TCJA Method of Accounting Changes to Section 263A and Inventory

TCJA Method of Accounting Changes to Section 263A and Inventory (included long-term contracts)
Most Businesses Now Qualified To Adopt the Cash Basis Method of Accounting

Summary - With the enactment of the Tax Cuts and Jobs Act (TCJA), taxpayers were provided with an abundance of tax saving opportunities for their businesses. This one comes with the bonus of simplification too, a rarity in taxation. Contrary to historical tax law, the TCJA allows businesses to write-off their inventory and receivables (net of payables) by electing the cash basis method of accounting.

The TCJA sharply increased the number of taxpayers qualifying for favorable small business accounting method reform and did so with simplification which should drive down tax accounting fees.

The small business changes grant significant tax relief, and will save time and money for both taxpayers and tax preparers.

This advice comes from a New Hampshire CPA firm with over 70 years of advising businesses about important tax matters; it is meant to be informative as we have discovered many were not aware and have been grateful for the advice.

Why does that matter?
    It's a big deal; Business could receive a tax deduction for the amount of their Inventory and Accounts Receivable (net of payables).
    As a result of these changes, most businesses no longer must report inventory (including long-term contracts) or receivables (net of accounts payable) on their tax returns.
    If you are not already taking advantage of this tax deduction, then you may be missing out on significant tax savings.

Does this apply to my business?
    It applies to all businesses with inventories, including manufacturers, wholesales, and retailers.

What's the catch?
    There are very few:
    1)     Average sales must be under $25 million.
    2)     Financial statements must conform to tax return. So, do you need to issue Generally Accepted Accounting Principals (GAAP) financial statements? We have been successful in educating lenders about the benefits to their borrowers and found that smart lenders are amenable to all planning techniques that strengthen the financial standing of their borrowers.

It sounds too good to be true!
   This is not hype, it is true and we stake our reputation on it. Converting from accrual to cash basis method of accounting obviously could mean very material tax reductions as working capital is expensive to earn. For most, the initial benefit is at least equal to 1/3 of inventories and receivables (net of payables) with ongoing annual tax planning benefits thereafter.

    Below is comprehensive technical explanation including the applicable text of the Tax Cuts and Jobs Act (TCJA) and the December 20, 2018 Joint Tax Committee Staff Report. Read it for yourself, and then please call us to learn how to apply this to your business.

Accept this invitation to learn more
    Call Donna Doucette, CPA, at 603-524-0507 x17 or email donna@dsbcpas.com.

    Dana S. Beane & Company has been serving businesses in New England since 1947, and our staff includes accountants with decades of experience and an in-house attorney.

Technical Explanation - Outline
    A. Joint Committee Staff Report (Dated December 20, 2018)
                1. Prior Law
                      i. General rule for methods of accounting
                    ii. Cash and accrual methods
                    iii. Accounting for inventories
                        iv. Uniform capitalization
                        v. Accounting for long-term contracts
                2. Explanation of Provision
                3. Effective Date
    B. Internal Revenue Code (as amended by the TCJA)
                1. Section 471, General rule for inventories, and
                2. Section 263A, Capitalization and inclusion in inventory costs of certain expenses
    C. TCJA Sec. 13102
                1. Sec. 13102(b) EXEMPTION FROM UNICAP REQUIREMENTS
                2. Sec. 13102(c) EXEMPTION FROM INVENTORIES

SUMMARY

A. Small Business Accounting Method Reform and Simplification (sec. 13102 of the Act and secs. 263A, 448, 460, and 471 of the Code)
1. Prior Law

            i. General rule for methods of accounting
Section 446 generally allows a taxpayer to select the method of accounting to be used to compute taxable income, provided that such method clearly reflects the income of the taxpayer. The term "method of accounting" includes not only the overall method of accounting used by the taxpayer, but also the accounting treatment of any one item.423 Permissible overall methods of accounting include the cash receipts and disbursements method ("cash method"), an accrual method, or any other method (including a hybrid method) permitted under regulations prescribed by the Secretary.424 Examples of any one item for which an accounting method may be adopted include cost recovery,425 revenue recognition,426 and the timing of deductions.427 For each separate trade or business, a taxpayer is entitled to adopt any permissible method, subject to certain restrictions.428

A taxpayer filing its first return may adopt any permissible method of accounting in computing taxable income for such year.429 Except as otherwise provided, section 446(e) requires taxpayers to secure the consent of the Secretary before changing a method of accounting. The regulations under this section provide rules for determining: (1) what a method of accounting is, (2) how a method of accounting is adopted,430 and (3) how a change in method of accounting is effectuated.431

ii. Cash and accrual methods
Taxpayers using the cash method generally recognize items of income when actually or constructively received and items of expense when paid. The cash method is administratively easy and provides the taxpayer flexibility in the timing of income recognition. It is the method generally used by most individual taxpayers, including farm and nonfarm sole proprietorships.

Taxpayers using an accrual method generally accrue items of income when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy.432 Taxpayers using an accrual method of accounting generally may not deduct items of expense prior to when all the events have occurred that fix the obligation to pay the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred.433 Accrual methods of accounting generally result in a more accurate measure of economic income than does the cash method. The accrual method is often used by businesses for financial accounting purposes.

