method used in applicable financial statements (AFS)(AFS Sec. 471(c) inventory method) or the method in taxpayer books and records prepared in accordance with accounting procedures if you do not have any AFS (non-AFS Section 471(c)inventory method).
Small taxpayers must note that the exemption from inventory holding under Section 471 does not necessarily translate into an immediate tax deduction for all inventory costs.
For taxpayers who choose to use the NIMS inventory method, the final regulation specifies that while these quantities are treated as non-incidental supplies and materials, they still retain their inventory status. The final regulation does not change the position that inventories treated as non-incidental materials and goods are "used and consumed" during the period when the taxpayer delivers the inventory to a customer, and costs are recovered through costs of goods sold that year or the tax year in which the expense is paid or incurred (according to the taxpayer's accounting method), regardless of which is later. The final regulation maintains the general rule of the proposed regulations that the "used and consumed" limit for NIMS is only reached when the taxpayer sells the stock.
Therefore, producers who transform raw materials into in-process or finished products by the end of the year, but have not yet sold their stocks, will not be able to deduct costs in accordance with the final regulations.
Some manufacturing taxpayers may have taken the position that raw materials are deductible when they are first used and consumed in the manufacturing process (for example, when items enter the processing phase); these taxpayers may be required to submit a change in method to comply with the final regulations. In addition, the final rule specifies that taxpayers using the NIMS inventory method should only capitalize on the direct material costs of properties produced or purchased for resale; therefore, direct or indirect labor costs should not be capitalized using this method and maybe deductible when incurred or paid.
The final regulation specifies that taxpayers can determine inventory cost amounts using a specific identification method, first-in, first-out, or average cost method but cannot use the latter or any other method described in section 471 or its regulations, including lowest cost or market method. In addition, inventory treated as incidental materials and supplies is not eligible under Reg. Sec. 1.263 (a)-1(f) de minimis safe harbor election because this choice specifically covers stocks.
As for taxpayers who, on the other hand, choose to follow AFS, Sec. 471(c) inventory method or non-AFS inventory method Sec. 471 (c), the final regulations specify that costs which should normally be capitalized for inventory in accordance with section 471 (a) but which are recorded as an AFS contribution, or in the books and records, may also be recorded like tax expenditures. This method can be beneficial to taxpayers who are currently spending inventory costs for accounting purposes, as taxes can often be the same. In particular, a taxpayer should ensure that inventory costs capitalized or recognized in AFS or its books and records are paid or incurred in accordance with the taxpayer's accounting method for tax purposes.
For taxpayers without AFS who choose to follow the non-AFS. Sec. 471(c) inventory method, if a physical count is made but is not actually used to capitalize and allocate inventory costs, these amounts may be deductible in the year paid or incurred. However, if a taxpayer uses a physical count to assign costs to inventory and then makes a journal entry to spend those costs in the financial statements, that journal entry is ignored for tax purposes, forcing the taxpayer to capitalize the costs physical count allocation.
Other simplifying provisions
The TCJA has also exempted small business taxpayers from the rules in Sec. 263A of UNICAP. In addition, in accordance with Sec. 460(e)(1)(B), for periods beginning after December 31, 2017, qualifying small business taxpayers are also exempt from using the percentage of completion method and can use a completion method for construction contracts which are expected to be completed within two years from the contract start date. The exempt contracting methods are cash, commission, and full contract. Please note that this exemption applies to long-term contracts involving real estate construction but does not apply to long-term production contracts.
Effective date
The rules apply to fiscal years beginning on or after the date of publication of the final rules in the Federal Register on January 5, 2021. The taxpayer may elect to apply the final regulations to the first fiscal year. After December 31, 2017, and before January 5, 2021, it is understood that if the taxpayer applies any aspect of the final regulation in accordance with the specific Code provision, the taxpayer must comply with all applicable rules in the regulations relating to the Code provision for the current and all subsequent tax years and the administrative procedures referred to in Regs. Sec. 1.446-1(e)(3)(ii) to present a change in accounting policy. Alternatively, subject to the same limitations, the taxpayer can use the proposed regulation for a fiscal year of that period.
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