By Benton Collins, CPA
Taxpayers will be hard pressed to find any of the often promised simplification when looking through the business provisions of the Tax Cuts and Jobs Act. There are, however, a few bright spots in the bill that afford taxpayers the ability to streamline their tax accounting processes while also reducing taxes due.
Accounting Methods
For tax years starting in 2018, a greater number of taxpayers will have the option to use the cash method of accounting, a very simple method of accounting that allows for greater flexibility in the timing of income and expenses. Even more beneficial for taxpayers is the ability to avoid the onerous and expensive rules for accounting for inventory.
Cash Method of Accounting
The magic number under the act is 25 million; taxpayers that have average annual gross receipts of $25 million (including affiliated groups of taxpayers) or less in the three prior tax years are now eligible to use the cash method. Previously, the process to determine eligibility itself was a convoluted process with various thresholds for different types of entities and businesses. Generally speaking, C corporations with $5 million or less of gross receipts and service companies with $10 million or less had the option to use the cash method. The ability to use the cash method was further constrained for companies with inventory; the threshold of gross receipts being lowered to $1 million or less in those cases.
The cash method of accounting allows businesses to recognize income and deduct expenses when the cash is received or paid, rather than having to accrue income and expense. In order to determine if a method change is beneficial, a simple analysis is to compare receivables and prepaids with payables and accrued liabilities at year-end. If receivables are greater, a switch to the cash method would result in less net income, the opposite being true if payables are greater. The timing of invoices and when bills are paid is determined by the taxpayer, this allows for a greater level of control around year-end planning.
It should be noted that for taxpayers with a GAAP financial statement requirement, a shift to the cash method for tax reporting would involve keeping the books under both methods. While under this scenario the benefits of a simpler accounting process are not realized, a reduction of current year taxable income may still justify a tax method change. The conversion from accrual to cash often entails only a few year-end adjustments.
Accounting for Inventories
When a taxpayer produces inventory, Section 471 of the Code states that the taxpayer may not take an immediate tax deduction for the direct costs of producing the inventory. Retailer/wholesalers must take into account the costs of acquiring and storing the property, which also may not be deducted. These direct costs of production – commonly known as labor, materials, and overhead – and the acquisition costs of inventory purchased for resale must be capitalized. Expenses capitalized to inventory are only deductible when the inventory is sold. This means that capitalized costs can be stuck on the balance sheet for extended periods of time after the expenses have been incurred.
Under the new law, the $25 million threshold strikes again as businesses with average gross receipts of $25 million or less may account for inventory as non-incidental materials and supplies. This means that only the raw materials portion of unsold inventory is required to remain on the balance sheet at year-end and that the labor and overhead portions may be expensed when paid. In the year of the accounting method change, as early as 2018, a release of the previously capitalized expenses will occur along with potential major tax savings. The tax benefit will be dependent on how heavy the manufacturing process is; in many industries the capitalized labor and overhead make up the bulk of total inventory cost.
The next and increasingly complex set of inventory capitalization rules were created in 1986 when Section 263A was written. Section 263A, also known as UNICAP, requires businesses with inventory to examine each item of expense on its profit & loss statement in order to capitalize amounts that are indirectly related to production/acquisition of inventory. For example, some portion of officer’s compensation must be capitalized because some portion of that officer’s role is to oversee production of inventory. While the concept sounds straightforward, the rules themselves are nightmarishly complicated and require significant time and money to comply with the letter of the law. By meeting the less than $25 million gross receipts standard, taxpayers will be exempt from the UNICAP rules, thereby releasing capitalized indirect expenses and saving on accounting costs.
It is clear that producer/manufacturers have the most to gain from the new exemptions on previously required accounting methods but all industries may also stand to benefit from the simplifications.