A C corporation, a partnership that has a C corporation as a partner, or a tax-exempt trust or corporation with unrelated business income generally may not use the cash method. Exceptions are made for farming businesses, qualified personal service corporations, and the aforementioned entities to the extent their average annual gross receipts434 do not exceed $5 million for all prior years (including the prior taxable years of any predecessor of the entity) (the "gross receipts test"). The cash method may not be used by any tax shelter.435 In addition, the cash method generally may not be used if the purchase, production, or sale of merchandise is an income producing factor.436 Such taxpayers generally are required to keep inventories and use an accrual method with respect to inventory items.437

A farming business is defined as a trade or business of farming, including operating a nursery or sod farm, or the raising or harvesting of trees bearing fruit, nuts, or other crops, timber, or ornamental trees (other than evergreen trees that are more than six years old at the time they are severed from their roots).438 Such farming businesses are not precluded from using the cash method regardless of whether they meet the gross receipts test. However, section 447 generally requires a farming C corporation (and any farming partnership if a corporation is a partner in such partnership) to use an accrual method of accounting. Section 447 does not apply to nursery or sod farms, to the raising or harvesting of trees (other than fruit and nut trees), nor to farming C corporations meeting a gross receipts test with a $1 million threshold. For family farm C corporations, the threshold under the gross receipts test is $25 million.

A qualified personal service corporation is a corporation: (1) substantially all of whose activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and (2) substantially all of the stock of which (by value) is owned by current or former employees performing such services, their estates, or heirs.439 Qualified personal service corporations are allowed to use the cash method without regard to whether they meet the gross receipts test.

iii. Accounting for inventories
In general, for Federal income tax purposes, taxpayers must account for inventories if the production, purchase, or sale of merchandise is an income-producing factor to the taxpayer.440 Treasury regulations also provide that in any case in which the use of inventories is necessary to clearly reflect income, the accrual method must be used with regard to purchases and sales.441 However, an exception is provided for taxpayers whose average annual gross receipts do not exceed $1 million.442 A second exception is provided for taxpayers in certain industries whose average annual gross receipts do not exceed $10 million and that are not otherwise prohibited from using the cash method under section 448.443 Such taxpayers may account for inventory as materials and supplies that are not incidental (i.e., "non-incidental materials and supplies").444

In those circumstances in which a taxpayer is required to account for inventory, the taxpayer must maintain inventory records to determine the cost of goods sold during the taxable period. Cost of goods sold generally is determined by adding the taxpayer's inventory at the beginning of the period to the purchases made during the period and subtracting from that sum the taxpayer's inventory at the end of the period.

Because of the difficulty of accounting for inventories on an item-by-item basis, taxpayers often use conventions that assume certain item or cost flows. Among these conventions are the first-in, first out ("FIFO") method, which assumes that the items in ending inventory are those most recently acquired by the taxpayer,445 and the last-in, first-out ("LIFO") method, which assumes that the items in ending inventory are those earliest acquired by the taxpayer.446

iv. Uniform capitalization
The uniform capitalization rules require certain direct and indirect costs allocable to real or tangible personal property produced by the taxpayer to be included in either inventory or capitalized into the basis of such property, as applicable.447 For real or personal property acquired by the taxpayer for resale, section 263A generally requires certain direct and indirect costs allocable to such property to be included in inventory.

Section 263A provides a number of exceptions to the general uniform capitalization requirements. One such exception exists for certain small taxpayers who acquire property for resale and have $10 million or less of average annual gross receipts;448 such taxpayers are not required to include additional section 263A costs in inventory. Another exception exists for taxpayers who raise, harvest, or grow trees.449 Under this exception, section 263A does not apply to trees raised, harvested, or grown by the taxpayer (other than trees bearing fruit, nuts, or other crops, or ornamental trees) and any real property underlying such trees. Similarly, the uniform capitalization rules do not apply to any plant having a preproductive period of two years or less or to any animal, which is produced by a taxpayer in a farming business (unless the taxpayer is required to use an accrual method of accounting under section 447 or 448(a)(3)).450 Freelance authors, photographers, and artists also are exempt from section 263A for any qualified creative expenses.451

v. Accounting for long-term contracts
In general, in the case of a long-term contract, the taxable income from the contract is determined under the percentage-of-completion method.452 Under this method, the taxpayer must include in gross income for the taxable year an amount equal to the product of (1) the gross contract price and (2) the percentage of the contract completed during the taxable year.453 The percentage of the contract completed during the taxable year is determined by comparing costs allocated to the contract and incurred before the end of the taxable year with the estimated total contract costs.454 Costs allocated to the contract typically include all costs (including depreciation) that directly benefit or are incurred by reason of the taxpayer's long-term contract activities.455 The allocation of costs to a contract is made in accordance with regulations.456 Costs incurred with respect to the long-term contract are deductible in the year incurred, subject to general accrual method of accounting principles and limitations.457

There are a number of types of long-term contracts excepted from the requirements to use the percentage-of-completion method to compute taxable income. One such exception is provided for certain construction contracts performed by small contractors ("small construction contracts").458 Contracts within this exception are those contracts for the construction or improvement of real property if the contract: (1) is expected (at the time such contract is entered into) to be completed within two years of commencement of the contract and (2) is performed by a taxpayer whose average annual gross receipts for the prior three taxable years do not exceed $10 million.459 Thus, long-term contract income from small construction contracts must be reported consistently using the taxpayer's exempt contract method.460 Permissible exempt contract methods include the completed contract method, the exempt-contract percentage-of-completion method, the percentage-of-completion method, or any other permissible method.461

2. Explanation of Provision
The provision expands the universe of taxpayers that may use the cash method of accounting. Under the provision, the cash method of accounting may be used by taxpayers, other than tax shelters, that satisfy the gross receipts test, regardless of whether the purchase, production, or sale of merchandise is an income-producing factor. The gross receipts test allows taxpayers with average annual gross receipts462 that do not exceed $25 million for the three prior taxable-year period (the "$25 million gross receipts test") to use the cash method. The $25 million amount is indexed for inflation for taxable years beginning after 2018.

