Tax Law Expands Accounting Method Options For Small Businesses
Thanks to changes included in the Tax Cuts and Jobs Act (TCJA), many more businesses can now use the simpler and more-flexible cash method of accounting for federal income tax purposes. The new law also includes some other tax accounting changes that are good news for small businesses. Like many TCJA changes that apply to businesses, these provisions are permanent. Here's what you need to know.
Expanded Use of Cash Method Accounting
Before the TCJA, C corporations with average annual gross receipts of more than $5 million for the previous three tax years generally weren't allowed to use the cash method. The same was true for entities with average annual gross receipts of more than $5 million that were:
- Partnerships with C corporation partners, or
- Limited liability companies (LLCs) treated as partnerships for tax purposes with C corporation members.
Instead, these taxpayers were required to use the accrual method of accounting. That limited their opportunities to manage taxable income over several years by altering the timing of income and deductions to minimize the cumulative federal income tax liability for those years.
Under the TCJA, for tax years beginning after 2017, cash method accounting is allowed for these taxpayers if their average annual gross receipts for the three previous tax years didn't exceed $25 million. The cash method is allowed even if the purchase, production or sale of merchandise is an income-producing factor for these taxpayers.
This change will allow many more C corporations — as well as partnerships and LLCs with C corporation partners and members — to use the cash method in 2018 and beyond.
Expanded Use of Simplified Inventory Accounting Rules
Under the TCJA, accounting for inventories will be much easier for many businesses for tax years beginning after 2017. This provision of the law generally exempts businesses with average annual gross receipts of $25 million or less for the three previous tax years from the requirement to use inventory accounting for federal income tax purposes. Instead, these taxpayers can either account for inventory costs:
1. As the cost of non-incidental materials and supplies that are simply written off when they're used or consumed, or
2. In the same manner as the costs are treated for financial accounting purposes.
In addition, businesses with average annual gross receipts of $25 million or less for the three previous tax years are also exempt from the complicated uniform capitalization (UNICAP) rules that mandate capitalizing many expenses as inventory costs. This change applies to producers and resellers. Before the TCJA, many businesses with average annual gross receipts in excess of $10 million were required to follow the UNICAP rules.
Long-Term Real Property Construction Contracts
Before the TCJA, construction companies with average annual gross receipts in excess of $10 million for the previous three tax years were generally required to use the percentage of completion method (PCM) to calculate annual taxable income from long-term contracts for the construction or improvement of real property. This method of accounting is less favorable, because it requires contractors to recognize taxable income earlier than under the completed contract method.
Under the TCJA, for tax years beginning in 2017 and beyond, businesses with average annual gross receipts of $25 million or less won't be required to use the PCM for contracts expected to be completed within two years.
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Accounting for taxes can be complicated. Fortunately, tax reform legislation has expanded the eligibility requirements for some simplified tax accounting methods for small businesses. Contact your tax advisor to determine whether these alternatives could work for your business in 2018, as well as for additional tax planning opportunities under the TCJA.