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CPA Urges Changes to Proposed Small Business Accounting Method Regs

SEP. 15, 2020

CPA Urges Changes to Proposed Small Business Accounting Method Regs

DATED SEP. 15, 2020
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RE: REG‐132766‐18 proposed regulations to implement legislative changes to §§263A, 448, 460, and 471 of the Internal Revenue Code for businesses with average gross receipts of $25 million or less.

On August 8, 2020 REG‐132766‐18 was published in the Federal Register. REG‐132766‐18 contains proposed regulations to implement legislative changes made by the Tax Cuts And Jobs Act (TCJA) to §263A, §448, §460, and §471 simplifying the application of those tax accounting provisions for businesses (other than tax shelters) having average gross receipts (AGR) for the prior three years of $25,000,000 or less as indexed. I am grateful for Treasury and the IRS's efforts to clarify the changes made to these sections of the Code.

Overall, the proposed regulations provide much‐needed guidance and clarification. However, there are several provisions in the proposed regulations that, in my opinion, should be changed in the final regulations to more closely reflect the intent of Congress. Since the passage of the Tax Cuts and Jobs Act (TCJA) I have attended multiple continuing professional education programs on Federal income tax topics as part of my CPA licensure requirements. During those presentations, we have heard consistent commentary and interpretations concerning TCJA and more specifically the simplification of the above code sections for businesses with AGR of $25/$26 million or less. I submit the following comments in light of the understanding that I and many of my colleagues have garnered through our own study of the law as well as through insight provided by commentators and instructors since the passage of the TCJA.

TAX SHELTER EXCLUSION (PROPOSED REG 1.448‐2)

1. The Proposed Regs. As under §448(a)(3) and existing Reg 1.448‐1T, Proposed Reg 1.448‐2 provides that the computation of taxable income using the cash method is prohibited if the taxpayer is a tax shelter as defined under §448(d)(3). In addition, the $25/26 million small business exception from the requirements to account for inventories under §471(a), apply the UNICAP provisions, and to use the percentage‐of‐completion method for long‐term contracts does not apply to tax shelters. Proposed Reg 1.448‐2(b)(2) defines a tax shelter as any: 1) Enterprise, other than a C corporation, if at any time interests in such enterprise have been offered for sale in any offering required to be registered with any Federal or state agency having the authority to regulate the offering of securities for sale; 2) Tax shelter, within the meaning of §6662(d)(2)(C), or 3) “Syndicate” as defined in Proposed Reg 1.448‐2(b)(2)(iii).

Proposed Reg 1.448‐2(b)(2)(iii) says “the term syndicate means a partnership or other entity (other than a C corporation) if more than 35 percent of the losses of such entity during the taxable year are allocated to limited partners or limited entrepreneurs.” The term “limited entrepreneur” is generally a person who does not actively participate in the management of the enterprise. In addition, the proposed regulations provide that in determining whether an interest in a partnership is held by a limited partner, or an interest in an entity or enterprise is held by a limited entrepreneur, §461(k)(2) applies in the case of the trade or business of farming and §1256(e)(3)(C) applies in all other cases.

Section 1256(e)(3)(C) provides that an interest in an entity shall not be treated as held by a “limited partner” or a “limited entrepreneur” — (i) for any period in which the interest is held by an individual who actively participates at all times during such period in the management of the entity; (ii) for any period if during such period such interest is held by the spouse, children, grandchildren, and parents of an individual who actively participates at all times during such period in the management of such entity, (iii) if such interest is held by an individual who actively participated in the management of such entity for a period of not less than five years, (iv) if such interest is held by the estate of an individual who actively participated in the management of such entity, or (v) the Secretary determines (by regulations or otherwise) that such interest should be treated as held by an individual who actively participates in the management of such entity, and that such entity and such interest are not used (or to be used) for tax‐avoidance purposes. Observation! Item (v) provides the Treasury and the IRS the authority to expand the “Active Participation” definition.