The provision expands the universe of farming C corporations (and farming partnerships with a C corporation partner) that may use the cash method to include any farming C corporation (or farming partnership with a C corporation partner) that meets the $25 million gross receipts test.

The provision retains the exceptions from the required use of the accrual method for qualified personal service corporations and taxpayers other than C corporations. Thus, qualified personal service corporations, partnerships without C corporation partners, S corporations, and other passthrough entities are allowed to use the cash method without regard to whether they meet the $25 million gross receipts test, so long as the use of such method clearly reflects income.463

In addition, the provision exempts certain taxpayers from the requirement to keep inventories. Specifically, taxpayers that meet the $25 million gross receipts test are not required to account for inventories under section 471,464 but rather may use a method of accounting for inventories that either (1) treats inventories as non-incidental materials and supplies,465 or (2) conforms to the taxpayer's financial accounting treatment of inventories.466

The provision expands the exception for small taxpayers from the uniform capitalization rules. Under the provision, any producer or reseller that meets the $25 million gross receipts test is exempted from the application of section 263A.467 The provision retains the exemptions from the uniform capitalization rules that are not based on a taxpayer's gross receipts.

Finally, the provision expands the exception for small construction contracts from the requirement to use the percentage-of-completion method. Under the provision, contracts within this exception are those contracts for the construction or improvement of real property if the contract (1) is expected (at the time such contract is entered into) to be completed within two years of commencement of the contract, and (2) is performed by a taxpayer that (for the taxable year in which the contract was entered into) meets the $25 million gross receipts test.468

Under the provision, a taxpayer who fails the $25 million gross receipts test for a taxable year is not eligible for any of the aforementioned exceptions (i.e., from the accrual method, from keeping inventories, from applying the uniform capitalization rules, or from using the percentage-of-completion method) for such taxable year.

Application of any of the above provisions is a change in the taxpayer's method of accounting for purposes of section 481. Application of the exception for small construction contracts from the requirement to use the percentage-of-completion method is implemented on a cutoff basis for all similarly classified contracts (hence there is no adjustment under section 481(a) for contracts entered into before January 1, 2018). In addition, any change in method of accounting due to application of the above provisions is treated as initiated by the taxpayer and made with the consent of the Secretary.469 For example, such change is made with the consent of the Secretary for any taxable year in which the taxpayer fails to meet the gross receipts test if the taxpayer met such test in the prior taxable year, and the taxpayer is changing from the cash method to an accrual method. In addition, such change is made with the consent of the Secretary for any taxable year in which the taxpayer meets the gross receipts test if the taxpayer failed to meet such test in the prior taxable year and the taxpayer is changing from an accrual method to the cash method. The Treasury Department has issued published guidance addressing this provision.470

3. Effective Date
The provisions to expand the universe of taxpayers, including farming C corporations, eligible to use the cash method, exempt certain taxpayers from the requirement to keep inventories, and expand the exception from the uniform capitalization rules apply to taxable years beginning after December 31, 2017. Application of these rules is a change in the taxpayer's method of accounting for purposes of section 481.

The provision to expand the exception for small construction contracts from the requirement to use the percentage-of-completion method applies to contracts entered into after December 31, 2017, in taxable years ending after such date. Application of this rule is a change in the taxpayer's method of accounting for purposes of section 481. Application of the exception for small construction contracts from the requirement to use the percentage-of-completion method is implemented on a cutoff basis for all similarly classified contracts (hence there is no adjustment under section 481(a) for contracts entered into before January 1, 2018).

