In-Depth Look At Tax Accounting Changes Under the Tax Cuts And Jobs Act (2017)

Congress Recently Passed the Tax Cuts and Jobs Act (2017), Which Will Usher in an Overhaul of Tax Accounting Changes

Recently, my book “Federal Tax Accounting” was published by Commerce Clearing House (CCH) covering a wide range of tax accounting topics such as tax accounting doctrines, entities tax years, adoption and methods of accounting, the cash and accrual method of accounting, changes in accounting methods, inventory, uniform capitalization rules, the installment method, capital expenditures, long-term contracts, domestic production activities, and time value of money.

No sooner was the book published that Congress passed the Tax Cuts and Jobs Act (the “Act”) which has changed some of the discussion. Here are some of the changes.

Taxable Year of Inclusion

In general, for a cash basis taxpayer, an amount is included in income when actually or constructively received. For an accrual basis taxpayer, an amount is included in income when all the events have occurred that fix the right to receive such income and the amount thereof can be determined with reasonable accuracy (i.e., when the “all events test” is met), unless an exception permits deferral or exclusion. A number of exceptions exist to permit deferral of income related to advance payments. The exceptions often allow tax deferral to mirror financial accounting deferral (e.g., income is recognized as the goods are provided or the services are performed).

Generally for tax years beginning after Dec. 31, 2017, a taxpayer is required to recognize income no later than the tax year in which such income is taken into account as income on an applicable financial statement (AFS) or another financial statement under rules specified by IRS, subject to an exception for long-term contract income under Code Sec. 460 .

In the accrual method chapter, I discuss prepaid income under Rev. Proc. 2004-34 which allows a one-year deferral in certain cases of prepaid income. The ruling pertains to prepayment for services to be rendered before the end of the next succeeding year. In particular, Revenue Procedure 2004-34 provides that a payment received by a taxpayer is an advance payment if:

1. the inclusion of the payment in gross income for the taxable year of receipt is a permissible method of accounting for federal income tax purposes;
2. the payment is recognized by the taxpayer (in whole or in part) in revenues in the taxpayer’s applicable financial statement for a subsequent taxable year or, for taxpayers without an applicable financial statement, the payment is earned by the taxpayer (in whole or in part) in a subsequent taxable year; and
3. the payment is for:
   • (a) services;
   • (b) the sale of goods (other than for the sale of goods for which the taxpayer uses a method of deferral provided in Reg. §1.451-5(b)(1)(ii));
   • (c) the use (including by license or lease) of intellectual property;
   • (d) the occupancy or use of property if the occupancy or use is ancillary to the provision of services (for example, advance payments for the use of rooms or other quarters in a hotel, booth space at a trade show, campsite space at a mobile home park, and recreational or banquet facilities, or other uses of property so long as the use is ancillary to the provision of services to the property user);
   • (e) the sale, lease, or license of computer software;
   • (f) guaranty or warranty contracts ancillary to an item or items described in subparagraph (a), (b), (c), (d), or (e), above;
   • (g) subscriptions (other than subscriptions for which an election under IRC §455 of the Code is in effect), whether or not provided in a tangible or intangible format;
   • (h) memberships in an organization (other than memberships for which an election under IRC §456 of the Code is in effect); or
   • (i) any combination of items described in subparagraphs (a) through (h) above.

Example:

On December 1, 2017, H, in the business of operating a chain of “shopping club” retail stores, receives advance payments for membership fees. Upon payment of the fee, a member receives an identification card that allows access for a 1-year period to H’s stores, which offer discounted merchandise and services. For financial reporting purposes, H includes 1/12 of the payment in gross receipts for 2017 and 11/12 of the payment in gross receipts for 2018. H uses the Deferral Method. For federal income tax purposes, H must include 1/12 of the payment in gross income for 2017, and the remaining 11/12 of the payment in gross income for 2018.

The Act also codifies the current deferral method of accounting for advance payments for goods and services provided by Rev Proc 2004-34 to allow taxpayers to defer the inclusion of income associated with certain advance payments to the end of the tax year following the tax year of receipt if such income also is deferred for financial statement purposes. In addition, it directs taxpayers to apply the revenue recognition rules under Code Sec. 452 before applying the original issue discount (OID) rules under Code Sec. 1272. ( Code Sec. 451, as amended by Act Sec. 13221).

Example:

T, a manufacturer of household furniture, is a calendar year taxpayer and uses an accrual method of accounting.

