IRS Issues Final Regulations Simplifying Tax Accounting Rules For Small ...

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08 January 2021

IRS issues final regulations simplifying tax accounting rules for small businesses to reflect TCJA favorable changes

Background

The TCJA (1) broadened the small-business exception by increasing the gross-receipts-test amount to $25 million or less, indexed for inflation, and (2) applied the same higher gross-receipts-test amount to businesses that want to use the simplified accounting rules under IRC Sections 471, 263A and 460.

Final regulations

IRC Section 471 small business taxpayer exemptions are modified

Indirect labor. Some commenters recommended that direct labor costs be excluded from the definition of inventory costs under the IRC Section 471(c) NIMS inventory method. Acknowledging that (1) other guidance (Revenue Procedures 2001-10 and 2002-28) created uncertainty around whether direct labor and overhead costs must be capitalized under the NIMS method and (2) tracking direct labor costs can be burdensome and difficult for many small businesses, the IRS and Treasury decided to exclude direct labor from the costs included in inventory treated as NIMS. Under the final regulations, the only inventory costs includible in the IRC Section 471(c) NIMS inventory method are (1) direct material costs of property produced and (2) costs of property acquired for resale.

Consistent with the proposed regulations, the final regulations remove the obsolete IRC Section 263A reseller exemption but retain the exemptions from the IRC Section 263A uniform capitalization rules that are not based on gross receipts.

In addition, the final regulations add some examples to clarify the significance of taking a physical account of inventory under the non-AFS IRC Section 471(c) inventory method. Essentially, if the taxpayer uses the information from the physical count to allocate costs to inventory, this information must be used when applying the non-AFS IRC Section 471(c) method, regardless of whether the taxpayers makes reconciling entries to expense these costs in its financial statements. According to the preamble, these examples "clarify the principle that a taxpayer may not ignore its regular accounting procedures or portions of its books and records under the non-AFS [IRC S]ection 471(c) inventory method."

Five-year restriction on automatic method changes is removed

Tax shelter determination may be made annually

The proposed regulations permitted a taxpayer to elect to use allocated taxable income or loss of the immediately preceding tax year to determine whether the taxpayer is a syndicate for the current tax year, but required a taxpayer making this election to apply the rule to all subsequent tax years, unless the IRS granted permission to revoke the election.

IRC Section 460

Applicability dates

Implications

If a taxpayer follows its AFS or non-AFS method (as applicable), the final regulations reiterate that taxpayer must consider applicable federal income tax rules to determine when a cost is includible in inventory and when the cost is recovered (e.g., a cost is not includible in inventory prior to when it is incurred under the taxpayer's overall method of accounting). Therefore, a taxpayer may need to reconcile any differences between its AFS/non-AFS treatment and federal income tax treatment for a cost (e.g., by adjusting the amount of a cost capitalized to inventory for book purposes to tax basis) and should note the potential for this additional administrative effort when choosing which non-IRC Section 471 method to implement. In addition, a taxpayer using the AFS IRC Section 471(c) inventory method that has mismatched financial reporting periods with its tax year must apply the same mismatched reporting method used for IRC Section 451 purposes.

Importantly, the final regulations modified the originally proposed tax shelter test election in the proposed regulations from a permanent election to an annual one. This could provide more certainty for taxpayers that have an atypical loss year among, for example, profitable years that would otherwise necessitate a change from the overall cash method. However, the government declined certain commentators' requests to not require an IRC Section 481(a) adjustment for method changes that arise by operation of the tax shelter testing rules of IRC Section 448.

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