The Tax Cuts and Jobs Act of 2017 has created several changes in requirements for businesses with sales below $25M. We will highlight and discuss these changes and some options that will be available to many businesses below this threshold. We will also discuss one change that will negatively affect you if your revenues are above this $25M threshold.
Prior to the new tax act, IRS Code Section 446 generally allowed taxpayers to select a method of accounting for use in filing and paying taxes. As usual, the tax code has some language that can be used by the IRS to muddy the water such as the phrase “provided that such method clearly reflects the income of the taxpayer.” This gives them room to challenge your selection; but, for the most part, with some exceptions, you can elect on your first tax return how you are going to be taxed.
Methods of Accounting
Most taxpayers choose either the cash method or the accrual method. Taxpayers using the cash method generally recognize income when they receive payment for their goods or services and deductions when they pay their bills.
Accrual method taxpayers recognize income when a sale has occurred and they have a right to receive money and deduct an expense when they have obligated themselves to pay for the goods or services. Generally speaking, the cash method is considered much easier to administer and has more flexibility in when to recognize income.
In addition, once you choose the method of accounting on which your tax will be calculated, you are required to keep that method in place unless you first ask the IRS for permission to change. And one of the requirements is there has to be a reason for changing.
There were some exceptions to this rule. If you were a C Corporation or a partnership with a C Corporation partner, to the extent that your income was above $5M, you were required to use the accrual method of accounting. Another exception was if you operated any business where you purchased, produced or sold merchandise and you kept inventory on hand. In this case,
if sales exceeded $1M, you were required to account for the inventory and use the accrual method of accounting, at least for sales and purchases of goods.
Another complication under the old rules was Code Section 263A and the requirement to allocate certain direct and indirect costs to property that is included in inventory. If your sales were $10M or less, you were exempt from this requirement.
For contractors, you were required to use the percentage of completion method to calculate taxable income unless your sales were $10M or less and your contracts were expected to be completed within two years.
Changes Under the New Law
So you get the picture. Under the old law, we had $1M exceptions, $5M exceptions and $10M exceptions, all for different rules and requirements as it related to how to measure taxable income and methods of accounting that were available to use. Welcome the Tax Cuts and Jobs Act of 2017.
The new law raises the income limitations for all of the items mentioned above to allow the cash method of accounting for any entity type if the average of the last three years’ income is $25M or less. The restrictions for required use of accrual accounting, inventories, use of 263A adjustments and required use of percentage of completion are also removed if sales are under this new threshold. This will allow many more small businesses to use this administratively easier concept of cash-basis accounting to keep their books and file and pay their taxes.
As mentioned earlier, you are allowed to change your method of accounting if you have a reason to change. Many of you did not have a reason to change because you were not allowed to. Now that the threshold and requirements are lifted, you have a reason to change. And for many of you, we will be recommending that we prepare Form 3115 and ask the IRS for permission to change your business to the cash basis of accounting for tax purposes. You may be asking “why would I go to the trouble?” Let me explain a real-life situation to help you better understand.
In our example, let’s assume that you are a required accrual basis business with inventory, you have income of $100,000 and your balance sheet has the following items:
Accounts Receivable $50,000
Accounts Payable $150,000
If today was December 31, you would pay tax on $100,000 of income.
If we request and are granted permission to change to the cash method of accounting, your taxable loss will be calculated for 2018 as follows:
Net income before change $100,000
Add: Accounts Payable $150,000
Subtract: Inventory ($500,000)
Subtract: Accounts Receivable ($50,000)
Taxable loss ($300,000)
We are hoping for some guidance from the IRS that will allow an automatic change in method if we file the Form 3115. Without it, we will file the 3115 but have to wait to receive a letter granting the permission. In addition, currently when you request and are granted permission to change methods, if the change results in a reduction of income, you take the reduction all at once as per the example above. If it were to create income, you pick it up evenly over five years. We do not anticipate a change, but the IRS may require that both the income and loss be spread out evenly. We will be watching for this guidance in the coming months.
On the negative side, you may have heard that there are certain limits on the deduction of interest paid. Once again, if you are below the $25M income limit, the restrictions do not apply.
If your average sales exceed the $25M threshold, there are serious limitations of your regular interest deduction. Beginning in 2018, the interest expense you’ll be allowed to deduct is as follows: 1) combined total of business interest income; 2) 30% of adjusted taxable income; and 3) any floor plan financing interest. Disallowed interest may be carried forward for up to five years. For purposes of the calculation, adjusted taxable income is the equivalent of EBIDA – earnings before interest, depreciation and amortization.
Each of your situations is different and will require different amounts and types of planning. As always, please reach out to one of the tax professionals at WSW if you have any questions.
PLEASE REMEMBER, THIS DEDUCTION WILL TAKE EFFECT ON THE TAX RETURNS WE FILE FOR A DUE DATE OF APRIL 15, 2019. OUR PRIMARY FOCUS IS FILING YOUR 2017 RETURNS ACCURATELY AND ON TIME. WE WILL BE WORKING WITH ALL CLIENTS AFTER THE CURRENT DEADLINE TO BEGIN PLANNING FOR THE END OF THE YEAR. THANK YOU, AS ALWAYS, FOR YOUR TRUST IN WSW CPAS.