Simplified tax accounting rules for small businesses are finalized
Final regulations implement changes the TCJA made to small business accounting rules. Learn more about the simplified tax accounting methods.
The Treasury Department and IRS issued final regulations to implement changes the TCJA made to small business tax accounting rules. These regulations generally adopt the guidance in proposed regulations with some clarifications. Their main focus is on simplified accounting methods available to small businesses. The final regulations are effective January 5, 2021 (the date they were posted to the Federal Register) and may be applied to tax years beginning after December 31, 2017.
Eligibility to use the cash method of accounting: The small business gross receipts test
Certain types of businesses generally may not use the cash method of accounting, including a C corporation and a partnership with a C corporation as a partner unless the entity meets the gross receipts test. Entities that have average annual gross receipts that don’t exceed a specified amount may use the cash method. The TCJA increased the gross receipts test threshold from $5,000,000 to $25,000,000 adjusted for inflation ($26,000,000 for 2020 and 2021). The gross receipts test is usually determined by averaging the entity’s gross receipts for the three preceding tax years. See “cash method” in IRS Pub. 538, Accounting Periods and Methods.
Election for a syndicate that is prohibited from using the cash method
Regardless of size, a business that is classified as a syndicate may not use the cash method. A syndicate is a type of tax shelter, defined as a business in which more than 35% of business losses are allocated to limited partners or limited entrepreneurs. Classification as a syndicate presents a problem for limited partnerships that are usually profitable in most years but have a loss for the current year. Such businesses would be required to switch to the accrual method of accounting and, if they want to use the cash method, switch back to the cash method when the business was profitable again.
The final regulations provide a solution by allowing syndicates to make an annual election in the “anomalous” loss year to use the allocated taxable income or loss of the immediately preceding tax year to determine if the business must be classified as a syndicate for the current year. To make the election, the business must file a statement with its original timely filed tax return (plus extensions) to make the choice for that tax year. Note that under proposed regulations, the election was permanent which, in and of itself, could have created additional issues.
Example 1: Pickett Co. has one general partner and one limited partner. The business was profitable in 2019, had a loss in 2020, and is profitable again in 2021. In the loss year, Pickett allocated 60% of the 2020 loss to the general partner and 40% of the loss to its limited partner. Because more than 35% of the loss was allocated to the limited partner, without an election, Pickett would be classified as a syndicate and thus prohibited from using the cash method of accounting in 2020. Pickett may instead elect under §1.448-2(b)(2)(iii)(B) to use the prior year allocated amounts. Since no loss was allocated to the limited partner in 2019, Pickett is not classified as a syndicate for 2020 and is not required to switch to the accrual method of accounting. Pickett is not a syndicate in 2021 because there were no losses in that year and the election made in 2020 applied to that year only.
Simplified rules for small businesses with inventories
A business that maintains an inventory must generally use an accrual method to account for purchases and sales. A small business that meets the gross receipts test may instead treat inventories as non-incidental materials and supplies (NIMS). If the business is applying the “NIMS” method, the business treats the inventoriable items as materials and supplies in the year they are used or consumed. The final regulations adopt the proposed regulations provision that items are treated as used or consumed in the year they are provided to customers and the cost of the items is recovered or, if later, the year in which the business pays for or incurs the cost.
Example 2: Best Cookies, Inc. is a C corporation with average annual gross receipts that are under the threshold amount and so qualifies to use the NIMS method for inventory items. In 2019 Best buys peanut butter and in December of 2019 uses all of it to bake cookies for sale. The cookies are sold to customers in January of 2020. Best may deduct the cost of the peanut butter in 2020, the year the items are provided for sale to Best’s customers.
A small business that meets the gross receipts test may use other tax accounting methods, including the accounting financial statement (AFS) method and non-AFS methods that are consistent with the business’s books and records. However, the final regulations clarify that if a business chooses to apply the NIMS method to inventory, the business may not apply any other method, including AFS, non-AFS, and last-in-first-out (LIFO) methods to any part of the inventory. See the final regulations for details on other acceptable accounting methods.