Footnotes:
421 A technical correction may be necessary to reflect this intent.
422 Heating, ventilation, and air-conditioning property includes all components (whether in, on, or adjacent to the building) of a central air conditioning or heating system, including motors, compressors, pipes and ducts. Treas. Reg. sec. 1.48-1(e)(2). 423 Treas. Reg. sec. 1.446-1(a)(1).
424 Sec. 446(c).
425 See, e.g., secs. 167 and 168.
426 See, e.g., secs. 451 and 460.
427 See, e.g., secs. 461 and 467.
428 Sec. 446(d); Treas. Reg. sec. 1.446-1(d).
429 Treas. Reg. sec. 1.446-1(e)(1).
430 See also Rev. Rul. 90-38, 1990-1 C.B. 57 (holding that a taxpayer adopts a method of accounting (1) when it uses a permissible method of accounting on a single tax return, or (2) when it uses the same impermissible method of accounting on two or more consecutive tax returns).
431 Treas. Reg. sec. 1.446-1(e).
432 See, e.g., sec. 451. For a discussion of changes made to section 451 by the Act, see the description of section 13221 of the Act (Certain Special Rules for Taxable Year of Inclusion).
433 See, e.g., sec. 461.
434 For this purpose, gross receipts are taken into account in the taxable year in which they are properly recognized under the taxpayer's method of accounting used in that taxable year. Gross receipts include total sales (net of returns and allowances) and all amounts received for services. In addition, gross receipts include income from investments, income from incidental or outside sources, interest (including original issue discount and tax-exempt interest within the meaning of section 103), dividends, rents, royalties, and annuities, regardless of whether such amounts are derived in the ordinary course of the taxpayer's trade or business. Gross receipts are not reduced by cost of goods sold or by the cost of property sold if such property is described in section 1221(1), (3), (4), or (5). With respect to sales of capital assets as defined in section 1221, or sales of property described in section 1221(2) (relating to property used in a trade or business), gross receipts are reduced by the taxpayer's adjusted basis in such property. Gross receipts do not include the repayment of a loan or similar instrument (e.g., a repayment of the principal amount of a loan held by a commercial lender). Finally, gross receipts do not include amounts received by the taxpayer with respect to sales tax or other similar State and local taxes if, under the applicable State or local law, the tax is legally imposed on the purchaser of the good or service, and the taxpayer merely collects and remits the tax to the taxing authority. If, in contrast, the tax is imposed on the taxpayer under the applicable law, then gross receipts include the amounts received that are allocable to the payment of such tax. See section 448(c)(3)(C) and Treas. Reg. sec. 1.448-1T(f)(2)(iv).
435 Secs. 448(a)(3) and (d)(3) and 461(i)(3) and (4). For this purpose, a tax shelter includes: (1) any enterprise (other than a C corporation) if at any time interests in such enterprise have been offered for sale in any offering required to be registered with any Federal or State agency having the authority to regulate the offering of securities for sale; (2) any syndicate (within the meaning of section 1256(e)(3)(B)); or (3) any tax shelter as defined in section 6662(d)(2)(C)(ii). In the case of a farming trade or business, a tax shelter includes any tax shelter as defined in section 6662(d)(2)(C)(ii) or any partnership or any other enterprise other than a corporation which is not an S corporation engaged in the trade or business of farming, (1) if at any time interests in such partnership or enterprise have been offered for sale in any offering required to be registered with any Federal or State agency having authority to regulate the offering of securities for sale or (2) if more than 35 percent of the losses during any period are allocable to limited partners or limited entrepreneurs. For this purpose, certain holdings held directly by individuals that are attributable to active farm management activities are not treated as being held by a limited partner or a limited entrepreneur. See the second section 461(j) (relating to farming syndicate defined), as in effect prior to the enactment of the Consolidated Appropriations Act, 2018, Pub. L. No. 115-141, section 401(a)(117), March 23, 2018, which, as part of repealing general deadwood-related provisions, redesignated the second "subsection (j)" (relating to farming syndicate defined) as "subsection (k)".
436 Treas. Reg. secs. 1.446-1(c)(2) and 1.471-1.
437 Sec. 471 and Treas. Reg. secs. 1.446-1(c)(2) and 1.471-1.
438 Secs. 448(d)(1) and 263A(e)(4). See also Treas. Reg. sec. 1.263A-4(a)(4).
439 Sec. 448(d)(2).
440 Sec. 471(a) and Treas. Reg. sec. 1.471-1.
441 Treas. Reg. sec. 1.446-1(c)(2).
442 Rev. Proc. 2001-10, 2001-1 C.B. 272.
443 Rev. Proc. 2002-28, 2002-1 C.B. 815.
444 Treas. Reg. sec. 1.162-3(a)(1). A deduction is generally permitted for the cost of non-incidental materials and supplies in the taxable year in which they are first used or are consumed in the taxpayer's operations.
445 See Treas. Reg. sec. 1.471-2(d).
446 See sec. 472.
447 Sec. 263A.
448 Sec. 263A(b)(2)(B). No exception is available for small taxpayers who produce property subject to section 263A. However, a de minimis rule under Treasury regulations treats producers with total indirect costs of $200,000 or less as having no additional indirect costs beyond those normally capitalized for financial accounting purposes. Treas. Reg. sec. 1.263A-2(b)(3)(iv).
449 Sec. 263A(c)(5).
450 Sec. 263A(d).
451 Sec. 263A(h). Qualified creative expenses are defined as amounts paid or incurred by an individual in the trade or business of being a writer, photographer, or artist (other than as an employee). However, such term does not include any expense related to printing, photographic plates, motion picture films, video tapes, or similar items.
452 Sec. 460(a).
453 See Treas. Reg. sec. 1.460-4. This calculation is done on a cumulative basis. Thus, the amount included in gross income in a particular year is that proportion of the expected contract price that the amount of costs incurred through the end of the taxable year bears to the total expected costs, reduced by the amounts of gross contract price included in gross income in previous taxable years.
454 Sec. 460(b)(1).
455 Sec. 460(c).
456 Treas. Reg. sec. 1.460-5.
457 Treas. Reg. secs. 1.460-4(b)(2)(iv) and 1.460-1(b)(8).
458 Other exceptions are provided for home construction contracts, residential construction contracts, qualified ship construction contracts, and qualified naval ship contracts. See sec. 460(e); Treas. Reg. secs. 1.460-2(d), 1.460-3(b) and (c), and 1.460-4(e); and sec. 708 of the American Jobs Creation Act of 2004, Pub. L. No. 108-357 (2004).
459 Secs. 460(e)(1)(B) and (4).
460 Since such contracts involve the construction of real property, they are subject to the interest capitalization rules without regard to their duration. See Treas. Reg. sec. 1.263A-8.
461 Treas. Reg. sec. 1.460-4(c)(1).
462 For purposes of the gross receipts test, items included in gross receipts are intended to be consistent with prior law. See section 448(c)(3)(C) and Treas. Reg. sec. 1.448-1T(f)(2)(iv).
463 Consistent with prior and present law, the cash method generally may not be used by taxpayers, other than those that meet the $25 million gross receipts test, if the purchase, production, or sale of merchandise is an income-producing factor.
464 In the case of a sole proprietorship, the $25 million gross receipts test is applied as if the sole proprietorship is a corporation or partnership.
465 Consistent with prior and present law, a deduction is generally permitted for the cost of non-incidental materials and supplies in the taxable year in which they are first used or are consumed in the taxpayer's operations. See Treas. Reg. sec. 1.162-3(a)(1). As the provision allows a taxpayer to treat inventories as non-incidental materials and supplies, a taxpayer may also be able to elect to deduct such non-incidental materials and supplies in the taxable year the amount is paid under the de minimis safe harbor election of Treas. Reg. sec. 1.263(a)-1(f). Under such election, a taxpayer with an applicable financial statement that has written accounting procedures in place that treat as an expense amounts paid for property costing less than a specified dollar amount may deduct amounts paid for non-incidental materials and supplies at the time of payment if the amount paid for the property does not exceed $5,000 per invoice (or per item as substantiated by the invoice). In addition, a taxpayer without an applicable financial statement that has accounting procedures in place that treat as an expense amounts paid for property costing less than a specified dollar amount may deduct amounts paid for nonincidental materials and supplies at the time of payment if the amount paid for the property does not exceed $500 per invoice (or per item as substantiated by the invoice). However, in either case, the taxpayer is not eligible to deduct inventory treated as non-incidental materials and supplies under this provision under the de minimis safe harbor election unless the taxpayer is also treating the amounts paid for such items as an expense in its applicable financial statement or its books and records, if the taxpayer does not have an applicable financial statement (i.e., the taxpayer is not eligible to apply the de minimis safe harbor if the amounts paid for such items are treated as inventory for financial reporting purposes). See Treas. Reg. sec. 1.263(a)-1(f)(1)(i)(C) and (ii)(C). If a taxpayer elects to apply the de minimis safe harbor, the taxpayer must apply such safe harbor to all materials and supplies that otherwise meet the requirements of Treas. Reg. sec. 1.263(a)-1(f).
466 The taxpayer's financial accounting treatment of inventories is determined by reference to the method of accounting used in the taxpayer's applicable financial statement (as defined in section 13221 of the Act (Certain Special Rules for Taxable Year of Inclusion)) or, if the taxpayer does not have an applicable financial statement, the method of accounting used in the taxpayer's books and records prepared in accordance with the taxpayer's accounting procedures.
467 In the case of a sole proprietorship, the $25 million gross receipts test is applied as if the sole proprietorship is a corporation or partnership.
468 In the case of a sole proprietorship, the $25 million gross receipts test is applied as if the sole proprietorship is a corporation or partnership.
469 See sections 263A(i)(3), 448(d)(7), 460(e)(2)(B), and 471(c)(4), all as amended by the Act. 470 See Rev. Proc. 2018-40, 2018-34 I.R.B. 320, August 20, 2018.