2. Suggested Relief From “Syndicate” Classification. The Preamble to these proposed regs says “The Treasury Department and the IRS continue to study the definition of tax shelter under section 448(d)(3) and request comments on whether additional relief is necessary.” The preceding labyrinth of code sections is evidence enough to demonstrate that better guidance it necessary and practitioners and taxpayers alike appreciate your being receptive to suggestions concerning this “tax shelter” classification.

It appears clear that prohibiting the use of the cash method by “tax shelters” was intended to prevent pass‐ through entities from being organized for tax‐avoidance purposes. However, the TCJA was intended to provide small businesses with certain tax benefits, one of which was the ability to use the cash method of accounting. Consequently, many small pass‐through businesses switched from the accrual method to the cash method of accounting beginning with the first tax year beginning after 2017. In some cases, more than 35% of the owners did not actively participate in the business for the 2018 tax year. In addition, because of the requirement that any negative §481(a) adjustment must be taken into account all in the year of change under Rev Proc 2015‐13, the business had a loss for that year and more than 35% of the loss was allocated to “limited partners” or “limited entrepreneurs.”

Compounding the problem is that many taxpayers were not aware that a business could be classified as a tax shelter in this circumstance. The “syndicate” definition related to tax shelters has been in place long before TCJA and has largely gone unnoticed. I submit that there have been multitudes of flow‐through entity returns filed on a cash basis pre‐TCJA that could be construed as a “syndicate” under the §1256 definition. So, if these businesses are classified as tax shelters for the 2018 tax year (or a prior year for that matter), they are currently using an improper accounting method. This would, technically, be the case even where the business is profitable for future years. Therefore, if the proposed regs are not modified when finalized, these businesses would be required to switch to the accrual method and the proposed regs seem to say they could not change back to the cash method within 5 years unless they receive IRS permission to do so. Such a result is overly burdensome and contrary to the small taxpayer relief intended by the TCJA. In addition, there are already provisions in place, §465 at‐risk and §469 passive loss, that serve to limit the ability of a limited partner or limited entrepreneur to utilize an allocated loss. The obscure and undefined “syndicate” definition seems to be an unnecessarily complication for a taxpayer to qualify as a small taxpayer.

Recommendation. I suggest the Treasury use the authority granted under §1256(e)(3)(C)(v) to provide that a business satisfying the $25/$26 million AGR threshold will not be classified as a syndicate (i.e., all the owners will be deemed to “actively participate” in the management of the entity for a taxable year) if one or more of the following apply:

1) The loss was created by a change to the cash method and/or any other change allowed by Rev Proc 2018‐40 to take advantage of the enactment of the TCJA. This could be conditioned on the business not having been classified as a syndicate within the last 3 years or some other reasonable period;

2) The average of the taxable income or loss of the business for the prior three years is income and not a loss or some similar test to ensure the business is not carried on primarily to pass losses through to limited partners or limited entrepreneurs;

3) The business has no more than 5 (or some other number) owners who do not actually actively participate in management and the total ownership of the business by those who do not actively participate is less than 50%;

4) The taxpayer can establish that the business was not organized primarily for tax avoidance purposes.

TREATMENT OF INVENTORY FOR TAXPAYERS WITH AVERAGE GROSS RECEIPTS OF $25/$26 MILLION OR LESS (Proposed Reg 1.471‐1(b)).

1. Summary. Proposed Reg 1.471‐1(a) says “Except as provided in paragraph (b) of this section, in order to reflect taxable income correctly, inventories at the beginning and end of each taxable year are necessary in every case in which the production, purchase, or sale of merchandise is an income‐producing factor.” Proposed Reg 1.471‐1(b) provides that Reg 1.471‐1(a) shall not apply to a taxpayer (other than a tax shelter) meeting the $25/$26 million AGR test that accounts for inventory by either: 1) accounting for inventory items as non‐incidental materials and supplies; 2) conforming the treatment of inventory to the taxpayer's applicable financial statement (AFS) (the so‐called AFS §471(c) inventory method); or 3) if the taxpayer does not have an AFS, accounting for inventory in accordance with the taxpayer's books and records prepared in accordance with the taxpayer's accounting procedures (the so‐called non‐AFS §471(c) inventory method).

