The IRS released proposed regulations (REG-132766-18
) to provide guidance on the small taxpayer exception rules enacted by the Tax Cuts and Jobs Act (TCJA) under Sections 448, 263A, 460 and 471. The small taxpayer rules apply to businesses with aggregate average annual gross receipts that do not exceed $25 million (indexed for inflation). However, some of the proposed regulations will impact larger taxpayers as well.
The TCJA expanded the definition of small business by increasing the gross receipts threshold under Section 448(c) from $10 million to $25 million (indexed for inflation) for determining eligible small businesses that may elect to use the overall cash method of accounting. The proposed regulations add guidance for aggregating gross receipts under Section 448(c) for taxpayers other than a corporation or partnership, including gross receipts from flow-through entities. They also provide a definition of the “mandatory” Section 448 year (previously “first” Section 448 year), that requires taxpayers that fail the gross receipts test to switch to the accrual method of accounting, while also removing the ability to make that change under the regulations. The package was not accompanied by any procedural guidance for the mandatory Section 448 year change to provide an automatic change to taxpayers that may be otherwise scoped out of the change because of, for example, the limitation on making an overall method change within the prior five years.
Tax shelters are not allowed to use the overall cash method of accounting, even if they meet the gross receipts test. A tax shelter is a partnership or any other entity (other than a C corporation) that has at least 35% of its losses allocable to limited partners or limited entrepreneurs. This can be problematic for certain taxpayers, because the rule does not account for large one-time deductions or losses such as favorable Section 481(a) adjustments or economic downturns, and because the determination of tax shelter status is based on current year allocated losses (so that a partnership may not know it is a tax shelter until the last day of the tax year). The proposed regulations provide an irrevocable election that allows taxpayers to make the determination using the prior year’s income, which may give some limited relief for prior planning.
The rules of Section 448 are foundational to many other provisions in the code, and these proposed rules affect more than just the cash method of accounting. The small business exemptions under Sections 263A, 460 and 471, outlined below, are all subject to a taxpayer meeting the gross receipts test, and not being considered as a tax shelter.
The TCJA added a new small taxpayer exemption to the rules of Section 263A (UNICAP), including interest capitalization. Affected taxpayers may generally discontinue applying the UNICAP rules in their entirety. The proposed regulations remove the old small reseller exception, including all related definitions, and replace it with the rules of Section 448. Simultaneously, the proposed rules may also impact certain larger producers that need to determine whether they must use the modified simplified production method by changing the $50 million gross receipts test from the small reseller exemption (generally line 1c of the tax return) to the much broader definition provided in Section 448, which includes sales, rents, royalties, interest, etc.
After modifications by the TCJA, taxpayers are exempt from applying the rules of Section 460 to a contract if, in the contracting year, the taxpayer meets the small taxpayer exemption. Such contract continues to be exempt even if the taxpayer fails the gross receipts test in a year subsequent to the contracting year, but prior to the year in which the contract is completed. For example, a taxpayer enters into a long-term contract in year 1, when it is considered a small taxpayer, and anticipates completion in year 3. The taxpayer then fails the gross receipts test in year 2. The year 2 contracts are subject to Section 460, but the year 1 contract remains exempt.
The proposed regulations also affect certain non-small business taxpayers by modifying the look-back rules. They clarify that a taxpayer with a contract that begins in a pre-TCJA year and ends in a post-TCJA year must only compute the AMT lookback component for the pre-TCJA year(s). The look-back calculation would also include tax into account changes to a taxpayer’s base erosion anti-abuse tax (BEAT) by modifying the base erosion minimum tax amount (BEMTA), if applicable.
The TCJA provided that small taxpayers do not need to follow the rules of Section 471 for valuing or identifying inventories, and allowed two alternative options: 1) follow the book inventory method, or 2) treat inventory as non-incidental materials and supplies. The proposed regulations provide mostly unfavorable guidance for those options.
For taxpayers that choose to follow their book inventory method, the proposed regulations would only allow a taxpayer to follow the types of costs capitalized for book purposes, but not the amount. They require certain adjustments to be capitalized to ending inventory, for example, Section 274 non-deductible meals and entertainment expenses. The regulations are also silent as to the treatment of certain inventory reserves, and whether a taxpayer may follow the book accounting for those valuation items.
If a taxpayer chooses to treat inventory as non-incidental materials and supplies, the proposed regulations provide that the items are deductible when used or consumed in the taxpayer’s trade or business but retain their character as inventory. For resellers, goods would be considered used or consumed is when the products are sold, not at some earlier point in time, for example, when placed on the shelf and offered for sale. For producers, raw materials would not be considered used and consumed, generally, until the title to the finished goods passes to the customer. Additionally, taxpayers would be required to capitalize all direct costs, for example, labor, during the production process. This makes it appear that taxpayers would need to follow some of the rules under Sections 263A and 471 to value and identify the amount of direct costs to be capitalized to the non-incidental materials and supplies inventory, even if they are not identified or capitalized for book purposes.
The rules will be effective beginning on or after the final regulations are published in the Federal Register. However, for tax years beginning after Dec. 31, 2017, and before the final regulations are published, a taxpayer may early-adopt the proposed regulations, as long as it does so in their entirety.
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