On December 23, 2020, the IRS and Treasury released an advance copy of final regulations to provide guidance for small business taxpayers to implement several simplifying exemptions enacted by the 2017 tax reform legislation known as the Tax Cuts and Jobs Act (TCJA); the regulations were published in the Federal Register on January 5, 2021. These simplifying provisions include the use of the overall cash method of accounting, as well as exemptions from inventory methods under Internal Revenue Code Section 471, from uniform capitalization rules under Section 263A (UNICAP) and from the use of the percentage-of-completion method for certain long-term construction contracts under Section 460. A qualifying small business taxpayer is also exempt from Section 163(j), which limits the deductibility of business interest expense.
The final regulations make several changes to the proposed regulations released on July 20, 2020.
The final regulations are generally applicable to taxable years beginning on or after the date the regulations were published in the Federal Register, i.e., for taxable years beginning on or after January 5, 2021 and, therefore, impact calendar year taxpayers starting in 2022. However, taxpayers have the option of relying on the final regulations for taxable years beginning after December 31, 2017, as long as the rules are applied consistently and to all subsequent taxable years.
While the final regulations provide additional clarity on the positions the IRS is taking, we anticipate that taxpayers will continue to encounter significant complexities associated with implementing some of these rules, particularly the exemption from Section 471 discussed below.
This alert summarizes some of the key highlights of the final rules.
Who Qualifies for the Small Business Taxpayer Exemptions?
Small business taxpayers are defined as those having average annual gross receipts for the three taxable year period ending before the current taxable year not exceeding $25 million, adjusted for inflation (gross receipts test). For taxable years beginning in 2019, 2020 and 2021, the gross receipts amount has been adjusted to $26 million. The final regulations generally retain the existing rules related to the computation of the gross receipts test, including the definition of gross receipts, the requirement to aggregate gross receipts with other entities and the proration of amounts for short taxable years.
A tax shelter is always prohibited from using the small business taxpayer exemptions, regardless of the amount of its gross receipts. A tax shelter is defined to include a syndicate under Section 1256(e)(3)(B), which is a partnership or other entity (other than a C corporation), of which more than 35% of that entity’s losses during the taxable year are allocated to limited partners or limited entrepreneurs.
In response to several commenters’ concerns regarding the broad scope of the tax shelter rules, the final regulations do not waive the tax shelter or syndicate rules, but offer some relief by allowing taxpayers to make an annual election to use their prior year taxable income/loss for purposes of determining their status as a syndicate. This annual election can be helpful for taxpayers that are generally taxable but happen to have a one-off year with a taxable loss, but may not provide much relief for taxpayers that generate taxable losses year after year.
What Changed in the Final Regulations about the Section 448 Requirements to Use the Accrual Method of Accounting?
In general, Section 448 prohibits a C corporation, partnership with a C corporation partner or tax shelter from using the overall cash receipts and disbursements method of accounting. However, C corporations and partnerships with a C corporation partner that meet the gross receipts test for the current year may use the overall cash method. The final regulations provide that for purposes of Section 448, a taxpayer that uses the cash method for some, but not all, items is considered to be on the cash method of accounting. Accordingly, a C corporation taxpayer or partnership with a C corporation partner may not account for any of its income or expense items using the cash method if its average annual gross receipts exceeds $26 million.
Additionally, the proposed regulations issued in July 2020 had limited the use of an automatic change to switch to the cash method of accounting if a taxpayer had previously filed a change to use the accrual method within a five-year period. This meant that if a taxpayer that initially qualified as a small business taxpayer exceeded the gross receipts threshold or triggered the tax shelter rule and was required to file a method change to switch to accrual, it would be required to remain on the accrual method for the next five years, even if its gross receipts dropped below the gross receipts threshold during that five-year period, unless it was willing to file a non-automatic method change. The final regulations remove this expansive restriction but note that taxpayers that voluntarily choose to switch between cash and accrual versus being required to use accrual under Section 448 will likely be treated differently in future procedural guidance.
How Do the Small Business Exemptions Apply to Taxpayers with Inventory?
Under Section 471, inventories are required in a taxable year in which the production, purchase or sale of merchandise is an income-producing factor; if inventories are required, an accrual method must be used for purchases and sales. The TCJA permitted taxpayers that meet the gross receipts test and that are not tax shelters under Section 448 to be exempt from Section 471 and to use certain simplified inventory methods, specifically to either (1) treat its inventory as non-incidental materials and supplies (NIMS) or (2) conform to the inventory method used in its applicable financial statement (AFS), or the taxpayer’s books and records prepared in accordance with its accounting procedures if it does not have an AFS.
For taxpayers that choose to use the NIMS inventory method, the final regulations clarify that even though these amounts are treated as non-incidental materials and supplies, they still retain their character as inventory. Accordingly, these amounts are not eligible for the de minimis safe harbor election under the Section 263(a) regulations (since the election specifically scopes out inventory), to the extent books is already expensing these amounts. However, taxpayers may still be able to use the AFS/books and records method to deduct the amounts.
The final regulations retain the general rule from the proposed regulations that the “used and consumed” threshold for NIMS is only met when the taxpayer sells the inventory. As such, manufacturers that convert raw materials into a work in progress or finished goods by year-end but have not yet sold the inventory will not be able to deduct the costs under the final regulations. In addition, because the final regulations clarify that taxpayers using the NIMS inventory method only have to capitalize direct material costs of the property produced or acquired for resale, direct labor or indirect costs are not required to be capitalized under this method.
With respect to taxpayers that choose to follow their AFS/books and records method, the final regulations clarify that costs that are normally required to be capitalized to inventory under Section 471(a) but are being expensed for AFS/books and records can also be expensed for tax purposes. For example, assume a small business taxpayer does not capitalize freight-in costs for book purposes to inventory. If the taxpayer uses the AFS/books and records method, tax can follow books and expense freight-in costs in the year paid or incurred. Importantly, a taxpayer must ensure that any inventoriable costs capitalized or taken into account for AFS/books and records are paid or incurred under its method of accounting for tax purposes.
For non-AFS taxpayers that decide to follow their books and records treatment, if a physical count is taken but not actually used to capitalize and allocate costs to inventory, then such amounts are potentially deductible in the year paid/incurred. However, if a taxpayer uses a physical count to allocate costs to inventory and then makes a journal entry to expense these costs in its financial statements, this journal entry would be ignored for tax purposes, thus requiring the taxpayer to capitalize in accordance with the physical count allocation.