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B. Internal Revenue Code (as amended by the TCJA)
1. Section 471, General rule for inventories (Refer to new subsection (c) below.)

(a) General rule

Whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.

(b) Estimates of inventory shrinkage permitted

A method of determining inventories shall not be treated as failing to clearly reflect income solely because it utilizes estimates of inventory shrinkage that are confirmed by a physical count only after the last day of the taxable year if--
        (1) the taxpayer normally does a physical count of inventories at each location on a regular and consistent basis, and
        (2) the taxpayer makes proper adjustments to such inventories and to its estimating methods to the extent such estimates are greater than or less than the actual shrinkage.

(c) Exemption for certain small businesses. --

        (1) In general. -- In the case of any taxpayer (other than a tax shelter prohibited from using the cash receipts and disbursements method of accounting under section 448(a)(3) which meets the gross receipts test of section 448(c) for any taxable year --
                (A) subsection (a) shall not apply with respect to such taxpayer for such taxable year, and
                (B) the taxpayer's method of accounting for inventory for such taxable year shall not be treated as failing to clearly reflect income if such method either --
                        (i) treats inventory as non-incidental materials and supplies, or
                        (ii) conforms to such taxpayer's method of accounting reflected in an applicable financial statement of the taxpayer with respect to such taxable year or, if the taxpayer does not have any applicable financial statement with respect to such taxable year, the books and records of the taxpayer prepared in accordance with the taxpayer's accounting procedures.

        (2) Applicable financial statement. -- For purposes of this subsection, the term "applicable financial statement" has the meaning given the term in section 451(b)(3).

        (3) Application of gross receipts test to individuals, etc. -- In the case of any taxpayer which is not a corporation or a partnership, the gross receipts test of section 448(c) shall be applied in the same manner as if each trade or business of such taxpayer were a corporation or partnership.

        (4) Coordination with section 481. -- Any change in method of accounting made pursuant to this subsection shall be treated for purposes of section 481 as initiated by the taxpayer and made with the consent of the Secretary.

(d) Cross reference. For rules relating to capitalization of direct and indirect costs of property, see section 263A.

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2. Section 263A Capitalization and inclusion in inventory costs of certain expenses (Refer to subsection i below)

(a) Nondeductibility of certain direct and indirect costs

        (1) In general

In the case of any property to which this section applies, any costs described in paragraph (2) --

                (A) in the case of property which is inventory in the hands of the taxpayer, shall be included in inventory costs, and

                (B) in the case of any other property, shall be capitalized.

        (2) Allocable costs

The costs described in this paragraph with respect to any property are --

        (A) the direct costs of such property, and

        (B) such property's proper share of those indirect costs (including taxes) part or all of which are allocable to such property.