2. Treatment of Inventory as Non‐Incidental Materials and Supplies (Proposed Reg 1.471‐1(b)(4)).

a. Summary. Under Reg 1.163‐3, non‐incidental materials and supplies are generally deductible when first used or consumed in a taxpayer's operations. Proposed Reg 1.471‐1(b)(4)(i) provides that inventory treated as non‐incidental materials and supplies are used or consumed in the taxpayer's business, and therefore deductible, in the later of 1) the taxable year in which the taxpayer provides the item to a customer or 2) the taxable year in which the taxpayer pays for or incurs (in the case of an accrual method taxpayer) such cost.

b. Capitalization of Direct Labor. Proposed Reg 1.471‐1(b)(4)(ii) says “The inventory costs includible in the section 471(c) materials and supplies method are the direct costs of the property produced or property acquired for resale.” This appears to mean that direct labor must be included in the costs of property produced by the taxpayer. However, the Preamble to the proposed regs says “The Treasury Department and IRS interpret section 471(c)(1)(B)(i) as generally codifying the administrative guidance existing at the time of enactment (that is, Revenue Procedure 2001‐10 and Revenue Procedure 2002‐28).” Rev Proc 2001‐10 did not require direct labor or overhead to be included in the costs of the inventory treated as non‐incidental materials and supplies.

Recommendation. Since the Preamble says that: 1) The purpose of the new rules under §471(c) is to “provide simplification to taxpayers” and 2) “The Treasury Department and IRS interpret section 471(c)(1)(B)(i) as generally codifying the administrative guidance existing at the time of enactment (that is, Revenue Procedure 2001‐10 * * * )” which does not require direct labor to be included in materials and supplies, the final regulations should only require direct material costs to be included in materials and supplies.

c. Proposed Reg Says Inventory Treated as Non‐Incidental Materials and Supplies Does Not Qualify for the De Minimis Expensing Provision of Reg 1.263(a)‐1(f). The Preamble to the proposed regs says “the Treasury Department and the IRS continue to interpret inventory treated as non‐ incidental materials and supplies as remaining characterized as inventory property. Consequently, proposed §1.471‐1(b)(4)(i) provides that inventory treated as section 471(c) non‐incidental materials and supplies is not eligible for the de minimis safe harbor election under §1.263(a)‐1(f). Extending the regulatory election under §1.263(a)‐1(f) to encompass section 471(c) materials and supplies is outside the intended scope of the election and runs counter to section 471(c), which indicates section 471(c) materials and supplies are inventory property.” [Emphasis added]* *.”

Proposed Regs Contrary to Joint Committee Explanation. Section 471(c)(1)(B) says “the taxpayer's method of accounting for inventory for such taxable year shall not be treated as failing to clearly reflect income if such method * * * treats inventory as non‐incidental materials and supplies.” What does it mean that a taxpayer “treats inventory as non‐incidental materials and supplies?” The Preamble to the proposed regs says that Treasury and the IRS interpret inventory to still be inventory even though it is treated as non‐incidental materials and supplies. However, others read the phrase literally and interpreted it to mean that what would be inventory is actually treated as non‐incidental materials and supplies and is not treated as inventory. Many of us had this question until the Blue Book was issued by the Joint Committee on Taxation. On December 20, 2018, the Joint Committee on Taxation issued the General Explanation of Public Law 115‐97 (i.e., the Tax Cuts and Jobs Act of 2017) ‐ the so‐called “Blue Book.” At footnote 465 on page 113, the Blue Book says “Consistent with prior and present law, a deduction is generally permitted for the cost of non‐incidental materials and supplies in the taxable year in which they are first used or are consumed in the taxpayer's operations. See Treas. Reg. sec. 1.162–3(a)(1). As the provision allows a taxpayer to treat inventories as non‐ incidental materials and supplies, 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).” [Emphasis added] In fact, Treas. Reg. sec 1.263(a)‐1(f) requires a taxpayer with a de minimis safe harbor election in place to apply such safe harbor to all materials and supplies that otherwise meet the requirements of paragraphs (1)(i) and (1)(ii) of the referenced section relating to AFS and non‐AFS taxpayers respectively.

