TCJA – The $25 Million Question

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Manufacturer performing inventory audit.

The Tax Cuts and Jobs Act (TCJA) turned one year old on December 22, 2018. It’s the most widespread tax legislation since the Tax Reform Act of 1986 and affects all taxpayers, whether they’re businesses, individuals, tax-exempt entities or governmental agencies. While a lot of focus has been on tax rate cuts, Section 199A and qualified business income, business interest deduction limitations and meals and entertainment, the TCJA also expanded the definition of small businesses’ gross receipts.

Under previous tax laws, the following were in effect:

  • C corporations that exceeded a $5 million average annual gross receipts test were generally unable to use the cash method of accounting.
  • Use of inventories was required for businesses with average annual gross receipts greater than $1 million ($10 million for certain types of businesses). Businesses below this threshold still had to treat inventory as nonincidental materials and supplies, meaning they could only deduct the inventory when used or consumed.
  • Application of §263A uniform capitalization rules to inventory was required for businesses with average annual gross receipts greater than $10 million for property acquired for resale, with no threshold for manufactured property.
  • Use of percentage-of-completion method was required for long-term contracts for businesses with average annual gross receipts greater than $10 million.

Under the TCJA, these thresholds increased to a $25 million average annual gross receipts test (adjusted for inflation for tax years beginning after December 31, 2018), opening up planning opportunities for manufacturers, retailers and contractors that weren’t available in previous years if they had gross receipts above the previous thresholds but below $25 million. The exception from §263A also was expanded to include both producers and resellers of inventory. Taxpayers falling within the new thresholds who were previously following the pre-TCJA laws must file a change in accounting method, i.e., Form 3115, to take advantage of these more favorable methods. It’s also important to remember that a taxpayer meeting the $25 million test may still be precluded from using these favorable accounting methods if it meets the definition of a “tax shelter.” While at first blush it may seem most legitimate businesses wouldn’t need to worry about the tax shelter exception, keep in mind this definition includes any pass-through entity where more than 35 percent of its losses are allocated to limited partner or limited entrepreneurs.

Since accounting method changes involve the timing of including income or taking a deduction, taxpayers need to consider any change in accounting method in conjunction with other provisions of the TCJA. For example, taxpayers eligible for the 20 percent §199A deduction should consider the potential effect of reducing taxable income under a change in accounting method, as any reduction in taxable income could permanently reduce the amount of available §199A deduction.

In addition to the changes described above, taxpayers that are below the $25 million average annual gross receipts threshold—and not tax shelters—aren’t subject to the new business interest deduction limitations under §163(j).

If you have questions related to the $25 million gross receipts threshold or other TCJA provisions, contact Tracy or your trusted BKD advisor.

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