Small business accounting regulations and tax shelter implications

The IRS issued proposed regulations (REG-132766-18) on July 30 related to simplified tax accounting rules for small businesses and updating various tax accounting regulations to adopt the simplified rules enacted by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, under Secs. 448, 263A, 460, and 471. The proposed regulations apply to taxpayers that have inflation-adjusted gross receipts of $26 million or less. (For additional background on the proposed regulations, see “Simplified Accounting Rules Issued for Small Businesses”; on the topic of small business exceptions under the TCJA see “A Quirk in the TCJA’s Small Business Exceptions” and “Relief for Small Business Tax Accounting Methods.”)

The simplifications provided for under the TCJA include a few main provisions, such as: (1) allowing small businesses to use the cash method of accounting instead of the accrual method, even if they have inventory (Sec. 448(c)); (2) not requiring capitalization of additional uniform capitalization (UNICAP) costs to inventory (Sec. 263(A)(i)); (3) treating inventory as nonincidental materials and supplies or using an inventory method that conforms to the taxpayer’s financial accounting treatment of inventories (Sec. 471(c)); and (4) not accounting for long-term construction contracts using the percentage-of-completion method (PCM) of accounting (Sec. 460(e)(1)(B)). Sec. 471(c) outlines that if the taxpayer does not have an applicable financial statement (AFS), it may account for inventory following the method used for “the books and records of the taxpayer prepared in accordance with the taxpayer’s accounting procedures.” The proposed regulations provide guidance and examples on the meaning of this method.

Taxpayers classified as tax shelters are prohibited from using the simplified rules as outlined above even if they meet the gross receipts test. A tax shelter is a partnership or any other entity (except a C corporation) where more than 35% of losses for the tax year are allocated to limited partners or limited entrepreneurs. Note that Temp. Regs. Sec. 1.448-1T(b)(3) uses the term “allocated” while Sec. 1256(e)(3)(B) uses the term “allocable.” The preamble to the proposed regulations describes “allocated” as more favorable because an entity could only potentially be a syndicate (tax shelter) in a year when it has losses. The proposed regulations follow Temp. Regs. Sec. 1.448-1T(b)(3) on this point (Prop. Regs. Sec. 1.448-2(b)(2)(iii)).

This definition of tax shelter can pose certain problems, as the rule does not allow or account for large deductions or losses during a tax year. For example, large Sec. 481(a) adjustments (a common adjustment related to implementing the recent qualified improvement property (QIP) technical correction change) might create a loss causing the entity to be a tax shelter for the year. The proposed regulations do not address a workaround or exceptions. The taxpayer is also then locked into the accrual method and cannot change back to the cash method for five years, which is generally unfavorable, unless requested using an advance consent accounting method change.

The proposed regulations allow for a permanent election to determine any year’s tax shelter status based on allocations of the prior year, which provides some limited relief. (See Prop. Regs. Sec. 1.448-2(b)(2)(iii)(B) for the details on how the election is made and what happens if the taxpayer is able to later have it revoked.) This election allows an entity to know at the start of the year if it is a syndicate rather than perhaps not knowing until past year end. However, this election to use last year’s information only delays the impact by a year. That is, the next year an affected entity would no longer be allowed to use any of the simplified methods for small businesses.

One recommendation to ease the transition to the accrual method would be to use a rolling multiyear average of taxable income, which could provide more certainty and consistency, although it may provide some challenges (for example, in cases where a first-year entity is involved). However, there is value in knowing when a business is changing from the cash to the accrual method and having a year in which to plan for the change. A business would be able to decide which tax year the Sec. 481(a) adjustment is included in taxable income, choosing to recognize the adjustment in the tax year most advantageous to the business. Also, even if the cash method is preferable, a business can plan ahead and make informed business decisions to minimize the impact of a change in accounting method, such as deferring payments of expenses to a subsequent accrual method tax year, using accrual accounting methods to accelerate the deduction of expenses and defer recognition of advance payments.

The reality for many taxpayers is that even though they are supposed to be on an accrual method according to the long-standing rule of Sec. 448(a) if they are in fact a tax shelter, they may have not changed historically because there was not a material difference between cash and accrual. However, with the pandemic many taxpayers are facing significant tax losses in 2020, so the difference may be material now. For example, a business unable to pay all of its bills cannot deduct those expenses in a cash-basis measure of taxable income. However, under the accrual method, all or most of the expenses may be deductible under the rules of Sec. 461. To change from cash to accrual, the tax shelter uses the automatic change procedures of Rev. Proc. 2019-43.

The AICPA has previously recommended (in a letter dated May 7, 2020) that the definition of tax shelter be modernized in order to simplify the tax system for many small businesses and provide parity among business entity forms. The TCJA allows favorable accounting methods for small businesses; however, if a small business meets the definition of a tax shelter these favorable rules do not apply, even though the business has no tax avoidance or evasion purpose. The definition of tax shelter used by the TCJA is the same one added to Sec. 448 in 1986 and goes well beyond an entity formed for tax avoidance or evasion purposes, which is how most people would define a tax shelter. The AICPA previously recommended that Treasury and the IRS exercise regulatory authority under Sec. 1256(e)(3)(C)(v) to provide that all the interests held in entities that meet the definition of a syndicate but otherwise meet the Sec. 448(c) gross receipts test be deemed as held by individuals who actively participate in the management of the entity. (See the AICPA’s comment letter “Re: Small Business Relief From Definition of Tax Shelter” (Feb. 13, 2019).)

The old (yet still used) definition, given even broader significance by the TCJA, includes a syndicate where over 35% of losses for a tax year are allocable to owners who do not actively participate in management of the entity (not uncommon for a small business operating as a limited liability company (LLC) with multiple owners). The IRS and Treasury did not accept the recommendation to deem all investors as active participants if the taxpayer is under the gross receipts’ threshold, which the AICPA put forth previously. The concerns of 1986 do not exist today particularly because the passive activity loss limitation rules of Sec. 469, enacted in 1986, prevent passive owners from deducting entity losses unless the owner also has passive activity income. In addition, in 1986, use of the LLC entity was rare, as most states did not even have LLC laws.

If a tax shelter limitation is needed, the definition of tax shelter at Sec. 6662(d)(2)(C) of an entity with a significant purpose of avoidance or evasion of federal income tax is the more appropriate definition today, given other loss limitation rules already in the law and the reality that LLCs are a favored entity form for small businesses. In addition, the broader definition harms entities with inactive owners who often provide needed financing, yet the entity was not formed for tax avoidance or evasion. (See the AICPA position paper “Recommendations for Tax Law Changes to Reflect How Small Businesses Operate in the Modern World” (March 20, 2019).)

The rules will be effective beginning on or after the date the final regulations are published in the Federal Register. For tax years beginning after Dec. 31, 2017, and before the final regulations are published, a taxpayer may early-adopt the proposed regulations provided that the taxpayer follows all the applicable rules contained in the proposed regulations for each Code provision that the taxpayer chooses to apply. Advisers should consider all of the available options and the client’s individual circumstances when applying the proposed regulations.

Elizabeth Young, CPA, J.D., LL.M., is a senior manager–Tax Policy & Advocacy with the AICPA in Washington, D.C. Nathan Clark, CPA, is a partner with Dixon Hughes Goodman LLP in Charlotte, N.C., and a member of the AICPA Tax Methods and Periods Technical Resource Panel. To comment on this article or to suggest an idea for another article, contact Alistair M. Nevius, J.D., (Alistair.Nevius@aicpa-cima.org) the JofA’s editor in chief, tax.

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