Recommendation. It seems clear that the Joint Committee on Taxation is in the best position to understand the intent of Congress since that committee was instrumental in actually drafting the legislation. Moreover, the intent of the de minimis safe harbor to "simplify the accounting" for non‐ incidental materials and supplies, is the very same intent behind allowing businesses with AGR of $25/$26 million or less to use simplified accounting procedures for inventories (i.e., to “simplify the accounting”). In addition, even though there were non‐authoritative postings at the IRS website stating that the de minimis safe harbor did not apply to inventory treated as non‐incidental materials and supplies under Rev Proc 2001‐10 and Rev Proc 2002‐28, it appears these Rev Procs were never amended to provide such. In addition, both of these Rev Procs have been officially obsoleted by Rev Proc 2018‐40 for tax years beginning after 2017. Therefore, I would hope the final regulations reflect the intent of Congress as outlined by the Joint Committee and allow taxpayers who treat inventory as non‐incidental materials and supplies to apply the de minimis safe harbor election under Reg 1.263(a)‐1(f).

3. Accounting for Inventory in Accordance with Taxpayer's Books and Records Prepared in Accordance with Taxpayer's Accounting Procedures (Proposed Reg 1.471‐1(b)(6)).

a. Summary. Under §471(c)(1)(B)(ii), a taxpayer, other than a tax shelter, that does not have an AFS and that meets the §448(c) gross receipts test (e.g., $25/$26 million) is not required to take an inventory under §471(a), and may choose to treat its inventory as reflected in the taxpayer's books and records prepared in accordance with the taxpayer's accounting procedures. The proposed regs refer to this method as the “non‐AFS section 471(c) method.”

b. “Books and Records of Taxpayer Prepared in Accordance with Taxpayer's Accounting Procedures.”

i. Definition Of “Books and Records.” In response to a request to define “books and records,” the Preamble says “The Treasury Department and the IRS decline to define books and records in these proposed regulations. It is well‐established under existing law that the books and records of a taxpayer comprise the totality of the taxpayer's documents and electronically‐stored data. See, for example, United States v. Euge, 444 U.S. 707 (1980). See also Digby v. Comm'r, 103 T.C. 441 (1994), and §1.6001‐1(a).” In addition, the Preamble says that under existing law, an accountant's workpapers are generally considered part of the books and records of the taxpayer. The Preamble references United States v. Arthur Young & Co., 465 U.S. 805 (1984).

ii. Description Of "Books and Records Method." The Preamble says “These proposed regulations permit a taxpayer without an AFS (non‐AFS taxpayer) to follow its method of accounting for inventory used in its books and records that properly reflect its business activities for non‐Federal income tax purposes * * * A books and records method that determines ending inventory and cost of goods sold that properly reflects the taxpayer's business activities for non‐Federal income tax purposes is to be used under the taxpayer's non‐AFS section 471(a) method. For example, a taxpayer that performs a physical count that is used in determining inventory in the taxpayer's books and records must use that count for purposes of the non‐AFS section 471 method.”

Example 1 (Proposed Reg 1.471‐1(b)(6)(iii)). Taxpayer E is a C corporation engaged in the retail trade or business of selling beer, wine, and liquor. In 2019, E has average annual gross receipts for the prior 3‐taxable‐years of less than $15 million, and is not otherwise prohibited from using the cash method under §448(a)(3). E does not have an AFS for the 2019 taxable year. E is eligible to use the non‐AFS section 471(c) method of accounting. E uses the overall cash method, and the non‐AFS section 471(c) method of accounting for Federal income tax purposes. In E's electronic bookkeeping software, E treats all costs paid during the taxable year as presently deductible. As part of its regular business practice, E's employees take a physical count of inventory on E's selling floor and its warehouse on December 31, 2019, and E also makes representations to its creditor of the amount of inventory on hand for specific categories of product it sells. E may not expense all of its costs paid during the 2019 taxable year because its books and records do not accurately reflect the inventory records used for non‐tax purposes in its regular business activity. E must use the physical inventory count taken at the end of 2019 to determine its ending inventory. E may include in cost of goods sold for 2019 those inventory costs that are not properly allocated to ending inventory.

c. Recommendations.

