Method of Accounting - Cash vs. Accrual
One of the most important decisions that a business needs to make when filing its first tax return is whether it will be a cash basis or an accrual basis taxpayer. Under the cash basis of accounting, income and expenses are reported when cash is received from customers and when expenses are paid to vendors. Under the accrual basis of accounting, income and expenses are reported when the sale is complete (when the company performs its services or delivers its goods) or when the expense is incurred (when services are performed for the business or when goods are delivered to the business).
Most businesses would prefer to use the cash basis method of accounting on its tax return so income tax expense matches the operating cash flow generated by the business. When using the accrual basis of accounting, it is possible for a taxpayer to pay income tax on a sale when that customer has not yet paid for the services rendered or the goods delivered. This can create cash flow problems for the business. Under prior tax law, there have been restrictions on which businesses can use the cash basis of accounting for tax purposes. The ability to use the cash basis method of accounting has been opened up to many more taxpayers under the TCJA.
Previous law required C Corporations and Partnerships with a C Corporation as a partner to follow the accrual method unless they had less than $5 million average annual gross receipts for all previous years. Under the new law, the gross receipts exemption is for average annual receipts up to $25 million, instead of $5 million.
Previous law also required business entities with inventory and gross receipts over $1 million annually to use the accrual method. Under the new tax law, businesses up to $25 million in gross receipts with inventory can elect to use the cash method if they either treat inventory under the materials and supplies rule, or conform their method of accounting to the method used in their books and records for financial statement purposes.
Additionally, the time period to apply to the gross receipts test is the average of the 3 previous years and the test is performed each year for the current year’s eligibility. Because of these changes, an entity is no longer stuck with the accounting method they have used since inception. Their accounting method could change year to year based on the outcome of the receipts test.
Uniform Capitalization Rule
Another tax provision impacted by the new $25 million gross receipts test is the Uniform Capitalization Rule (UNICAP). Under UNICAP, certain taxpayers must capitalize a portion of indirect costs as part of inventory. Under prior tax law, businesses that purchase property for resale with gross receipts over $10 million and all businesses that produce real or personal property were required to comply with this onerous rule. Under the new law, all businesses with gross receipts under $25 million are exempt including those that produce real and personal property.
Percentage of Completion Method
Another tax provision impacted by the expanded gross receipts test is the requirement for construction contractors to use the percentage of completion method. Under prior law, certain contractors with receipts in excess of $10 million were required to use the percentage of completion method to account for their construction contracts, which means that they need to record income throughout the term of a project rather than just when it is done. Under the new law, this test has been conformed to the $25 million gross receipts test.
Rules for Related Businesses
The $25 million rule is subject to aggregation rules. If you are a taxpayer with ownership in several entities, the $25 million gross receipts test requires that you group all of your related entities together to see if you pass the test. Entities are considered related if 1) one or more entities owns at least 80% of any other entity or 2) five or fewer people own more than 50% of multiple entities.
Assume Joe owns 20% of Company A and his spouse Jane owns 20% of the same company. Bob also owns 20% of Company A. The remainder of Company A is owned by various other minority owners. Joe also owns 40% of Company B. Bob owns the remaining 60% of Company B. When determining if Company A or Company B are “small taxpayers,” the gross receipts of both companies must be aggregated because the common ownership is more than 50% by 5 or fewer shareholders. Being a minority shareholder doesn’t exclude the entity from being included in the aggregate.
Application for Change in Accounting Method
In order to take advantage of the new law, a business will likely need to file IRS Form 3115 Application for Change in Accounting Method for each tax provision that will change as a result of these new rules. It is possible the change will become an automatic change as more revisions and adjustments are made to the law. This is one area for which we expect additional guidance from the IRS sometime this year.
The special rules which used to apply to farming businesses and personal service corporations have now generally been conformed to the rules used for all other business entities including the $25 million receipts test and inventory rules.
The new $25 million gross receipts test will be adjusted for cost-of-living inflation adjustments and rounded to the next $1 million. The previous thresholds were static and didn’t take inflation into account.