IRS releases guidance on small business accounting method changes
On Aug. 3, 2018, the IRS released Revenue Procedure 2018-40, which offers small businesses procedures for obtaining automatic consent to change certain methods of accounting. Rev. Proc. 2018-40 amends Rev. Proc. 2018-31 to add automatic method changes for qualifying small businesses to implement changes introduced through tax reform.
The tax reform legislation passed in December 2017 (commonly referred to as the Tax Cuts and Jobs Act, or TCJA), increased the number of taxpayers that qualify as small businesses under section 448, by raising the cap on gross receipts from $5 million to $25 million averaged over the prior three years. Qualifying as a small business under the gross receipts test of section 448(c) allows taxpayers to use several simplified methods of accounting.
Small business taxpayers may be eligible to use the cash receipts and disbursements method (cash method) of accounting. These taxpayers may be exempt from accounting for inventories under sections 263A and 471. Small business taxpayers may also be exempt special methods of accounting for long-term contracts under section 460. It is also important to note that the definition of a tax shelter had not changed under section 448. Any consideration of adopting the overall cash disbursements and receipts method of accounting (or other methods permitted by Rev. Proc. 2018-40) should include an analysis of the tax shelter definition under section 448.
Rev. Proc. 2018-40 adds the following automatic method changes to Rev. Proc. 2018-31:
- Change to the overall cash method of accounting from the overall accrual method. Rev. Proc. 2018-40 adds a new section 15.18 to Rev. Proc. 2018-31, and offers a designated automatic accounting method change number (DCN) 233 to effect the change. Note that the accrual method or other methods may still be required for certain items or entities, even if the taxpayer meets the gross receipts test.
- Change to a method that no longer capitalizes costs under section 263A, including self‑constructed assets under section 263A(i). Rev. Proc. 2018-40 adds a new section 12.16 to Rev. Proc. 2018-31, and offers a new DCN 234 to effect the change.
- Change from a section 471 method of accounting for inventory items. Taxpayers currently accounting for inventory under section 471 may change to a method that either (a) treats inventory as non-incidental materials and supplies under section 1.162-3, or (b) conforms to the taxpayer’s method of accounting reflected in its applicable financial statements (AFS), or for taxpayers without an AFS, as reflected in the taxpayer’s book method. Rev. Proc. 2018-40 adds a new section 22.19 to Rev. Proc. 2018-31, and offers a new DCN 235 to effect the change.
- Change to a simplified method of accounting for long-term construction contracts or home construction contracts. Taxpayers may change from the percentage‑of‑completion method to an exempt contract method described in section 1.460-4(c) for exempt long-term construction contracts described in section 460(e)(1)(B). Under this same section, a taxpayer may also choose to stop capitalizing costs under section 263A for home construction contracts defined in section 460(e)(1)(A). Note that this change only applies to contracts that are entered into after Dec. 31, 2017, in taxable years ending after Dec. 31, 2017. This change is available even for taxpayers who have long-term contracts that are not exempt. Rev. Proc. 2018-40 amends section 19.01 of Rev. Proc. 2018-31, and offers a new DCN 236 to effect the change.
Rev. Proc. 2018-40 modifies existing sections in Rev. Proc. 2018-31 to require that qualifying method changes be made under the new sections described above. If taxpayers filed Forms 3115 under non-automatic procedures before Aug. 3, 2018 to implement these methods, Rev. Proc. 2018-40 offers a transition rule by which the taxpayers may choose to use the automatic procedures instead.
The Treasury Department and IRS are requesting public comments on future guidance related to these sections. The Revenue Procedure specifically identifies a need for comments on the following issues: (1) how the section 448(c) gross receipts test applies to each trade or business of a taxpayer that is not a corporation or partnership; (2) how “books and records of the taxpayer prepared in accordance with the taxpayer’s accounting procedures” should be interpreted in section 471(c)(1)(B); and (3) how to interpret section 460(e)(2)(B) in the context of Rev. Rul. 92-28, which examines how a taxpayer reports income from long-term contracts if the taxpayer has both exempt and non-exempt contracts.
Takeaways
These changes can significantly lessen the burden of tax compliance on small business taxpayers, and many more businesses are eligible for simplified methods under the expanded $25 million gross receipts threshold. Small business taxpayers are encouraged to contact a tax professional to determine whether they qualify to make these accounting method changes.
Check RSM’s Tax Reform Resource Center for the latest analysis on this and other developments related to tax reform.