Final regulations on the small-business taxpayer exception

| 3/11/2021
Final regulations on the small-business taxpayer exception

The IRS published final regulations on the small-business taxpayer provisions under IRC Sections 448, 263A, 460, and 471 on Jan. 5. These changes, which were enacted as part of the Tax Cuts and Jobs Act of 2017, provide simplified tax accounting methods for certain small businesses. The final regulations generally adopt the proposed regulations published on Aug. 5, 2020. However, the final regulations make the following important changes.

Small-business taxpayer exception

Under IRC Section 448, small businesses with a $25 million or less three-year average of gross receipts (small-business taxpayer exception) are permitted to use the cash method of accounting. This threshold was indexed for inflation and stands at $26 million for taxable years beginning in 2020 or 2021. Taxpayers that meet the small-business taxpayer exception under IRC Section 448 also may use the following simplified methods of accounting:

  • In lieu of applying the rules under IRC Section 471(a), taxpayers may account for inventories either as nonincidental materials and supplies (NIMS) or as conforming to their applicable financial statements (AFS) (or books and records if a taxpayer does not have an AFS).
  • Taxpayers may forgo the capitalization of additional costs to property produced or acquired for resale under IRC Section 263A.
  • Taxpayers may be exempt from the requirement to account for long-term contracts under the percentage-of-completion method under IRC Section 460.

In addition, the gross receipts tests under IRC Section 448 is used to provide special rules for small businesses in other sections of the IRC, such IRC Section163(j) regarding the limitation on business interest.

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Highlights of changes in the final regulations

Tax shelter/syndicate rules. The final regulations generally retain the definition of a syndicate as a tax shelter ineligible for the cash method of accounting under IRC Section 448 and other small-business taxpayer provisions. A syndicate is defined as an entity (other than C corporations) where more than 35% of the entity’s losses are allocated to limited partners or limited entrepreneurs. This definition can create difficulties and uncertainties for taxpayers, as an entity might meet the definition of syndicate in one year and not the next due to fluctuations in profitability.

The final regulations provide one key point of relief – an annual election to test an allocation of losses based on the prior taxable year rather than the current year. This election, under Treasury Regulation Section 1.448-2(b)(2)(iii)(B), is irrevocable, but only for the year in which it is made. This rule is a change from the proposed regulations, which made the election irrevocable for the year the election was made and all future taxable years.

The annual election will provide taxpayers some flexibility in applying the syndicate rules and maintaining small-business taxpayer status. Additionally, due to the annual nature of the election, a taxpayer can forgo the election in a subsequent year and test its eligibility based on that year’s allocations of income and loss. As such, taxpayers might be able to avoid the implications of the syndicate rules altogether if loss allocations are limited to nonconsecutive taxable years.

Accounting for inventories. The final regulations clarify the inventory rules for small businesses. IRC Section 471(c) allows taxpayers meeting the gross receipts test to treat inventories as nonincidental materials and supplies (Section 471(c) NIMS). The final regulations require the capitalization of all direct material costs for property produced or acquired for resale, but they do not include the provision under the proposed regulations that would require small businesses to also capitalize their direct labor costs.

The final regulations also clarify that inventories accounted for as Section 471(c) NIMS are not eligible for immediate deduction under the de minimis safe harbor rule under IRC Section 1.263(a)-1(f). However, if inventories are expensed under a taxpayer’s books, the inventories might be eligible for a corresponding deduction for tax under one of the other small-business inventory methods.

In addition, the final regulations provide simplifying inventory costing methods allowing taxpayers meeting the gross receipts test to use either their AFS (AFS Section 471(c)), or books and records if they do not have an AFS (non-AFS Section 471(c)) to determine the value of inventories. The regulations also provide examples clarifying that taxpayers might need to adjust their book inventory amounts if they use a different overall method for tax purposes.

Effective date. Generally, these rules are applicable to taxable years beginning on or after Jan. 5, 2021. For calendar year taxpayers, the first year that these rules apply is the 2022 tax year. However, taxpayers generally may apply the rules in the final regulations to taxable years beginning after Dec. 31, 2017, and before Jan. 5, 2021, if they are applied in their entirety and in a consistent manner.

Looking ahead

Taxpayers adopting a method permitted under the small-business taxpayer exception rules generally are required to file a Form 3115, “Application for Change in Accounting Method,” under the automatic method change rules. However, specific procedural guidance has not yet been issued for changes under the final regulations.

These small-business taxpayer exception provisions are a significant benefit for many taxpayers, although many restrictions and limitations exist in addition to those noted. Taxpayers should consult with their tax advisers to evaluate the applicability and potential benefit of adopting these methods.

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