Any cost which (but for this subsection) could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph.

(b) Property to which section applies

    Except as otherwise provided in this section, this section shall apply to --

        (1) Property produced by taxpayer

Real or tangible personal property produced by the taxpayer.

(2) Property acquired for resale

Real or personal property described in section 1221(a)(1) which is acquired by the taxpayer for resale.

(1) Personal use property

This section shall not apply to any property produced by the taxpayer for use by the taxpayer other than in a trade or business or an activity conducted for profit.

(2) Research and experimental expenditures

This section shall not apply to any amount allowable as a deduction under section 174.

(3) Certain development and other costs of oil and gas wells or other mineral property

This section shall not apply to any cost allowable as a deduction under section 167(h), 179B, 263(c), 263(i), 291(b)(2), 616, or 617.

(4) Coordination with long-term contract rules

This section shall not apply to any property produced by the taxpayer pursuant to a long-term contract.

        (5) Timber and certain ornamental trees

        This section shall not apply to --

                    (A) trees raised, harvested, or grown by the taxpayer other than trees described in clause (ii) of subsection (e)(4)(B) (after application of the last sentence thereof), and

                    (B) any real property underlying such trees.

        (6) Coordination with section 59(e)

Paragraphs (2) and (3) shall apply to any amount allowable as a deduction under section 59(e) for qualified expenditures described in subparagraphs (B), (C), (D), and (E) of paragraph (2) thereof.

(7) Coordination with section168(k)(5)

This section shall not apply to any amount allowed as a deduction by reason of section 168(k)(5) (relating to special rules for certain plants bearing fruits and nuts).

(d) Exception for farming businesses

(1) Section not to apply to certain property

(A) In general

This section shall not apply to any of the following which is produced by the taxpayer in a farming business:

(i) Any animal.

(ii) Any plant which has a preproductive period of 2 years or less.

(B) Exception for taxpayers required to use accrual method

Subparagraph (A) shall not apply to any corporation, partnership, or tax shelter required to use an accrual method of accounting under section 447 or 448(a)(3).

(2) Treatment of certain plants lost by reason of casualty

(A)In general

If plants bearing an edible crop for human consumption were lost or damaged (while in the hands of the taxpayer) by reason of freezing temperatures, disease, drought, pests, or casualty, this section shall not apply to any costs of the taxpayer of replanting plants bearing the same type of crop (whether on the same parcel of land on which such lost or damaged plants were located or any other parcel of land of the same acreage in the United States).

(B) Special rule for person with minority interest who materially participates

Subparagraph (A) shall apply to amounts paid or incurred by a person (other than the taxpayer described in subparagraph (A)) if --

(i) the taxpayer described in subparagraph (A) has an equity interest of more than 50 percent in the plants described in subparagraph (A) at all times during the taxable year in which such amounts were paid or incurred, and

(ii) such other person holds any part of the remaining equity interest and materially participates in the planting, maintenance, cultivation, or development of the plants described in subparagraph (A) during the taxable year in which such amounts were paid or incurred.

The determination of whether an individual materially participates in any activity shall be made in a manner similar to the manner in which such determination is made under section 2032A(e)(6).

(i) In general

In the case of the replanting of citrus plants, subparagraph (A) shall apply to amounts paid or incurred by a person (other than the taxpayer described in subparagraph (A)) if --

(I) the taxpayer described in subparagraph (A) has an equity interest of not less than 50 percent in the replanted citrus plants at all times during the taxable year in which such amounts were paid or incurred and such other person holds any part of the remaining equity interest, or

(II) such other person acquired the entirety of such taxpayer's equity interest in the land on which the lost or damaged citrus plants were located at the time of such loss or damage, and the replanting is on such land.

(ii) Termination

Clause (i) shall not apply to any cost paid or incurred after the date which is 10 years after the date of the enactment of the Tax Cuts and Jobs Act.

(3) Election to have this section not apply

(A) In general

If a taxpayer makes an election under this paragraph, this section shall not apply to any plant produced in any farming business carried on by such taxpayer.

(B) Certain persons not eligible

No election may be made under this paragraph by a corporation, partnership, or tax shelter, if such corporation, partnership, or tax shelter is required to use an accrual method of accounting under section 447 or 448(a)(3).

An election under this paragraph shall not apply with respect to any item which is attributable to the planting, cultivation, maintenance, or development of any citrus or almond grove (or part thereof) and which is incurred before the close of the 4th taxable year beginning with the taxable year in which the trees were planted. For purposes of the preceding sentence, the portion of a citrus or almond grove planted in 1 taxable year shall be treated separately from the portion of such grove planted in another taxable year.

(D) Election

Unless the Secretary otherwise consents, an election under this paragraph may be made only for the taxpayer's 1st taxable year which begins after December 31, 1986, and during which the taxpayer engages in a farming business. Any such election, once made, may be revoked only with the consent of the Secretary.

(e) Definitions and special rules for purposes of subsection (d)

(1) Recapture of expensed amounts on disposition

(A) In general

In the case of any plant with respect to which amounts would have been capitalized under subsection (a) but for an election under subsection (d)(3) --

(i) such plant (if not otherwise section 1245 property) shall be treated as section 1245 property, and

(ii) for purposes of section 1245, the recapture amount shall be treated as a deduction allowed for depreciation with respect to such property.

