Among the many significant changes made by the Tax Cuts & Jobs Act of 2017 (TCJA) were several accounting method changes available for qualifying businesses. Two key changes include the expansion of the availability of the cash method of accounting for tax purposes and the immediate expensing of certain inventory costs.
Cash Method of Accounting
Prior to the TCJA, the ability to elect the cash method of accounting, where revenue is recognized when received rather than when earned and expenses are recorded when paid rather than when incurred, was available only to entities with average annual gross receipts for the three preceding tax years of $10 million or less. The TCJA expanded the election to include entities with average annual gross receipts of $25 million or less.
Accounting for Inventories
Prior to the TCJA, if the purchase, production, or sale of goods was an income-producing factor of your business, you were required to account for inventories. Exceptions existed for taxpayers with gross receipts of less than $1 million and for taxpayers in specified industries with gross receipts of less than $10 million. Such entities could account for inventory as “incidental materials or supplies,” which are deducted when used or consumed. Prior to their use or consumption, they are accounted for as inventory.
The TCJA expanded the election to allow all entities with gross receipts of $25 million or less to elect to treat their inventory as “incidental materials and supplies” and deduct these items when used or consumed. Making such an election can have a significant impact on taxable income for manufacturers as their materials and supplies are consumed in the manufacturing of their products.
Making the Elections
To elect either of these changes, you must file Form 3115, Application for Change in Accounting Method, along with your timely-filed federal tax return for the year of the change and also submit a separate, signed copy of the form to the IRS.
In preparing the form, you will compute the amount of your Section 481(a) adjustment, which accounts for the change in the accounting methods as if they had occurred as of the beginning of your tax year, which can represent a substantial tax deduction in the year of the change. For example, if as of the beginning of your tax year you had accounts receivable of $950,000 (which was subject to tax in the prior year(s)) and accounts payable of $700,000 (which was deductible in the prior year(s)) and no other such accrual basis items, your Section 481(a) adjustment—and, therefore, your deduction in the current year—would be $250,000.
Analysis
Consideration should be given as to the best tax year in which to make the elections in order for them to be the most advantageous to you. Given the modifications made by the TCJA to the net operating loss (NOL) deduction whereby such NOLs are no longer able to be carried back and the carried-forward NOL may be used to offset only 80% of taxable income in future years, if you anticipate having a loss in your current tax year before making the changes, it may be better to wait to make the changes until a future tax year in which you have income.
To illustrate, assume the same facts above with a $250,000 Section 481(a) adjustment resulting from making the election to switch to the cash method of accounting. If you have a loss of $10,000 prior to the adjustment, making the change would result in an NOL of $260,000 which would be carried forward to future years. If, in the subsequent year, you have income of $240,000, you would only be able to use $192,000 ($240,000 x 80%) of the $260,000 NOL, resulting in taxable income of $48,000, with the remaining NOL to be carried forward. In such a case, it would be more advantageous to wait to make the change until the subsequent year, at which point the entire $250,000 Section 481(a) adjustment can be used to offset the $240,000 of income in that year.
These changes can be made simultaneously, in the same tax year, or separately, in different tax years. So if making both elections in the current tax year puts you into a loss position similar to the one discussed above, you can spread out the elections over multiple tax years to take full advantage of the deductions.
Conclusion
The election of these two accounting method changes under the right circumstances can result in a significant tax savings for your business. Contact us to help you determine if your business qualifies for either of these changes and how best to take advantage of them.
