Summary of newly-released proposed regulations related to changes made under the TCJA.
On July 29, 2020, the IRS and Treasury released an advance copy of proposed regulations (REG-132766-18) to provide guidance for small business taxpayers to implement several statutory exemptions enacted by the 2017 tax reform bill known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, for the purpose of simplifying the method of accounting rules. Small business taxpayers are defined as having average annual gross receipts for the three taxable year period ending before the current taxable year not exceeding $25 million, adjusted for inflation (gross receipts test). For taxable years beginning in 2019 and 2020, the gross receipts amount has been adjusted to $26 million. Importantly, for gross receipts testing purposes, the aggregation rules of Section 448(c)(2) may apply to combine gross receipts of another entity.
The proposed regulations affect the use of the overall cash method of accounting, inventory methods, uniform capitalization rules under Section 263A (UNICAP), and long-term contracts. The statutory exemptions do not apply to businesses that are considered tax shelters, as discussed below. While these regulations provide additional clarity as to the positions the IRS is taking, we anticipate that taxpayers will continue to encounter significant complexities associated with implementing these rules.
The regulations are generally applicable to taxable years beginning on or after the date the final regulations are published in the Federal Register – e.g., for 2020 with respect to calendar year taxpayers. However, taxpayers have the option of relying on the proposed regulations for taxable years beginning after December 31, 2017, as long as all the applicable rules for each Code provision that a taxpayer chooses to apply are followed. There is guidance applicable to tax shelters and manufacturers that wish to treat their inventory as non-incidental materials and supplies that may require immediate action, as discussed below.
This alert discusses the highlights of the proposed regulations.
Definition of Tax Shelter
A tax shelter is always prohibited from using the simplifying methods described above, regardless of the amount of its gross receipts. A tax shelter is defined to include a syndicate under Section 1256(e)(3)(B), which is a partnership or other entity (other than a C corporation), of which more than 35% of that entity’s losses during the taxable year are allocable to limited partners or limited entrepreneurs. Temporary Reg. Section 1.448-1T(b)(3) narrows this definition by providing that a taxpayer is a syndicate only if more than 35% of its losses are allocated to limited partners or limited entrepreneurs. This means a partnership or other entity may be considered a syndicate only for a taxable year in which it has losses. The IRS noted in the preamble to the proposed regulations that they specifically did not permit relief from meeting the tax shelter definition to taxpayers that report negative taxable income in a taxable year solely because of a negative (favorable) Section 481(a) adjustment from an accounting method change.
The proposed regulations permit a taxpayer to elect to use the allocated taxable income or loss of the immediately preceding taxable year, instead of the current taxable year, to determine whether the taxpayer is a syndicate for purposes of Section 448 for the current taxable year. The preamble to the proposed regulations notes that a taxpayer making this election will have certainty at the beginning of its current taxable year as to whether it is a tax shelter or not. The election is made by attaching a statement to a timely filed original federal income tax return for the first taxable year for which the election is made. Once made, the election applies to all subsequent taxable years, and for all purposes for which status as a tax shelter is defined under Section 448(a)(3), including the Section 163(j) limitation on business interest deduction, unless the taxpayer obtains the IRS’s consent to revoke the election by filing a private letter ruling request. The proposed regulations state that no late elections will be permitted, and an election cannot be made by filing an amended return. Further, the election may never be revoked earlier than the fifth taxable year following the first taxable year for which the election was made unless extraordinary circumstances are demonstrated to the satisfaction of the IRS. Once an election has been revoked, a new election cannot be made until the fifth taxable year following the taxable year for which the election was revoked unless extraordinary circumstances are demonstrated to the satisfaction of the IRS.
The impact of this guidance is that making this election would allow an entity to obtain certainty at the beginning of the year as to whether it is required to use the overall accrual method, similar to a C corporation or a partnership with a C corporation partner that must apply the gross receipts test at the beginning of the year by looking at prior years’ gross receipts. But, by not modifying the definition of a tax shelter to exclude the syndicate definition, the proposed regulations continue to subject taxpayers meeting the syndicate definition to the Section 448 requirement to use the overall accrual method and exclude such taxpayers from the other statutory exclusions discussed in the proposed regulations that apply to small business taxpayers, including Section 163(j).