(B) Recapture amount

For purposes of subparagraph (A), the term "recapture amount" means any amount allowable as a deduction to the taxpayer which, but for an election under subsection (d)(3), would have been capitalized with respect to the plant.

(2) Effects of election on depreciation

(A) In general

If the taxpayer (or any related person) makes an election under subsection (d)(3), the provisions of section 168(g)(2) (relating to alternative depreciation) shall apply to all property of the taxpayer used predominantly in the farming business and placed in service in any taxable year during which any such election is in effect.

(B) Related person

For purposes of subparagraph (A), the term "related person" means --

(i) the taxpayer and members of the taxpayer's family,

(ii) any corporation (including an S corporation) if 50 percent or more (in value) of the stock of such corporation is owned (directly or through the application of section 318) by the taxpayer or members of the taxpayer's family,

(iii) a corporation and any other corporation which is a member of the same controlled group described in section 1563(a)(1), and

(iv) any partnership if 50 percent or more (in value) of the interests in such partnership is owned directly or indirectly by the taxpayer or members of the taxpayer's family.

For purposes of this paragraph, the term "family" means the taxpayer, the spouse of the taxpayer, and any of their children who have not attained age 18 before the close of the taxable year.

(3) Preproductive period

(A) In general

For purposes of this section, the term "preproductive period" means --

(i) in the case of a plant which will have more than 1 crop or yield, the period before the 1st marketable crop or yield from such plant, or

(ii) in the case of any other plant, the period before such plant is reasonably expected to be disposed of.

For purposes of this subparagraph, use by the taxpayer in a farming business of any supply produced in such business shall be treated as a disposition.

(B) Rule for determining period

In the case of a plant grown in commercial quantities in the United States, the preproductive period for such plant if grown in the United States shall be based on the nationwide weighted average preproductive period for such plant.

(4) Farming business

For purposes of this section --

(A) In general

The term "farming business" means the trade or business of farming.

(B) Certain trades and businesses included

The term "farming business" shall include the trade or business of --

(i) operating a nursery or sod farm, or

(ii) the raising or harvesting of trees bearing fruit, nuts, or other crops, or ornamental trees.

For purposes of clause (ii), an evergreen tree which is more than 6 years old at the time severed from the roots shall not be treated as an ornamental tree.

(5) Certain inventory valuation methods permitted

The Secretary shall by regulations permit the taxpayer to use reasonable inventory valuation methods to compute the amount required to be capitalized under subsection (a) in the case of any plant.

(f) Special rules for allocation of interest to property produced by the taxpayer

(1) Interest capitalized only in certain cases

Subsection (a) shall only apply to interest costs which are --

(A) paid or incurred during the production period, and

(B) allocable to property which is described in subsection (b)(1) and which has --

(i) a long useful life,

(ii) an estimated production period exceeding 2 years, or

(iii) an estimated production period exceeding 1 year and a cost exceeding $1,000,000.

(2) Allocation rules

(A) In general

In determining the amount of interest required to be capitalized under subsection (a) with respect to any property --

(i) interest on any indebtedness directly attributable to production expenditures with respect to such property shall be assigned to such property, and

(ii) interest on any other indebtedness shall be assigned to such property to the extent that the taxpayer's interest costs could have been reduced if production expenditures (not attributable to indebtedness described in clause (i)) had not been incurred.

(B) Exception for qualified residence interest

Subparagraph (A) shall not apply to any qualified residence interest (within the meaning of section 163(h)).

Except as provided in regulations, in the case of any flow-through entity, this paragraph shall be applied first at the entity level and then at the beneficiary level.

(3) Interest relating to property used to produce property

This subsection shall apply to any interest on indebtedness allocable (as determined under paragraph (2)) to property used to produce property to which this subsection applies to the extent such interest is allocable (as so determined) to the produced property.

(4) Exemption for aging process of beer, wine, and distilled spirits

(A) In general

For purposes of this subsection, the production period shall not include the aging period for --

(i) beer (as defined in section 5052(a)),

(ii) wine (as described in section 5041(a)), or

(iii) distilled spirits (as defined in section 5002(a)(8)), except such spirits that are unfit for use for beverage purposes.

(B) Termination

This paragraph shall not apply to interest costs paid or accrued after December 31, 2019.

(5) Definitions

For purposes of this subsection --

(A) Long useful life

Property has a long useful life if such property is --

(i) real property, or

(ii) property with a class life of 20 years or more (as determined under section 168).

(B) Production period

The term "production period" means, when used with respect to any property, the period --

(i) beginning on the date on which production of the property begins, and

(ii) except as provided in paragraph (4), ending on the date on which the property is ready to be placed in service or is ready to be held for sale.

The term "production expenditures" means the costs (whether or not incurred during the production period) required to be capitalized under subsection (a) with respect to the property.

(g) Production

For purposes of this section --

(1) In general

The term "produce" includes construct, build, install, manufacture, develop, or improve.

(2) Treatment of property produced under contract for the taxpayer

The taxpayer shall be treated as producing any property produced for the taxpayer under a contract with the taxpayer; except that only costs paid or incurred by the taxpayer (whether under such contract or otherwise) shall be taken into account in applying subsection (a) to the taxpayer.

(h) Exemption for free lance authors, photographers, and artists

(1) In general

Nothing in this section shall require the capitalization of any qualified creative expense.

(2) Qualified creative expense

For purposes of this subsection, the term "qualified creative expense" means any expense --

(A) which is paid or incurred by an individual in the trade or business of such individual (other than as an employee) of being a writer, photographer, or artist, and

(B) which, without regard to this section, would be allowable as a deduction for the taxable year.