For financial reporting purposes, income is accrued when furniture is shipped. For tax purposes, income is accrued when furniture is delivered and accepted.

In Year 1, T receives an advance payment of $8,000 from X with respect to an order of furniture to be manufactured for X for a total price of $20,000. The furniture is shipped to X in December of Year 1, but is not delivered to, nor accepted by, X until January of Year 2.

As a result of this contract, T must include the entire advance payment in its gross income for tax purposes in Year 1. T must include the remaining $12,000 of the gross contract price in its gross income in Year 2 for tax purposes.

In the case of any taxpayer required by this provision to change its accounting method for its first tax year beginning after Dec. 31, 2017, such change will be treated as initiated by the taxpayer and made with IRS’s consent.

Under a special effective date provision, the AFS conformity rule applies for OID for tax years beginning after Dec. 31, 2018, and the adjustment period is six years.

Cash Method of Accounting

Under pre-Act law, a corporation, or a partnership with a corporate partner, may generally only use the cash method of accounting if, for all earlier tax years beginning after Dec. 31, ’85, the corporation or partnership met a gross receipts test-i.e., the average annual gross receipts the entity for the three-tax-year period ending with the earlier tax year does not exceed $5 million. Under current law, farm corporations and farm partnerships with a corporate partner may only use the cash method of accounting if their gross receipts do not exceed $1 million in any year. An exception allows certain family farm corporations to qualify if the corporation’s gross receipts do not exceed $25 million. Qualified personal service corporations are allowed to use the cash method without regard to whether they meet the gross receipts test.

For tax years beginning after Dec. 31, 2017, the cash method may be used by taxpayers (other than tax shelters) that satisfy a $25 million gross receipts test, regardless of whether the purchase, production, or sale of merchandise is an income-producing factor. Under the gross receipts test, taxpayers with annual average gross receipts that do not exceed $25 million (indexed for inflation for tax years beginning after Dec. 31, 2018) for the three prior tax years are allowed to use the cash method.

The exceptions from the required use of the accrual method for qualified personal service corporations and taxpayers other than C corporations are retained. Accordingly, qualified personal service corporations, partnerships without C corporation partners, S corporations, and other pass-through entities are allowed to use the cash method without regard to whether they meet the $25 million gross receipts test, so long as the use of the method clearly reflects income. ( Code Sec. 448, as amend by Act Sec. 13102).

A qualified personal service corporation is one if substantially all of the corporation’s activities involve the performance of services in certain fields, including the fields of accounting, actuarial services, architecture, consulting, engineering, health, law, or the “performing arts.”

Use of this provision results in a change in the taxpayer’s accounting method for purposes of Code Sec. 481.

Accounting for Inventories

Under pre-Act law, businesses that are required to use an inventory method must generally use the accrual accounting method. However, the cash method can be used for certain small businesses that meet a gross receipt test with average gross receipts of not more than $1 million ($10 million businesses in certain industries). These business account for inventory as non-incidental materials and supplies.

For tax years beginning after Dec. 31, 2017, taxpayers that meet the $25 million gross receipts test are not required to account for inventories under Code Sec. 471, but rather may use an accounting method for inventories that either (1) treats inventories as non-incidental materials and supplies, or (2) conforms to the taxpayer’s financial accounting treatment of inventories. ( Code Sec. 471, as amended by Act Sec. 13102).

In PLR 9209007, the IRS stated its position that incidental supplies means items of minor importance and not those that are essential or necessary for the taxpayer’s business. In this regard, the IRS will assert generally that materials are of nonincidental importance if they are identified for financial reporting purposes, such as:

• Supplies consumed in production, e.g., fuel to run production equipment;
• Supplies held for sale in a business where inventories are not required, e.g., gold fillings owned by a dentist;
• Nonmanufacturing supplies, e.g., stationery in a manufacturing business; and
• Short-lived capital assets, e.g., uniforms in a service business.