Overall Accounting Method
In general, Section 448 prohibits a C corporation, partnership with a C corporation partner, or tax shelter from using the overall cash receipts and disbursements method of accounting. C corporations and partnerships with a C corporation partner that meet the gross receipts test for the current year may use the overall cash method. Under the changes to Section 448 made by the TCJA, a C corporation or partnership with a C corporation partner is no longer prohibited from using the cash method of accounting for all future years after it first exceeds the gross receipts test; that is, if a taxpayer’s gross receipts fall under the gross receipts test threshold in subsequent years, it may be eligible to use the cash method of accounting again by filing an accounting method change. However, the proposed regulations maintain the eligibility restriction under Section 5.01(1)(e) of Rev. Proc. 2015-13 that prohibits a taxpayer from qualifying for an automatic accounting method change if it has made or requested an overall method change during any of the five taxable years ending with the year of change. Therefore, a taxpayer that has changed to the overall accrual method within this five-year period would have to file a non-automatic method change request to change back to the overall cash method. Given the IRS’s general five-year restriction on changing the same method of accounting, it is not surprising that IRS has not waived the restriction, which would permit taxpayers to switch back and forth between the overall cash and accrual methods in a shorter period of time. The preamble to the proposed regulations indicates that the IRS is concerned that multiple changes in a taxpayer’s overall method of accounting within a short period of time may cause income and expenses to not be treated consistently and that income may not be clearly reflected. Consequently, taxpayers that exceed the gross receipts test will generally be required to use the overall accrual method for five years before being able to change back to the overall cash method automatically, even if they fall within the gross receipts test threshold prior to the five-year period, or weigh the cost (including IRS filing fees and Form 3115 preparation fees) associated with filing a non-automatic change within the five-year period against the benefit of changing to overall cash. Conversely, a taxpayer that changes to the cash method will generally be able to automatically change to the overall accrual method for the first year that it exceeds the gross receipts test, without having to wait for five years.
Treatment of Inventory
Under Section 471, inventories are required in a taxable year in which the production, purchase, or sale of merchandise is an income-producing factor; if inventories are required, an accrual method must be used for purchases and sales. The TCJA permitted taxpayers that meet the gross receipts test and that are not tax shelters under Section 448 to be exempt from Section 471 and to use certain simplified inventory methods, specifically to either (1) treat its inventory as non-incidental materials and supplies (Section 471(c) materials and supplies) or to (2) conform to its inventory method used in its applicable financial statement (AFS), or the taxpayer’s books and records prepared in accordance with its accounting procedures, if it does not have an AFS.
Taxpayers that choose to treat inventory as Section 471(c) materials and supplies are required to treat such costs as deductible in the year in which they are actually consumed and used in the taxpayer’s business. The proposed regulations state that Section 471(c) materials and supplies are considered to be used or consumed in the taxable year in which the taxpayer provides the item to a customer or the taxable year in which the taxpayer pays for or incurs such cost, whichever is later. The preamble to the proposed regulations indicates that the IRS believes the TCJA Conference Report requires the recovery of non-incidental materials and supplies to be consistent with the law in existence when the TCJA was passed. The law in effect at that time was administrative guidance under Rev. Proc. 2001-10 and Rev. Proc. 2002-28 that provided the same rule as in the proposed regulations. Thus, the IRS does not adopt a rule, suggested by a commenter, that for manufacturers, raw materials used to produce finished goods would be deemed used or consumed when the raw materials were used during production, which would permit the deduction to be taken earlier than in the proposed guidance. As such, taxpayers that took a position to deduct raw materials in the year the amounts were used in production and filed a method change with their 2018 or 2019 return to do so may need to consider whether to file another method change to comply with the proposed regulations, or wait until the regulations are finalized to assess whether the government will reconsider the position. While taxpayers are not required to conform to this rule until and unless it is finalized, it is possible that IRS examiners may look to the rule as the position they should take in an examination.
A taxpayer may make another automatic accounting method change under Section 22.19 of Rev. Proc. 2019-43 to conform to the proposed regulations’ determination of when Section 471(c) materials and supplies are used or consumed, or to change to use the taxpayer’s inventory method used in its applicable financial statements (or its books and records prepared in accordance with its accounting procedures, if it does not have an applicable financial statement). The eligibility restriction prohibiting a change in the same item within five taxable years is waived for the first, second, and third taxable year beginning after December 31, 2017. Thus, under the current procedural rules, taxpayers that become subject to the Section 471 requirements when their gross receipts exceed the threshold will generally need to remain on their Section 471 method for at least five years, even if their gross receipts drop below the threshold sometime within the five year period.
Questions have arisen as to whether a taxpayer treating its inventory as non-incidental materials and supplies may use the de minimis safe harbor election under Reg. Section 1.263(a)-1(f). The de minimis safe harbor election permits a taxpayer to deduct amounts paid for the acquisition or production of a unit of tangible property; such amounts would not be capitalized or treated as a material or supply it if the taxpayer meets the requirements of the safe harbor. The proposed regulations clarify the IRS’s position that the de minimis safe harbor election does not apply to Section 471(c) materials and supplies. The IRS believes that Section 471(c) materials and supplies retain their characterization as inventory property, and inventory is not eligible for the de minimis safe harbor election. This position is consistent with the position the IRS took at the time the tangible property regulations were released in FAQs published on their website.
