September 30, 2023


The Number One Source For Business

Simplified accounting rules for small businesses allow annual election

The IRS on Wednesday finalized updates to various tax accounting regulations to adopt the simplified tax accounting rules for small businesses enacted by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. The regulations (T.D. 9942) finalize proposed regulations issued in July (REG-132766-18) with a few changes in response to comments,

For tax years beginning in 2020 and 2021, these simplified tax accounting rules apply for taxpayers with inflation-adjusted average annual gross receipts of $26 million or less (known as the gross receipts test).

Tax shelter annual election

Taxpayers classified as tax shelters are prohibited from using the simplified rules even if they meet the gross receipts test. The final regulations, however, have a special election for certain entities classified as tax shelters. In the preamble, the IRS explained that it was aware of the adverse effects of being defined as a tax shelter under Sec. 448(d)(3) for a tax year.

To address these concerns, the final regulations modify the election for syndicates by making the election an annual election (instead of permanent, as had been proposed). A syndicate is, generally, a business in which more than 35{de3fc13d4eb210e6ea91a63b91641ad51ecf4a1f1306988bf846a537e7024eeb} of the losses during the tax year are allocable to limited partners or limited entrepreneurs. An annual election balances the statutory language with the consistency requirement for using a method of accounting under Sec. 446(a) and Regs. Sec.1.446-1, the IRS says.

A cash method taxpayer that is generally profitable year-to-year may experience an unforeseen taxable loss for an anomalous year but return to its profitable position in subsequent years. If the taxpayer allocated more than 35{de3fc13d4eb210e6ea91a63b91641ad51ecf4a1f1306988bf846a537e7024eeb} of the taxable loss to its limited partners or limited entrepreneurs, the taxpayer would be required to change from the cash method to another method for the anomalous year under Sec. 448(a)(3). However, that taxpayer would otherwise not be prohibited from using the cash method in the next tax year when it was profitable. An annual election under final Regs. Sec. 1.448-2(b)(2)(iii)(B) allows a taxpayer to elect in the loss year to use the allocated taxable income or loss of the immediately preceding tax year to determine whether the taxpayer is a syndicate for the current tax year.

Permitting taxpayers to continue to use the cash method in those situations, as well as other methods affected by being determined to be a tax shelter, is consistent with the Sec. 446(a) requirements, the IRS says.

This tax shelter election applies for all Code provisions that refer to Sec. 448(a)(3) to define a tax shelter, including the small business exemptions under Secs. 163(j)(3), 263A(i)(1), 460(e)(1)(B), and 471(c)(1).

To make this election, a taxpayer must file a statement with its original timely filed federal income tax return, with extensions, to affirmatively choose this election for that tax year. The election is valid only for the tax year for which it is made and cannot be revoked. The IRS intends to issue guidance to address the revocation of an election that was made under the proposed regulations.

Annual gross receipts test and other provisions

A taxpayer is considered to meet the gross receipts test and be permitted to use the cash method of accounting if average annual gross receipts for the three-tax-year period ending immediately before the current tax year are $25 million (adjusted for inflation to $26 million for 2020 and 2021) or less.

The TCJA also exempted small business taxpayers from the Sec. 263A uniform capitalization rules and added an exception to the requirement to use an inventory method if their inventory is treated as nonincidental materials and supplies, or in accordance with the applicable financial statement (AFS). If they do not have an AFS, taxpayers can use their books and records. The final regulations implement these statutory changes and provide clarifying guidance on the definition of an AFS, and the types and amounts of costs reflected in an AFS that can be recovered under Sec. 471(c), and when those costs can be taken into account.

In another clarification to the proposed regulations, the final regulations provide that a taxpayer that uses the Sec. 471(c) nonincidental material and supplies (NIMS) inventory method may not use any other method described in the Sec. 471 regulations or the last-in, first-out (LIFO) method described in Sec. 472 and its regulations to identify inventory treated as nonincidental materials and supplies, or to value the NIMS inventory.

The regulations are effective when they are published in the Federal Register (they have been submitted to the Office of the Federal Register, but no publication date has been scheduled yet), but many of the provisions are effective for tax years ending after Dec. 31, 2017.

In addition, for a tax year beginning after Dec. 31, 2017, and before the date of publication in the Federal Register, a taxpayer may apply the last sentence of Regs. Secs. 1.263A-8(a)(1) (requirement to capitalize interest) and 1.263A-9(e)(2) (the avoided cost method), provided that the taxpayer follows all the rules in the Sec, 263A regulations for that tax year and all subsequent years. Similar effective date rules apply to the other regulations.

Sally P. Schreiber, J.D., ([email protected]) is a JofA senior editor.