The IRS released proposed regulations on July 29 that pertain to the various small taxpayer accounting method opportunities created by the tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA). While answering some important questions, the proposed regulations are largely unfavorable to taxpayers and would upend certain tax planning strategies, particularly those involving inventory. The proposed regulations also leave many important questions unanswered for taxpayers analyzing the tax shelter rules. Taxpayers and their advisors should begin planning for changes that may be necessary to tax strategies if the proposed rules are later finalized.

Background

The TCJA expands the number of small business taxpayers eligible to use the overall cash method of accounting. Further, the TCJA provides an exemption from the requirements to apply certain accounting method rules for Internal Revenue Code (IRC) Section 471 inventories, Section 263A cost capitalization, and Section 460 long-term contracts. These four opportunities generally are available to taxpayers, other than tax shelters, that have a three-year average of gross receipts that do not exceed $25 million. For tax years beginning in 2019 and 2020, the inflation-adjusted figure is $26 million.

Taxpayers using the cash method generally recognize items of income when actually or constructively received and items of expense when paid. The cash method is administratively simple and provides the taxpayer flexibility in the timing of income recognition, as well as predictability for tax obligations that better match cash flows. Taxpayers exempt from the Section 471 inventory rules are not required to follow narrowly-defined inventory costing criteria, and taxpayers exempt from the Section 263A cost capitalization rules are not required to apply complex rules regarding the capitalization of indirect costs involved in producing, acquiring, and holding property. Taxpayers exempt from the Section 460 long-term contract rules are generally eligible to account for long-term contracts by taking into account the revenue and costs of the contract in the year that the contract is complete.

No taxpayer that is a tax shelter qualifies for any of these opportunities. Among other categories, a tax shelter includes a “syndicate.” A syndicate is defined as a partnership or other entity (excluding C corporations) where more than 35% of the entity’s losses are allocable to “limited partners or limited entrepreneurs.”

Inventory Accounting Alternatives

An eligible small business taxpayer that utilizes the exemption from Section 471 inventory accounting rules must select one of two alternatives to account for inventory items. Under the first alternative, the taxpayer may account for its inventories as non-incidental materials and supplies. A deduction for the cost of non-incidental materials and supplies is generally permitted in the taxable year in which the materials and supplies are first used or are consumed in the taxpayer’s operations.

As the Joint Committee on Taxation originally noted in its explanation of the TCJA, a taxpayer may also be able to elect to deduct such non-incidental materials and supplies in the taxable year the amount is paid under the de minimis safe harbor election of Treas. Reg. sec. 1.263(a)-1(f). However, the IRS explicitly forbids this treatment in the proposed regulations. The proposed regulations require that inventory treated as non-incidental materials and supplies is not eligible for the de minimis rule, and must be treated as used or consumed during the year that they are provided (sold) to a customer.

Under the second alternative, the taxpayer may determine its inventory method with reference to the taxpayer’s method reflected in an applicable financial statement (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. A taxpayer’s AFS generally includes financial statements filed with the Securities and Exchange Commission (SEC), a U.S. Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) certified audited financial statement, and other financial statements that are less common.

Despite the move toward conformity that this alternative provides, the proposed regulations do not permit absolute conformity. The proposed regulations provide that costs not otherwise deductible for income tax purposes cannot be recovered as inventory costs merely because they are treated that way for financial statement or book purposes, nor can costs that have not been paid or incurred pursuant to a taxpayer’s overall accounting method. Further, the proposed regulations provide that the books and records of a taxpayer without an AFS include the totality of documents or data used to track the taxpayer’s business activities for non-tax purposes (such as physical count data). Hence, the proposed regulations do not allow taxpayers to recover an inventory cost before it is provided to a customer merely because the cost is not reflected on certain books and records, if the taxpayer also performs and tracks physical count data.

Tax Shelter Determinations

As previously mentioned, a partnership or other entity that allocates more than 35% of losses to limited partners or limited entrepreneurs is a tax shelter that is ineligible for any of the four small taxpayer opportunities. To determine whether a taxpayer has “losses” for this purpose, the proposed regulations helpfully provide that a taxpayer may elect to reference its immediately preceding tax year, rather than its current tax year. This election alleviates concerns and difficulties in ascertaining tax shelter status in the midst of the current year tax return preparation, so a business knows whether it is a tax shelter before it performs other calculations for its current year tax filing.

However, all is not rosy in measuring a taxpayer’s losses for this purpose. The proposed regulations also note in the preamble that Section 481(a) adjustments from accounting method changes may not be excluded from the measurement of losses that a business may have. This rule is disappointing because it can effectively preclude a business from ever using any of the small taxpayer opportunities. Consider a business that consistently has positive taxable income and that would have a negative adjustment from the adoption of one of the opportunities. If the negative adjustment would throw the positive taxable income into a net loss position, then the change itself becomes something that disqualifies the business from using one of the opportunities.

Taxpayers also must cope with many ambiguities concerning tax shelter determinations that the proposed regulations do not address. For instance, an important exception from tax shelter status is available when losses are allocated to those who “actively participate” in the business, but this term is not defined. While it is fairly clear that active participation for tax shelter purposes is a lesser standard than the one provided for passive activity loss purposes under Section 469, the lack of guidance is sure to be frustrating. Another area of ambiguity concerns the level at which allocated losses should be assessed. Many partnerships are structured through several tiers of ownership, where losses are allocated through these tiers to the ultimate indirect partners. The proposed regulations do not address whether the partnership must look only to its direct partners, or must look to these ultimate partners to decide whether those owners are limited partners or limited entrepreneurs.

Gross Receipts Calculations

The proposed regulations mostly conform to previous guidance concerning the scope of items included in calculating the three-year average gross receipts of a business. The proposed regulations clarify that, when aggregation rules do not apply to entities under common control, an owner’s allocable share of gross receipts from a pass-through entity must be added to the owner’s other gross receipts. However, the proposed regulations do not offer a definition for “predecessor” businesses, whose gross receipts must be included with those of the current business for purposes of measuring the average gross receipts test.

Planning Considerations from the Proposed Regulations

Many taxpayers that followed the earlier guidance on the treatment of inventories described by the Joint Committee of Taxation may need to reevaluate their positions, and plan for a change to begin capitalizing inventory costs under the approach in the proposed regulations. For other taxpayers with previous questions about tax shelter determinations, these taxpayers unfortunately remain without certainty. The IRS hopefully will respond to comments under the proposed regulations, and resolve these issue in the final regulations. For more information concerning the proposed regulations and how they may impact your business, please contact us.

Published on August 04, 2020