The proposed regulations further provide that a taxpayer may identify and value their Section 471(c) materials and supplies using either a specific identification method; a first-in, first-out method; or an average cost method, provided the method is used consistently. The last-in, first-out method or lower-of-cost-or market methods may not be used, because, according to the IRS, they require sophisticated computations and the purpose of the exception from inventory is to provide simplification. A taxpayer using the Section 471(c) materials and supplies method is required to include only direct costs paid to produce or acquire the inventory as Section 471(c) materials and supplies, but not overhead costs. Accordingly, there could still be an opportunity for acceleration of certain deductions under this approach.
To the extent that a small business taxpayer chooses not to treat inventory as Section 471(c) materials and supplies, the proposed regulations also provide guidance for a taxpayer that wishes to treat its inventory in accordance with its applicable financial statement (AFS Section 471(c) method). The definition of an AFS references the definition used in Section 451(b)(3) and the proposed regulations under Sections 1.451-3(c)(1) and 1.451-3(h). A taxpayer’s inventory costs are the costs that a taxpayer capitalizes for property produced or property acquired for resale in its AFS. A taxpayer is not permitted to recover a cost that it otherwise would be neither permitted to recover nor deduct for federal income tax purposes solely by reason of it being an inventory cost in the taxpayer’s AFS inventory method. Further, a taxpayer may not capitalize a cost to inventory any earlier than the taxable year in which the amount is paid or incurred under its overall method of accounting for federal income tax purposes, nor a cost that is not permitted to be capitalized by another Code provision. This may require a reconciliation of any differences between a taxpayer’s AFS and federal income tax return treatment for costs included in the taxpayer’s AFS inventory method under the AFS Section 471(c) method. The IRS states that it believes the exemption for the inventory rules of Section 471(a) does not exempt taxpayers from applying other Code provisions that determine the deductibility or recoverability of costs, or the timing of when costs are considered paid or incurred. These rules also apply to a taxpayer without an AFS that elects to treat inventory as reflected in its books and records prepared in accordance with its accounting procedures. Additionally, this non-AFS Section 471(c) method requires that a method that determines ending inventory and cost of goods sold that properly reflects the taxpayer’s business activities for non-federal income tax purposes be used; for example, a taxpayer that performs a physical count of inventory that it uses in reports to its creditor must use that count for purposes of the non-AFS Section 471 method, even though the taxpayer treats all costs paid during the taxable year as presently deductible.
Section 460 requires the use of the percentage of completion method (PCM) for long-term contracts. Under the PCM, a taxpayer must include in income a portion of its total contract revenue based on the ratio of costs incurred during the taxable year over total costs expected to be incurred for the contract, regardless of when cash is actually received. However, small business taxpayer construction contracts that are expected to be completed within a two-year period are exempt from PCM, as well as home construction contracts in general. The preamble to proposed regulations clarify that a taxpayer may adopt any permissible method of accounting for each type of contract. In addition, the proposed regulations confirm that taxpayers are required to file a method change in situations in which a taxpayer has been using PCM for exempt contracts and seeks to change to a different exempt contract method, such as the completed contract method.
The proposed regulations also provide additional rules related to the look-back method, which requires taxpayers subject to PCM to determine upon the completion of long-term contracts whether they must pay interest or are entitled to receive interest to the extent differences exist between the estimated contract costs and actual total contract costs. In particular, the proposed regulations provide that taxpayers subject to the base erosion anti-abuse tax (BEAT) under Section 59A must apply the look-back method to re-determine the taxpayer’s modified taxable income and the taxpayer’s base erosion minimum tax amount for each year prior to the filing year that is affected by contracts completed or adjusted in the filing year as if the actual total contract price and costs had been used in applying the percentage of completion method. The preamble indicates this update is necessary because the income from long-term contracts determined using the PCM may be overestimated or underestimated, which may change the taxpayer’s modified taxable income or base erosion minimum tax amount, or whether or not a taxpayer is an applicable taxpayer in a particular taxable year.
The relatively short time frame between the issuance of these proposed regulations and the extended due dates for calendar year 2019 federal tax returns means that there is not much reaction time to evaluate the taxpayer’s methods affected by these regulations and determine if action is needed before the 2019 tax return is filed. Taxpayers should familiarize themselves with the guidance to determine whether any immediate action items may be necessary for their 2019 tax year and take appropriate actions.