This information is based on the statutes and guidance available as of the date of publication and is subject to change. 

In an attempt to ease the tax compliance burden for smaller business, new tax reform provisions allow smaller taxpayers to use simplified procedures to account for revenue and expenses. However, larger businesses that are not eligible to use the simplified procedures may actually find themselves with an increased compliance burden, as well as accelerated recognition of taxable income, under the new rules.

Small Business Accounting Reform and Simplification

Cash Method of Accounting

Most taxpayers are required to use an accrual method of accounting for tax return purposes through a myriad of restrictions placed on use of the cash method. Specifically, corporations and partnerships with a corporate partner were previously only allowed to use the cash method if their average gross receipts for the prior three tax years were less than $5,000,000, referred to as the “gross receipts test”.  Tax reform revises this threshold to $25,000,000, and many taxpayers that were previously required to file tax returns on the accrual method may now qualify for the cash method. 

The gross receipts test is applied at an affiliated group level, including all businesses with more than 50% common ownership with the taxpayer. Foreign corporations are included in the affiliated group if they meet the 50% ownership test.  

The effective date for the new threshold is for tax years ending on or after December 31, 2017. In applying the test for the tax year, the taxpayer only needs to determine if they meet the gross receipts test for that tax year. This is a change from the old law that required taxpayers to meet the test for all prior years before the taxpayer could pass the test.

Note that the $25,000,000 threshold will be indexed for inflation for tax years beginning after December 31, 2018, rounded to the nearest million.

Accounting for Inventory

Under prior law, most businesses were required to account for inventories on an accrual method that complied with §471 (i.e., full absorption method, retail method, etc.). Under tax reform, taxpayers that meet the average gross receipts test described above are no longer required to account for inventories under a method described in §471. Instead, these taxpayers are allowed to use a method of accounting that either treats inventories as non-incidental materials and supplies, or follows the taxpayer’s method of accounting for financial statement purposes.  

In addition, and to the relief of many taxpayers, the requirement to apply §263A (“UNICAP”) to inventories is also raised to the $25,000,000 average gross receipts level. Generally, the UNICAP rules require direct and certain indirect costs attributable to real or tangible property produced by the taxpayer to be capitalized into the basis of the property. The prior small taxpayer exemption from UNICAP only applied to retailers and resellers with gross receipts below $10,000,000 – producers were still required to follow UNICAP. The expansion of the small business exception under tax reform now applies the new $25,000,000 gross receipts test to both retailers and producers of both real and personal property, making this an attractive change of accounting method for any taxpayers that meet the new gross receipts test.

Long-Term Contract Accounting

Generally, a “long-term contract” for tax purposes is any contract in which the completion of the contract occurs in a tax year later than the year in which the contract is entered. Note that this does not necessarily have to be a full twelve months – a contract entered into in November but completed in February would meet this definition for a calendar year taxpayer. The percentage-of-completion method in accounting for long-term contracts is generally required for tax purposes. There is an exception, however, for taxpayers with gross receipts below a $10,000,000 threshold and an anticipated completion date of less than 2 years from commencement of the contract.

Tax reform now applies the higher gross receipts threshold of $25,000,000 before requiring the percentage-of completion method to be utilized as long as the 2-year rule is still met. These new rules for long-term contract accounting apply for contracts entered into after December 31, 2017 and occurring in a tax year ending after that date.  

Applying the Accounting Method Changes to Small Taxpayers

Any taxpayer that now qualifies as a “small taxpayer” and would like to change their method of accounting for tax purposes to a simpler method is deemed to elect the new method “with IRS consent”. However, the IRS can still require taxpayers to follow normal change of accounting method rules and file Form 3115 in the year of change, which we expect to be the case.  

New Accounting Method Rules Applicable to All Taxpayers

Taxable Income Inclusion Must Now Conform with Financial Statements

Under prior tax law, accrual-method taxpayers included an item in income when all events had occurred that fixed the right to receive the income and the amount could be determined with reasonable accuracy (the “all-events test”). Some exceptions to this general rule were available, depending on the type of income.  

The new law requires taxpayers to recognize taxable income no later than the year in which the income is taken into account in the taxpayer’s applicable financial statements (“AFS”), or any other financial statement the IRS may specify for this purpose (the “AFS conformity rule”). Taxpayers with deferred tax liabilities resulting from income deferral will now have these items accelerated and taxed in the year in which they are considered income for financial statement purposes.  

An “applicable financial statement” is defined as:

  • A financial statement which is certified as being prepared in accordance with generally accepted accounting principles (GAAP) and which is any one of the following:
    • A Form 10-K or annual statement to shareholders;
    • An audited financial statement used for credit purposes, reporting to shareholders, partners or other beneficiaries, or for any other substantial nontax purpose; or
    • Filed by the taxpayer with any other federal agency for purposes other than federal tax purposes.
  • A financial statement based on international financial reporting standards filed by the taxpayer with an agency of a foreign government that is equivalent to the U.S. Securities and Exchange Commission;
  • A financial statement filed by the taxpayer with any other regulatory or governmental body specified by the IRS.

If the financial results of a taxpayer are reported on AFS for a group of entities, that statement may be treated as the AFS of the taxpayer.

Any taxpayers required to change their method of accounting to comply with this provision are deemed to be make the change with IRS consent. As mentioned above, however, taxpayers will likely still be required to file Form 3115. 

Another significant modification to the normal change in accounting method rules applicable to all taxpayers provides that unfavorable changes (i.e., changes that increase taxable income in the year of change) may be included in income over a six-year period rather than the traditional four-year period. Favorable adjustments can still be fully taken into account in the year of change.

Treatment of Advance Payments

Under the general all-events test, income recognition for some payments received in advance for goods or services could be deferred until the goods or services were provided to the customer. This deferral generally followed the financial statement treatment for these items.  

Tax reform codified this deferral method of accounting for advance payments. As long as the taxpayer’s financial statements will include the payment in income during the next tax year, the taxpayer may also defer taxable income recognition until that tax year. If deferral is expected to go beyond the next tax year, the taxpayer is required to include the entire amount in taxable income in the year of receipt.

Note that certain payments are not considered to be “advance payments” for this purpose:

  • Rents;
  • Warranty or guarantee contracts with a third-party obligor;
  • Certain insurance premiums or payments with respect to financial instruments;
  • Payments subject to:
    • Tax on income of nonresident alien individuals not connected with a U.S business;
    • Tax on income of foreign corporations not connected with a U.S. business;
    • Tax withheld on payments to foreign persons or corporations under §§1441 or 1442.

Research and Experimental Expenses after 2021

Research and experimental costs have been deductible in the year incurred under §174 since the Tax Reform Act of 1986. Under the new tax reform law, taxpayers must capitalize and amortize over a 5-year period research costs incurred in tax years after 2021. Costs incurred for research performed outside the U.S. must be amortized over a 15-year period.