The current regulations provide a more detailed explanation of materials and supplies:

Materials and supplies means tangible property that is used or consumed in the taxpayer’s operations that is not inventory and that–

• Is a component acquired to maintain, repair, or improve a unit of tangible property (as determined under Reg. §1.263(a)-3(e)) owned, leased, or serviced by the taxpayer and that is not acquired as part of any single unit of tangible property;
• Consists of fuel, lubricants, water, and similar items, reasonably expected to be consumed in 12 months or less, beginning when used in the taxpayer’s operations;
• Is a unit of property as determined under Reg. §1.263(a)-3(e) that has an economic useful life of 12 months or less, beginning when the property is used or consumed in the taxpayer’s operations;
• Is a unit of property as determined under Reg. §1.263(a)-3(e) that has an acquisition cost or production cost (as determined under IRC §263A) of $200 or less (or other amount as identified in published guidance in the Federal Register or in the Internal Revenue Bulletin (see Reg. §601.601(d)(2)(ii)(b)) or
• Is identified in published guidance in the Federal Register or in the Internal Revenue Bulletin (see Reg. §601.601(d)(2)(ii)(b)) as materials and supplies for which treatment is permitted under this section.

Examples of non-inventory of all supplies:

• Supplies consumed in production g. fuel to run production equipment;
• Supplies held for sale in a business where inventories are not required, g., gold fillings owned by a dentist;
• Non-manufacturing supplies, g. stationary in a manufacturing business; and
• Short-lived capital assets, g. uniforms in a service business.

Use of this provision results in a change in the taxpayer’s accounting method for purposes of Code Sec. 481.

Capitalization and Inclusion of Certain Expenses in Inventory Costs

The uniform capitalization (UNICAP) rules generally require certain direct and indirect costs associated with real or tangible personal property manufactured by a business to be included in either inventory or capitalized into the basis of such property. However, under pre-Act law, a business with average annual gross receipts of $10 million or less in the preceding three years is not subject to the UNICAP rules for personal property acquired for resale. The exemption does not apply to real property (e.g., buildings) or personal property that is manufactured by the business. This exception is called the Small Reseller Exception.

Gross receipts are the total amount derived from all of the taxpayer’s trades or businesses, excluding the following amounts: (1) returns and allowances; (2) interest, dividends, rents, royalties, or annuities not derived in the ordinary course of a trade or business; (3) receipts from the sale or exchange of capital assets; (4) repayments of loans or similar instruments; (5) receipts from a sale or exchange not in the ordinary course of business; and (6) receipts from any activity other than a trade or business or an activity engaged in for profit. Gross receipts for a short taxable year must be annualized.

Gross receipts (other than those arising from transactions between group members) are aggregated for purposes of determining whether the $25,000,000 threshold is exceeded.[1]

If a taxpayer has been in existence for less than three years, the taxpayer determines its average annual gross receipts for the number of taxable years that it has been in existence.[2]

For tax years beginning after Dec. 31, 2017, any producer or re-seller that meets the $25 million gross receipts test is exempted from the application of Code Sec. 263A. The exemptions from the UNICAP rules that are not based on a taxpayer’s gross receipts are retained. ( Code Sec. 263A(b), as amended by Act Sec. 13102 )

Use of this provision results in a change in the taxpayer’s accounting method for purposes of Code Sec. 481.

Accounting for Long-Term Contracts

Under pre-Act law, an exception from the requirement to use the percentage-of-completion method (PCM) for long-term contracts was provided for construction companies with average annual gross receipts of $10 million or less in the preceding three years (i.e., small construction contracts) that met certain requirements. They were allowed to instead deduct costs associated with construction when they were paid and recognize income when the building was completed.

For contracts entered into after Dec. 31, 2017, in tax years ending after that date, the exception for small construction contracts from the requirement to use the PCM is expanded to apply to contracts for the construction or improvement of real property if the contract: (1) is expected (at the time such contract is entered into) to be completed within two years of commencement of the contract and (2) is performed by a taxpayer that (for the tax year in which the contract was entered into) meets the $25 million gross receipts test. ( Code Sec. 460(e), as amended by Act Sec. 13102)

Use of this PCM exception for small construction contracts is applied on a cutoff basis for all similarly classified contracts (so there is no adjustment under Code Sec. 481(a) for contracts entered into before Jan. 1, 2018).

[1] Reg. §1.263A-3(b)(3). In determining gross receipts, all persons treated as a single employer under IRC §52(a) or (b), IRC §414(m), or any regulation prescribed under IRC §414 (or persons that would be treated as a single employer under any of these provisions if they had employees) shall be treated as one taxpayer. The gross receipts of a single employer (or the group) are determined by aggregating the gross receipts of all persons (or the members) of the group, excluding any gross receipts attributable to transactions occurring between group members.

[2] Reg. §1.263A-3(b)(1)(i).

If you have any questions or if you would like to discuss the matter further, please contact me, Frank Brunetti, at 201-806-3364.