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.
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.
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.
(c) General exceptions
(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).
(C) Special temporary rule for
citrus plants lost by reason of casualty
(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).
(C) Special rule for citrus and
almond growers
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.
(C) Members of 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)).
(C) Special rule for flow-through
entities
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.
(C) Production expenditures
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.
(C) Artist
(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:
(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, 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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