Final Regulations issued on small business taxpayer exceptions
On Dec. 23, 2020, the IRS and the Treasury Department released Final Regulations to implement the Tax Cuts and Jobs Act’s (TCJA’s) changes to Internal Revenue Code (IRC) Sections 263A, 448, 460, and 471, which gave small businesses – with average annual gross receipts of $25 million or less (“small businesses” or “small taxpayers”) – the option to simplify their tax accounting methods. (The $25 million threshold is indexed for inflation and is currently $26 million.) The IRS and Treasury had published Proposed Regulations in July 2020.
The Final Regulations address numerous issues raised by commenters. They adopt some suggestions, reject other suggestions, clarify numerous issues, and provide numerous examples. The following is a summary of significant issues addressed by in the Final Regulations, which are about 100 pages, including the Preamble.
1. Syndicate definition under Section 448: A company cannot take advantage of any of the small taxpayer rules if it is a “syndicate” as defined in the Code. Generally, a company is a syndicate if it is a flow-through entity and more than 35% of its losses are allocated to limited partners or limited entrepreneurs. A company is only a syndicate in a year in which it has a loss. Numerous commenters asked for clarification and/or a change in the definition of syndicate. The IRS rejected those comments. However, in an attempt to help taxpayers avoid syndicate classification, the IRS and Treasury broadened an election that would allow the taxpayer to look to the prior year’s taxable income – instead of the current year’s income – to determine if the company has losses. In the Proposed Regulations, that election – once made – would have been binding and applied to all subsequent taxable years. Under the Final Regulations, the syndicate election may be made as an annual election. This change will allow companies to choose – on a year-by-year basis – which tax year to look to when determining if it is a syndicate.
Additionally, commenters asked for an exception from the tax shelter definition when a company has a loss (and becomes a syndicate) because of a favorable Section 481(a) adjustment. The IRS rejected this request and noted that the abovementioned election could potentially help taxpayers in this situation.
2. Five-year scope limitation: Generally, if a taxpayer’s gross receipts rise above, and fall below, the small business threshold, the taxpayer has to request a change in accounting method to change from (or to) the small taxpayer provisions. In the Proposed Regulations, changes to and from the various small taxpayer methods of accounting would be subject to the “five-year scope limitations,” which would make the accounting method change request a non-automatic change if done within five years of another change to the same item. In the Final Regulations, the five-year scope limitation/restriction was removed.
3. Section 471(c) NIMS (non-incidental material and supply) inventory method (Preamble to TD 9942): The small taxpayer rules allow companies to treat inventory as if it is non-incidental materials and supplies. That rule allows taxpayers to deduct the costs of such “materials and supplies” when they are “used or consumed.” In the Final Regulations, the IRS provided clarification in connection with this rule:
a. Goods treated as materials and supplies under this rule are nonetheless actually inventory for all other purposes. This clarification is important because it means that a small business cannot use the de minimis rule to deduct items treated as materials and supplies under the small business rules.
b. In the Final Regulations, the IRS clarified that under the small business rules, only direct materials costs need be included in the costs of the “materials and supplies.”
c. The IRS clarified that items are “used or consumed” by a producer is the time when inventory is sold, not when the item goes into production.
d. Inventory Costs: The Final Regulations clarified that costs that are required to be capitalized to inventory (Code Sect. 471(a)) but are not capitalized in the taxpayer’s books and records are not required to be capitalized to inventory.
4. Items/Comments not addressed or remaining unchanged:
a. Definition of “books and records” in Treas. Reg. Section 1.471-1(b)(6)
5. Applicability date: The Final Regulations apply for tax years beginning on or after the date they are published in the Federal Register. Taxpayers are permitted to apply the regulations to tax years beginning after Dec. 31, 2017.
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