1) Even though a taxpayer takes a physical count of inventory, the taxpayer should be allowed to expense the inventory for income tax purposes where the inventory is expensed on its books and records. If this is not automatically allowed, I recommend that the above example be modified to explain that E could expense the inventory if E's employees took a physical count of inventory, but E did not make representations to creditors as to the amount of the inventory.

2) Reg 1.446‐1(a)(1) says “Section 446(a) provides that taxable income shall be computed under the 'method of accounting' on the basis of which a taxpayer regularly computes his income in keeping his books.” Under existing law, taxpayers otherwise permitted to use the cash method of accounting are allowed to keep their books and records on the accrual method during the year if they reconcile the books and records to the cash method at the end of the year (please see Reg 1.446‐1(a)(4) and Patchen v. Comm, 258 F. 2d 544 (1958)). In addition, an accountant's working papers reconciling the books and records to the cash method are treated as part of the taxpayer's books and records according to the Preamble to the proposed regs. It is difficult to understand why the rules for inventory, where a taxpayer uses the non‐AFS section 471(c) method should be any different than the rules for using the cash method. It appears that since taxpayers with audited financial statements or financial statements provided to certain regulatory agencies cannot use the non‐AFS section 471(c) method, that should prevent abuse of such a rule. Therefore, the final regs should allow a taxpayer to track inventory during the year and expense the inventory for income tax purposes by adjusting its records to expense the inventory amounts.

ACCOUNTING METHOD CHANGES TO COMPLY WITH FINAL REGULATIONS

1. Entity Must Change from Cash Method If Becomes A Tax Shelter or Exceeds $25/$26 Million AGR Threshold. Proposed Reg 1.448‐2(b)(2)(v) provides that an entity using the cash method must change to the accrual method for the taxable year it becomes classified as a tax shelter under the regulations. In addition, the proposed regs provide that a taxpayer must change to the accrual method of accounting in the year the taxpayer's AGR exceeds the $25/$26 million threshold. The change to the accrual method is to be made under the automatic accounting method change procedures. Proposed Reg 1.448‐2(g)(3) provides that if a taxpayer had changed its overall accounting method from the cash method during any of the five taxable years ending with the taxable year, because it became a tax shelter or its gross receipts exceeded the $25/$26 million threshold, the taxpayer may not change its overall method of accounting back to the cash method without the written consent of the Commissioner in accordance with the applicable procedures published in the Internal Revenue Bulletin.

Recommendation. If 1) a taxpayer changed to the cash method of accounting, changed its treatment of inventories, or made any other change permitted by Rev Proc 2018‐40 for a taxable year beginning before the proposed regs are finalized, 2) the §481(a) adjustment created a loss for the year of change and 3) more than 35% of the loss was allocated to limited partners or limited entrepreneurs, it would seem equitable to allow the taxpayer to automatically switch to the cash method if the business does not have a loss for the following year. This would benefit those businesses that inadvertently became a tax shelter because of the §481(a) adjustment. However, as previously mentioned, I believe the most equitable relief would be for taxpayers in this situation to be given a waiver of the tax shelter classification if the only reason the taxpayer had a loss for the year of the accounting method change was because of the §481(a) adjustment.

2. Businesses with Inventory Methods That Do Not Comply with The Final Regs. Prior to issuance of these proposed regs, no business was certain of the proper treatment of inventory if the business wished to treat inventory as non‐incidental materials and supplies. In addition, the meaning of treating inventory in accordance with the “books and records of the taxpayer prepared in accordance with taxpayer's accounting procedures” was even more elusive.

Recommendation. Since the proper treatment of inventory under §471(c) was not explained clearly in the statute or the committee reports, it would seem prudent to allow businesses that made a good faith attempt to treat inventories in accordance with §471(c) and find themselves not in compliance with the final regs to automatically change their accounting method for inventories to comply with the final regs and spread any positive adjustment over 4 years as provided in Rev Proc 2015‐13.

Thank you for the opportunity to comment on the proposed regs and I welcome the opportunity to discuss any of these comments with you. Thank you for your time and consideration of these suggestions.

Sincerely,

Mark L. Groves, CPA

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