IRS provides welcome flexibility and clarification in final small business tax accounting regulations | Eversheds Sutherland (US) LLP

On Wednesday, December 23, Treasury and the IRS released final regulations¹ under sections 263A, 448, 460, and 471 of the Internal Revenue Code (Code) to implement statutory changes made by the Tax Cuts and Jobs Act (the TCJA).² The TCJA expanded the base of taxpayers qualifying for favorable small business accounting method reform and provided a simplified accounting method change filing requirement for years beginning after December 31, 2017. While proposed regulations released July 29, 2020, largely incorporated the statutory changes made by the TCJA, a number of outstanding questions remained, in particular regarding the scope of the syndicate rule as applied to section 448(c) and the application of the inventory accounting alternatives under section 471. With respect to both issues, the final regulations offer simplifying provisions that taxpayers will appreciate.

This alert summarizes the final regulations under sections 448(c) and 471, highlighting the guidance for syndicates and inventory accounting.

Section 448 and the small business taxpayer gross receipts test

As a general rule, C corporations, partnerships with a C corporation partner, and tax shelters are prohibited from using the cash method of accounting. However, under section 448(c), C corporations and partnerships with a C corporation as a partner that satisfy an average annual gross receipts threshold for any three-taxable-year period are permitted to use the cash method of accounting.³ The TCJA updated this gross receipts test, originally enacted in 1986, from $5 million to $25 million, and indicated that this amount will be adjusted for inflation. By raising the threshold on the gross receipts test, the TCJA expanded the scope of taxpayers eligible to use the cash method of accounting under section 448. Additionally, the TCJA applies the gross receipts test for the current tax year rather than for all prior tax years as previously measured, which further expands the scope of taxpayers eligible to use the cash method.

Irrespective of satisfying the section 448(c) gross receipts test, section 448(a)(3) prohibits tax shelters from using the cash method of accounting. As defined via cross-reference to section 461(i)(3), which in turn cross-references section 1256(e)(3)(B), tax shelters include syndicates, defined as a partnership or other entity (other than a C corporation) in which more than 35% of the losses of that entity during the tax year are allocable to limited partners or limited entrepreneurs. Proposed regulations narrowed the definition of syndicate to provide that a taxpayer is a syndicate only if more than 35% of its losses are allocated to limited partners or limited entrepreneurs. The proposed regulations permit a taxpayer to elect to use the allocable taxable income or loss of the immediately preceding tax year to determine syndicate status under section 448(d)(3) for the current year. Such election is effective for subsequent tax years, unless the Commissioner permits a revocation of the election.

Treasury and the IRS received numerous recommendations to ease the narrowly-drawn definition of a syndicate. An active participation rule was suggested such that any taxpayer satisfying the gross receipts test would be an active member of the small business. However, because the legislative history failed to indicate that Congress intended to modify the definition of “tax shelter” or “syndicate,” Treasury and the IRS did not adopt this suggestion. Treasury and the IRS similarly declined to clarify what is meant by “active participation.” The preamble acknowledges the practical concerns of determining tax shelter status and modified the syndicate election in Treas. Reg. §1.448-2(b)(2)(iii)(B). The election from the proposed regulations allowed a taxpayer to make a permanent choice to determine any tax year’s shelter status based on allocations from the prior year; the final regulation’s modification indicates the election is made annually, a change reflecting the practical concerns made by commenters. The annual election applies to all Code provisions that specifically reference section 448(a)(3) to define tax shelter, including the small business exemptions under sections 163(j)(3), 263A(i)(1), 460(e)(1)(B) and 471(c)(1). The preamble indicates that procedural guidance regarding the revocation of a syndicate election will be forthcoming.

Commenters also advocated for an exception to the tax shelter rules for taxpayers which satisfy the section 448(c) gross receipts test and change to the cash method of accounting, resulting in a negative section 481(a) adjustment, which triggered an allocated loss and made the taxpayer a tax shelter under section 448(a)(3). As a result, the taxpayers became ineligible to use the cash method for the year in which the negative section 481(a) adjustment was recognized, but may be otherwise eligible to use the cash method for future years. Under proposed Treas. Reg. §1.448-2(g)(3), these taxpayers would be ineligible for the automatic change procedure to make a subsequent change back to the cash method once they are no longer tax shelters within a five-year period. Treasury and IRS declined to adopt an exception for small businesses that fall into this situation, maintaining the definition of tax shelter in section 448(d)(3). Instead, the preamble notes that taxpayers should find relief in the annual syndicate election of Treas. Reg. §1.448-2(b)(2)(iii)(B), discussed above.

