Proposed regulations issued to implement TCJA small business taxpayer simplified accounting methods

On July 29, 2020, the IRS and Treasury Department released proposed regulations to implement the small business taxpayer simplified accounting method provisions enacted under the Tax Cuts and Jobs Act (TCJA) for tax years beginning after Dec. 31, 2017. The proposed regulations clarify the gross receipts test requirements and provide guidance for implementing the small business taxpayer simplified method provisions. However, positions taken on the treatment of syndicates and the inventory accounting exception are likely to be less favorably received and may create additional uncertainty, complexity and administrative burden for affected taxpayers. Although these regulations are not yet effective, taxpayers may rely on them for taxable years beginning after Dec. 31, 2017, provided they consistently implement all the applicable rules for each adopted provision.

Background

The TCJA favorably amended certain small business taxpayer methods of accounting to increase the gross receipts test threshold to $25 million, index it for inflation and eliminate the requirement that the test be met for all prior tax years. These changes enable more taxpayers to use the cash method of accounting and can exempt them from the often costly and onerous uniform capitalization (UNICAP) requirements, comply with the percentage-of-completion method (PCM) rules and accounting for inventories. However, under the TCJA small business taxpayer provisions, tax shelters (including syndicates) remain ineligible for the small business taxpayer simplified methods regardless of their gross receipts levels. For purposes of this rule, a syndicate is defined as a partnership or other entity (other than a C corporation) which allocates more than 35% of the entity’s losses for the taxable year to limited partners or limited entrepreneurs.

UNICAP exception

The proposed regulations, which are generally taxpayer favorable, remove the now obsolete small reseller exemption and replace it with the UNICAP small business taxpayer exception enacted under the TCJA.

The 2017 tax reform increased the gross receipts threshold to $25 million from $10 million and extended the UNICAP exception to producers as well as resellers. However, unlike the small reseller definition that generally included only receipts from sales of goods and services, the small business taxpayer test includes income from other sources such as interest, dividends, rents and royalties. This has implications for other simplifying conventions under the UNICAP rules. For example, the addition of receipts from other sources may cause a taxpayer to exceed the threshold and require an accounting method change. There are also special rules for farm trades or businesses.

Cash method of accounting

The proposed rules reflect amendments made by the TCJA to the gross receipts test for taxable years beginning after Dec. 31, 2017. As noted, the TCJA increased and indexed the gross receipts test threshold but left other cash method provisions unchanged, such as the short year and aggregation rules and the exclusion of tax shelters from using the cash method. Unfortunately, the proposed rules also contain unfavorable provisions that may significantly limit use of the cash method in certain circumstances.

Syndicates

Consistent with pre-TCJA rules, syndicates are classified as tax shelters ineligible to use the cash method. Syndicate status will only apply for a year in which the entity has a loss and not in a year the entity is profitable and meets the gross receipts test. Thus, a syndicate’s eligibility for the small business taxpayer methods may change yearly and, further, may not be determinable until after year-end, which can significantly complicate tax planning and delay tax reporting for these entities.

Syndicates, or tax shelters, are defined much more broadly than one would anticipate. A “tax shelter” for this purpose is an entity, other than a C corporation, if more than 35% of the losses during the taxable year are allocated to limited partners or limited entrepreneurs. A “limited entrepreneur” is a person who has an interest in an entity (other than a limited partnership interest) and who does not actively participate in the management of the entity.

The proposed regulations may actually increase the likelihood of an entity becoming a syndicate because the section 163(j) business interest limitation does not apply to small business taxpayers. Although intended to simplify the process of determining an entity’s syndicate status, this rule may also create a trap for the unwary if the entity is profitable after taking into account the interest limitation, but has a loss and is a syndicate under the 35% loss rule because the interest deduction is not limited for this purpose.

Affected entities may need to evaluate the trade-offs of implementing strategies to avoid a tax loss (e.g., election to opt out of bonus) versus losing eligibility for the favorable small business taxpayer simplified methods of accounting. To allow adequate time for planning, the proposed regulations provide an election that permits a taxpayer to apply the 35% loss rule by electing to use the allocated taxable income or loss of the immediately preceding taxable year, rather than the current-year amounts.

Taxpayers should carefully consider whether the election is beneficial because it applies for all purposes for which status as a tax shelter is relevant (e.g., section 163(j) interest deduction limitation) and is irrevocable unless the taxpayer obtains IRS permission.

In summary, the proposed rules related to syndicates are generally unfavorable and have implications beyond the small business taxpayer simplified methods (e.g., section 163(j) small business taxpayer provisions). Additionally, entities that move in and out of syndicate status may be prevented from making frequent changes back to the cash method in years they cease to be a syndicate. Consequently, entities treated as syndicates may derive limited or no benefit from the favorable small taxpayer provisions if the proposed rules are finalized in their current form. The Treasury Department and the IRS continue to study the definition of a tax shelter, which may indicate that changes to these rules could be forthcoming.

Inventory exception

The TCJA provided welcome simplification by permitting eligible small business taxpayers to either treat inventory as non-incidental materials and supplies or, alternatively, to follow the inventory 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. The proposed regulations provide guidance for implementing this inventory accounting exception for small business taxpayers. However, several proposed provisions limit book/tax conformity, potentially resulting in added complexity and administrative burden and undermining the legislative intent to simplify inventory accounting for small business taxpayers.

For example, the proposed regulations allow small business taxpayers to treat non-incidental materials and supplies as “used or consumed” in the later of the year the taxpayer provides the item to the customer or the year the items are paid for (cash method) or incurred (accrual method). The regulations also permit taxpayers to use most inventory accounting methods to identify these non-incidental materials and supplies, with the exception of the last in, first out (LIFO) and lower of cost or market (LCM) valuation methods. Finally, guidance is provided on the definition of AFS, the types and amounts of costs that can be recovered for tax purposes, and when such costs may be taken into account.

Some of the additional requirements and restrictions are surprising and contrary to the simplification purpose expressed by the Treasury Department and the IRS. If finalized in their current form, these provisions could require significant taxpayer resources to analyze and reconcile differences between book and tax inventory and accounting records, which may effectively reduce or eliminate the benefit of using the small business simplified inventory method for many.

Long-term contract exceptions

The proposed regulations incorporate amendments made by the TCJA that modify the small construction contract PCM exception and homebuilder UNICAP exemption to increase the gross receipts threshold and revise the PCM lookback rules to reflect the repeal of corporate alternative minimum tax (AMT) and the enactment of base erosion and anti-abuse tax (BEAT). Notably, the modified lookback rules apply to both small and large taxpayers. Additionally, the proposed rules clarify when and how a taxpayer adopts a method of accounting for a long-term contract and provide guidance for determining the classification of long-term contracts when a taxpayer becomes a small business taxpayer or ceases to qualify as a small business taxpayer.

Accounting method changes  

The proposed regulations provide no method change procedures and generally direct taxpayers to use existing guidance to implement changes to and from the small business taxpayer simplified methods.

In August 2018, the IRS issued procedures for eligible small business taxpayers to obtain automatic IRS consent to change to the small business taxpayer simplified methods, generally effective for tax years beginning after Dec. 31, 2017.

Under these procedures, 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 temporarily waived for changes filed for a taxpayer’s first, second or third taxable year ending on or after Dec. 31, 2017. Thereafter, a taxpayer requesting a change within the five-year waiting period is required to apply under the more onerous and costly advance consent procedures. Although the TCJA favorably modified the gross receipts test so taxpayers could requalify for the small business taxpayer simplified methods, the proposed rules unfortunately appear to limit a taxpayer’s ability to make such changes on a frequent basis.

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