On July 29, 2020, the IRS released an advance copy of proposed regulations implementing changes to the accounting method rules for small business taxpayers as a result of amendments made by TCJA. (REG-132766).
In general, the proposed regulations implement recent amendments to sections 263A, 471, 448 and 460 for small business taxpayers. Interestingly, however, the IRS also included proposed rules that appear to apply to large taxpayers—and therefore might be overlooked due to their inclusion in a small business taxpayer regulation package. With respect to large taxpayers, the IRS proposed amendments to the look-back rules under section 460 related to the percentage of completion method for long-term contracts to incorporate the repeal of the corporate AMT and the addition of the base erosion anti-abuse rules (BEAT) under section 59A. The IRS also requested comments concerning a contemplated rule relating to the allocation of transaction price among contracts that include income subject to both section 451 and a special method of accounting.
In general, the new rules clarify the existing statutory scheme, but the proposed regulation package is comprehensive. The new rules provide significant detail on proper methods under sections 460 and 471 that may change the way taxpayers account for long-term contracts or inventory.
Recent tax reform legislation passed as Public Law No. 115-97 (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 $10 million to $25 million averaged over the prior three years. The gross receipts threshold is indexed for inflation, and rose to $26 million in 2019. Qualifying as a small business under the gross receipts test of section 448(c) allows some taxpayers to use several simplified methods of accounting. Not all taxpayers qualify, and tax shelters are generally prohibited from using simplified methods.
Qualifying small business taxpayers may use the overall cash receipts and disbursements method (cash method) of accounting, are exempt from applying capitalization rules under section 263A, may use simplified alternatives to account for inventory under section 471, and may also be exempt from special methods of accounting for long-term contracts under section 460.
The new regulations
The proposed regulations clarify that rules for aggregating gross receipts of related trades or businesses should be treated the same under each affected code section as in section 448 (e.g. the UNICAP exception for certain small businesses under section 263A(i)), and provide examples to help delineate unrelated gross receipts.
The proposed regulations remove the obsoleted small reseller exemption from standard UNICAP rules that existed for taxpayers with average annual gross receipts under $10 million prior to TCJA. TCJA made qualified small business taxpayers exempt from UNICAP entirely and added section 263A(i) to use the section 448(c) gross receipts test to determine eligibility. The proposed regulations also establish that the small business taxpayer exception to section 263A applies to the requirement to capitalize interest under section 263A(f) and update the inventory rules for farming trades or businesses.
The proposed regulations make a number of changes under section 448 to clarify which taxpayers qualify for simplified methods and how to change methods to use them. The proposed regulations replace the term ‘first section 448 year’ with ‘mandatory section 448 year’ and clarify how taxpayers change to the accrual method if the taxpayer was prohibited from using the cash method in a previous year.
Determining whether a taxpayer is a ‘tax shelter’ prohibited from using the cash method and certain simplified methods has challenged taxpayers. The proposed regulations define ‘tax shelter’ by incorporating the definition of a ‘syndicate’ in temporary Reg. section 1.448-1T. The proposed regulations also allow taxpayers to elect to use the allocated taxable income or loss of the preceding taxable year to determine whether the taxpayer is a syndicate for purposes of section 448(d)(3) for the current taxable year. This election, once made, is revocable only with consent of the Commissioner.
The proposed regulations add guidance for long-term contracting methods under section 460, both for qualified small businesses and large businesses. Because long-term contracts span multiple tax years, and taxpayers may not qualify in each tax year, the new rules help determine eligibility. The proposed regulations set the year a contract is entered into as the point to measure eligibility for the small contractor exemption from the requirement in section 460(e)(1)(B)(ii), as well as eligibility to avoid capitalizing costs under section 263A for home construction contracts estimated at less than two years. The proposed regulations further clarify look-back rules and the de minimis exception contained within. For small and large taxpayers, new rules help harmonize section 460 with BEAT rules under section 59A.
The proposed regulations make significant changes under section 471. Taxpayers now have more detailed rules for treating inventory as non-incidental materials and supplies. These rules include defining what it means for materials and supplies to be ‘used or consumed’ as the later of the taxable year in which the taxpayer provides the item to a customer and the cost of such item is recovered in that year, or the year in which the taxpayer pays for or incurs such cost. Inventory treated as section 471(c) non-incidental materials and supplies is expressly ineligible for the de minimis safe harbor election under Reg. section 1.263(a)-1(f)(2). The proposed regulations also guide taxpayers on allowable and prohibited methods for identifying and valuing materials and supplies.
Taxpayers with applicable financial statements (AFS) can now rely on section 451 for determining the types and amounts of costs reflected in an AFS. The proposed regulations emphasize that section 471 is a timing provision and thus does not implicate the characterization of items of income or expense as deductible or recoverable through cost of goods sold or basis.
The proposed regulations for small business taxpayer methods are comprehensive and add a great deal of clarity to the existing scheme. Taxpayers should examine their section 471 inventory methods, as the new rules fill in definitions and narrow the methods for inventory treated as section 471(c) materials and supplies. Small business taxpayers engaged in long-term contracts now have clearer guidance on changing accounting methods, and should consult their tax advisors if they have not already changed their methods of accounting or if these proposed rules contrast with positions they have previously taken. These simplified methods can benefit small businesses by reducing the cost of ongoing compliance.
The IRS and Treasury are soliciting public comments on the proposed regulations. Notably, the IRS signaled that it continues to study the definition of a tax shelter. The IRS further requests comments regarding the effects of section 451(b) on the application of section 460, 467, or another special method of accounting, within the meaning of section 451(b)(2). These rules can have major implications and taxpayers are encouraged to contact RSM to determine whether they may be affected.