In addition to providing for an annual election to determine any year’s tax shelter status, the final regulations also addressed accounting method changes brought about by the TCJA. The TCJA amended section 448(d)(7) to apply to any change under section 448, that is, an accounting method change because the taxpayer is prohibited, or no longer prohibited, from using the cash method under section 448. Also, the TCJA removed section 481(a) adjustment provisions originally included in section 448(d)(7) reflecting a transition rule to the ’54 Code. Significantly, the statute now provides that any changes are treated as initiated by the taxpayer with the consent of the Commissioner, which means that such method changes will be available automatically. Recognizing that certain companies may need to make such accounting method changes frequently as receipts hover near the $25 million threshold, going above in some years and below $25 million in other tax years, the preamble indicates that procedural guidance will be issued waiving the five-year restriction on accounting method changes to the same item.

Section 471 and the small business inventory exemption rules

Prior to the TCJA, section 471 required a taxpayer to maintain inventory when certain merchandise transactions constituted “an income-producing factor.” The TCJA removed this requirement for taxpayers (other than a tax shelter) that meet the section 448(c) gross receipts test. The amended section 471 small business taxpayer exemption provides that the requirements of section 471(a) do not apply to a taxpayer for that taxable year, and the taxpayer’s method of accounting for inventory for such taxable year shall not be treated as failing to clearly reflect income if the taxpayer either: (1) treats the taxpayer’s inventory as non-incidental materials and supplies, or (2) conforms the taxpayer’s inventory method to the taxpayer’s method of accounting for inventory reflected in an applicable financial statement as defined in section 451(b)(3) (an AFS) (or, if the taxpayer does not have an AFS, in the taxpayer’s books and records prepared in accordance with the taxpayer’s accounting procedures).

NIMS inventory method

The final regulations refer to the section 471(c)(1)(B)(i) method allowing taxpayers to treat inventory as incidental materials and supplies as the “section 471(c) NIMS inventory method.” The proposed regulations provided that items of inventory treated as materials and supplies under section 471(c) are used or consumed in the taxable year in which the taxpayer provides the item to a customer, and the cost of such item is recovered in that taxable year or the taxable year in which the taxpayer pays for or incurs such cost, whichever is later. While commenters requested that the “used or consumed” provision under section 471(c)’s NIMS inventory method be consistent with Treas. Reg. §1.162-3’s “used or consumed” standard, i.e., when the raw materials enter the taxpayer’s production process, Treasury and the IRS declined to change the definition of “used or consumed” in the final rules, stating that “the statute and legislative history do not support a reading of the provision that would provide such a disparity in the recovery of inventory costs between producers and resellers.” The final regulations adopt the proposed regulations without change.

Comments were also received regarding the types of direct costs required to be included as an inventory cost under the section 471(c) NIMS inventory method. Treasury and the IRS acknowledged the uncertainty under Revenue Procedure 2001-10 and Revenue Procedure 2002-28 regarding whether direct labor and overhead costs were required to be capitalized under the non-incidental materials and supplies method permitted. Recognizing the burden of tracking such direct labor costs, the final regulations provide that inventory costs includible in the section 471(c) NIMS inventory method are direct material costs of the property produced or the costs of property acquired for resale.

AFS inventory rules

As proposed, a taxpayer with an AFS that uses the AFS section 471(c) inventory method would be required to consistently apply the same mismatched reportable period method of accounting provided in proposed Treas. Reg. §1.451-3(h)(4) for its AFS section 471(c) inventory method of accounting that is used for section 451 purposes. The final regulations adopt this consistency rule. Taxpayers, other than tax shelters, which do not have an AFS and that meet section 448(c)’s gross receipts test are not required to take an inventory under section 471(a), and can instead use the non-AFS section 471(c) inventory method, which is the method of accounting for inventory reflected in the taxpayer’s books and records that are prepared in accordance with the taxpayer’s accounting procedures and that properly reflect the taxpayer’s business activities for non-tax purposes. The final regulations do not clarify the definition of “books and records,” but do note that a taxpayer may not ignore its regular accounting procedures or portions of its books and records under the non-AFS section 471(c) inventory method.

Finally, in response to comments, the final regulations clarify in Treas. Reg. §1.471-1(b)(6)(i) that costs, which are generally required to be capitalized to inventory under section 471(a) but that the taxpayer is not capitalizing in its books and records are not required to be capitalized to inventory for tax purposes. Under the non-AFS 471(c) inventory method, such costs are not treated as amounts paid to acquire or produce tangible property under Treas. Reg. §1.263(a)-2, and are generally deductible when they are paid or incurred if such costs may be otherwise deducted or recovered, notwithstanding Treas. Reg.. §1.471-1(b)(4), under another provision of the Code or regulations. Additionally, the final rules provide that costs capitalized for the non-AFS section 471(c) inventory method are those costs that related to the production or resale of the inventory to which they are capitalized in the taxpayer’s books and records. Similar clarifications were made in Treas. Reg. §1.471-1(b)(5) regarding the AFS section 471(c) inventory method.

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