Such term does not include any expense related to printing, photographic plates, motion picture films, video tapes, or similar items.

(3) Definitions

For purposes of this subsection --

(A) Writer

The term "writer" means any individual if the personal efforts of such individual create (or may reasonably be expected to create) a literary manuscript, musical composition (including any accompanying words), or dance score.

(B) Photographer

The term "photographer" means any individual if the personal efforts of such individual create (or may reasonably be expected to create) a photograph or photographic negative or transparency.

(i) In general

The term "artist" means any individual if the personal efforts of such individual create (or may reasonably be expected to create) a picture, painting, sculpture, statue, etching, drawing, cartoon, graphic design, or original print edition.

(ii) Criteria

In determining whether any expense is paid or incurred in the trade or business of being an artist, the following criteria shall be taken into account:

(I) The originality and uniqueness of the item created (or to be created).

(II) The predominance of aesthetic value over utilitarian value of the item created (or to be created).

(D) Treatment of certain corporations

(i) In general

If --

(I) substantially all of the stock of a corporation is owned by a qualified employee-owner and members of his family (as defined in section 267(c)(4)), and

(II) the principal activity of such corporation is performance of personal services directly related to the activities of the qualified employee-owner and such services are substantially performed by the qualified employee-owner,

this subsection shall apply to any expense of such corporation which directly relates to the activities of such employee-owner in the same manner as if such expense were incurred by such employee-owner.

(ii) Qualified employee-owner

For purposes of this subparagraph, the term "qualified employee-owner" means any individual who is an employee-owner of the corporation (as defined in section 269A(b)(2)) and who is a writer, photographer, or artist."

(i) Exemption for certain small businesses

(1) In general

In the case of any taxpayer (other than a tax shelter prohibited from using the cash receipts and disbursements method of accounting under section 448(a)(3)) which meets the gross receipts test of section 448(c) for any taxable year, this section shall not apply with respect to such taxpayer for such taxable year.

(2) Application of gross receipts test to individuals, etc.

In the case of any taxpayer which is not a corporation or a partnership, the gross receipts test of section 448(c) shall be applied in the same manner as if each trade or business of such taxpayer were a corporation or partnership.

(3) Coordination with section 481

Any change in method of accounting made pursuant to this subsection shall be treated for purposes of section 481 as initiated by the taxpayer and made with the consent of the Secretary.

(j) Regulations

The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this section, including --

(1) regulations to prevent the use of related parties, pass-thru entities, or intermediaries to avoid the application of this section, and

(2) regulations providing for simplified procedures for the application of this section in the case of property described in subsection (b)(2).

C. Pub. L. 115-97 (Tax Cuts and Jobs Act)

https://www.congress.gov/115/bills/hr1/BILLS-115hr1enr.pdf

1. Sec. 13102(b) EXEMPTION FROM UNICAP REQUIREMENTS--

(1) IN GENERAL. --Section 263A is amended by redesignating subsection (i) as subsection (j) and by inserting after subsection (h) the following new subsection:

(i) EXEMPTION FOR CERTAIN SMALL BUSINESSES.--

(1) IN GENERAL.--In the case of any taxpayer (other than a tax shelter prohibited from using the cash receipts and disbursements method of accounting under section 448(a)(3)) which meets the gross receipts test of section 448(c) for any taxable year, this section shall not apply with respect to such taxpayer for such taxable year.

(2) APPLICATION OF GROSS RECEIPTS TEST TO INDIVIDUALS, ETC.-- In the case of any taxpayer which is not a corporation or a partnership, the gross receipts test of section 448(c) shall be applied in the same manner as if each trade or business of such taxpayer were a corporation or partnership.

(3) COORDINATION WITH SECTION 481.--Any change in method of accounting made pursuant to this subsection shall be treated for purposes of section 481 as initiated by the taxpayer and made with the consent of the Secretary.

(2) CONFORMING AMENDMENT.--Section 263A(b)(2) is amended to read as follows:

(2) PROPERTY ACQUIRED FOR RESALE.--Real or personal property described in section 1221(a)(1) which is acquired by the taxpayer for resale.

2. Sec. 13102(c) EXEMPTION FROM INVENTORIES.--Section 471 is amended by redesignating subsection (c) as subsection (d) and by inserting after subsection (b) the following new subsection:

(A) subsection (a) shall not apply with respect to such taxpayer for such taxable year, and

(B) the taxpayer's method of accounting for inventory for such taxable year shall not be treated as failing to clearly reflect income if such method either--

(i) treats inventory as non-incidental materials and supplies, or

(ii) conforms to such taxpayer's method of accounting reflected in an applicable financial statement of the taxpayer with respect to such taxable year or, if the taxpayer does not have any applicable financial statement with respect to such taxable year, he books and records of the taxpayer prepared in accordance with the taxpayer's accounting procedures.

(2) APPLICABLE FINANCIAL STATEMENT.--For purposes of this subsection, the term 'applicable financial statement' has the meaning given the term in section 451(b)(3).

(3) APPLICATION OF GROSS RECEIPTS TEST TO INDIVIDUALS, ETC.--In the case of any taxpayer which is not a corporation or a partnership, the gross receipts test of section 448(c) shall be applied in the same manner as if each trade or business of such taxpayer were a corporation or partnership.

(4) COORDINATION WITH SECTION 481.--Any change in method of accounting made pursuant to this subsection shall be treated for purposes of section 481 as initiated by the taxpayer and made with the consent of the Secretary.

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