Your business’ tax strategy defines and supports the right accounting methods for your business. Do you want to defer income? Accelerate income? What decisions can you make that are advantageous to you now and in the future?
While you may be satisfied with your current accounting methods, the Tax Cuts and Jobs Act did make some notable adjustments to who qualifies for the cash method and to accounting for inventory, revenue recognition, and long-term contracts.
Many of these changes allow businesses to further defer income and the related tax.
Now is a good time to review these changes, compare them to your overall tax strategy, and decide if you should make a change to one of your current accounting methods.
Types of accounting methods
Your overall accounting method sets the framework for how revenues and expenses are reported for tax return purposes.
Each method can show a range of profits reported in the short-term. The accrual basis and cash basis are the two most common methods.
You can use a hybrid or variation of each, but once you’ve selected a method, you must consistently use it from year to year.
1. Accrual basis of accounting
You recognize revenue or income when its earned, regardless of when a payment happens. You take expenses into account when they’re spent or incurred, even if a payment isn’t made that year.
If you receive a prepayment from a customer, you’re typically expected to include this payment as income, even if the income isn’t earned yet.
Cash transactions don’t hold much weight – if any – under this method.
2. Cash basis of accounting
Unlike the accrual basis, cash is king.
You recognize revenue or income in the year you receive cash payments. And, you take expenses into account when cash payments are made.
Who can use the cash method?
The Act made significant changes to the eligibility requirements for the cash method of accounting. Now, this method is available to more businesses.
Why? Because the gross receipts limitation was increased and some former exclusions were dropped.
Under the Act, any business with average annual gross receipts less than $25 million – previously $5 million – for the previous three years can use the cash method. You can adopt this method regardless of your business’ entity structure or industry.
However, aggregation rules still apply when calculating average annual gross receipts. You must combine the gross receipts of related businesses to determine your eligibility every year.
Remember – the gross receipts threshold is indexed for inflation. This change is effective for tax years beginning after Dec. 31, 2017.
So – are you eligible to elect the cash method now? Does it make sense to change your accounting method? Would a change better align with your tax strategy?
Treatment of inventory
Any business with average annual gross receipts less than $25 million for the previous three years can treat inventories as nonincidental material and supplies.
Or, you can apply an inventory treatment according to the method of accounting used in your financial statement, books, or records, regardless of your entity structure or industry.
Before the Act, this average annual gross receipts limit was $10 million.
If they’re treated as nonincidental materials and supplies, items must – generally – be inventoried and expensed when used or consumed.
Uniform capitalization (UNICAP)
Any businesses with average annual gross receipts less than $25 million for the previous three years are exempt from UNICAP rules, regardless of entity structure or industry.
Previously, the annual gross receipts threshold was $10 million. If your business meets these requirements, you can account for inventories at prime cost. You’re no longer required to capitalize certain costs under Section 263A.
This change could lead to additional deductions on your tax return because you’d be able to expense these costs rather than capitalize them into inventory.
Does this change in inventory accounting bring new tax opportunities to your business?
The new tax law also updated how revenue may need to be recognized for tax purposes. Now, you should recognize revenue when the all-events test has been satisfied OR when the revenue is recognized in an applicable financial statement.
An applicable financial statement is an audited financial statement that’s prepared in accordance with applicable financial statements or for a government entity.
What’s the impact of this change? Well, the new revenue recognition standard could result in earlier recognition of revenues. If that happens, you must also recognize that income in the same year for tax purposes.
What’s your next step? Consider whether your method of revenue recognition conforms to the new standard.
The new law affirms the ability to recognize all advance payments as income in the year it’s received or when it’s recognized for financial statement purposes.
The remaining income is recognized for tax purposes in the next tax year. This deferral creates a gap between book and tax because the prepayment covers periods that go beyond the year after income is received.
Why does this matter? Many companies recognize payments for tax purposes and keep them consistent with their financial statements.
If you have contracts that span more than 12 months, this could be incorrect. You could benefit from income deferral opportunities depending on the accounting method you use.
Do you predict risk in this area? Should you defer income?
Now, any businesses with average annual gross receipts less than $25 million for the previous three years aren’t required to use the percentage-of-completion accounting method for long-term contracts under Section 460, regardless of their entity structure.
This new standard is effective for any contracts entered into after Dec. 31, 2017.
Businesses that meet this exception should use their exempt method for long-term contracts. The exempt method could be the completed-contract method or any other permissible exempt method. The application of this provision is calculated on the cutoff basis.
Why does this matter? If you can use the completed-contract method, it allows you to defer income and expenses until the project is substantially complete. Substantially complete means the project is 95% done and it’s ready for its intended use.
If you use the percentage-of-completion method, you recognize income over the life of the project.
If you choose to apply any of these provisions or want to request an accounting method change, you must file Form 3115 with the IRS. We highly recommend you consult with your tax professional before doing so.
The Tax Cuts and Jobs Act significantly increased accounting methods thresholds for small businesses.
Because of these changes, businesses have more opportunities to defer tax into future years and potentially realize real money savings in the meantime. But even with all these changes, an accounting method change may not be right for you.
Contact your tax professional to discuss your options, your overall tax strategy, and how your accounting methods align with your strategy.
Have question about these accounting method changes? Let’s talk!