The small business taxpayer exception rules have been around for many years. Despite the everchanging landscape of tax code this is one area that has increased in popularity over the past decade. What used to be $1M exception from certain areas of the tax code evolved to $5M (sometimes $10M), and as of the 2017 tax overhaul known as the Tax Cuts and Jobs Act (TCJA) is now $26M (indexed for inflation from the original $25M) for years 2019, 2020 and 2021. Rev. Proc. 2018-40, 2018-34 finalized the regulations related to these changes published as of January 5, 2021. While most of us are aware of many of these exceptions, there are certain areas that we do not see often but could have a large impact on tax compliance.
In most instances the ability to take advantage of these exceptions relies on the average annual gross receipts for the prior 3 years being less than $25M. Generally, if the business meets this criterion, it can significantly reduce time spent on overall tax compliance. However, the small business taxpayer exceptions do not apply to tax shelters, as defined under Secs. 448(d)(3) and 461(i)(3) and Reg. Sec. 1.448-2(b)(2). A tax shelter is generally defined as any partnership or other entity that is not a C Corporation that allocates more than 35% of a loss to limited partners during the tax year.
It is important to note that multiple businesses may be treated as a single employer under the aggregation rules of Section 52(a) or 52(b) or Section 414(m) or 414(o). The mitigating factor in this case is common control as defined under these sections. The control can be parent-subsidiary, brother-sister, or other combined groups. For parent-subsidiary groups common control is met if there is common ownership of 50%. Common control for brother-sister groups is met when both of the following requirements are satisfied:
- The same five or fewer persons who are individuals, estates, or trusts own at least 80 percent of two or more organizations; and
- The same five or fewer persons who are individuals, estates, or trusts own, in combination, 50% or more the organizations considering only identical ownership interests in each.
Additionally, there are some adjustments that need to be made if the business has not been in existence for 3 years or if one of the years is a short taxable year. If the business was not in existence the average is taken for the years in existence. Furthermore, if one of the years is a short taxable year, gross receipts must be annualized before included in the average.
Some of the most advantageous rules related to small business taxpayers are as follows.
- Cash Basis Taxpayer: One of the most common exceptions is related to cash basis accounting methods for tax purposes. Under Section 448 Corporations and Partnerships with C-Corporation partners may elect cash basis method of accounting if they are under the $26M average.
- Look-back Interest on Percentage of Completion (PCM) Contracts: Under IRC 460(e) the look-back method is required for all PCM contracts except those for home construction or any other construction contract entered into by the taxpayer where (1) the contract is estimated to be completed within 2 years from the contract date and (2) the average annual gross receipts for the prior 3 tax years does not exceed $26M (increased from $10M in 2017).
- Completed Contract Method (CCM) of Accounting for Contracts: The CCM allows taxpayers to defer income recognition on a contract until it is completed. The contract is considered completed based upon the earlier of the tax year in which the consumer uses the constructed asset and at least 95% of the total costs have been incurred OR final completion and acceptance of the contract. However, there is a caveat here when the taxpayer is subject to AMT (alternative minimum tax). If the taxpayer is subject to AMT they must use PCM to compute AMTI on any long-term contract. This caveat does not apply to home construction contracts.
- 263A UNICAP: Under IRC 263A, the uniform capitalization rules (UNICAP), taxpayers are required to capitalize direct and indirect costs properly allocable to real or tangible personal property produced or acquired for resale. Due to the small business taxpayer exception this capitalization is not required if the taxpayer average annual gross receipts are under $26M.
- 163(j) Interest Limitation: Under 163(j) interest expense may be limited based on a calculation of adjusted taxable income. However, if the taxpayer meets the gross receipts test and is under $26M in average annual gross receipts, they are not subject to this limitation. There are some special rules related to aggregation with 163(j). In order to meet the gross receipts test, the taxpayer must include gross receipts of commonly controlled groups of entities as well as the proportionate share of gross receipts from any Partnership it owns.
- 471 Inventory: Under TCJA small business taxpayers meeting the $26M gross receipt test are not required to account for inventories under IRC 471 and instead may adopt either of the following methods. (1) Treat inventory as nonincidental materials and supplies, which effectively lets the taxpayer expense the cost when the inventory is “used or consumed” upon sale. (2) Use book method of accounting for inventory whether under an applicable financial statement (AFS) or the method used in accordance with the taxpayers accounting standards.
As we continue to monitor any upcoming changes to the tax code, it becomes more important that we continue to understand the changes brought on with the TCJA and the impact on taxpayers for 2021.
In order to adopt the methods described herein, the taxpayer must file Form 3115 to report a change in accounting method. Consequently, if a taxpayers gross receipts rise above the threshold, they will have to file a subsequent Form 3115. The final regs also waived the 5 year period requirement between changes so the taxpayer will no longer have to wait 5 years before they can change back if the average receipts fall below the threshold. This allows taxpayers to file for an automatic change regardless of the time lapsed between changes.
Citrin Cooperman is a nationally recognized, full-service CPA firm, currently ranked in the U.S. top 25. The firm offers assurance, tax, and business advisory services to help clients remain competitive in today’s market.
Jessica Sawyer is a partner in Citrin Cooperman’s Providence office, with over 15 years of public accounting experience. She is skilled in tax consulting and specializes in corporate, partnership, and individual taxation in various industries including manufacturing and distribution, construction, real estate, and technology and life sciences.
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