Tax Monitor

Proposed Regulations Provide Guidance on Entities That Can Use Small Business Accounting

August 31, 2020

By: Rebecca G. M. Krehbiel and Trinity J. Gray

Recent IRS proposed regulations outline new accounting method procedures for businesses who want to use the cash method for accounting and how they can qualify to do so under expanded statutory requirements.

The IRS recently issued proposed regulations to implement changes made to the permissible accounting method used by small businesses under the Tax Cuts and Jobs Act of 2017 (“TCJA”). While these new proposed regulations are not final, taxpayers may rely on them.  Prior to these proposed regulations, preliminary guidance in light of the TCJA changes was issued in Revenue Procedure 2018-40, which contains the procedures for changes in accounting method under the new proposed regulations.

Gross Receipts Test

Before the enactment of the TCJA, §448 of the Internal Revenue Code (“Code”) prevented certain businesses averaging annual gross receipts of more than $5 million from using the cash method of accounting (“Gross Receipts Test”). Generally, a C corporation or a partnership that has a C corporation as a partner is disallowed from using the cash accounting method.  Code §448(b), however, makes an exception to this general rule for farming businesses, qualified personal service corporations, and businesses that meet the Gross Receipts Test. The TCJA increased the threshold of the Gross Receipts Test from $5 million to $25 million, adjusted for inflation ($26 million in 2020), which now allows more businesses to take advantage of the simpler cash accounting method.

Additionally, under prior law, the calculation of gross receipts was based on a rolling average over the three preceding tax years. Previously, if the average gross receipts for any taxable year exceeded the threshold, the company was permanently barred from using the cash method moving forward, even if the average dipped below the threshold in the future. Between the low gross receipts threshold and the restrictiveness of the permanent bar, the cash method was unavailable to many small businesses. The TCJA changed this so that for taxable years after 2017, if a business does not meet the Gross Receipts Test in one taxable year based on the three-year rolling average, it is not prevented from meeting it in a future tax year.

Other than to update the parameters of the Gross Receipts Test, the proposed regulations did not change the short taxable year and aggregation rules already in existence, but the proposed regulations do clarify that the gross receipts of a C corporation partner are included in the gross receipts of a partnership if the aggregation rules apply to the C corporation partner and the partnership.

Procedures for Changing Accounting Method under Proposed Regulations

While a taxpayer is not completely barred from using the cash method in the future, it is more procedurally cumbersome to switch back to the cash method once a taxpayer is disqualified from using it for failing the Gross Receipts Test or being considered a tax shelter (discussed below). The proposed regulations state that if a taxpayer meets the Gross Receipts Test but at some point in the past five years was required to switch from the cash method because it failed the Gross Receipts Test or because it was considered a tax shelter, the taxpayer cannot change its method back to cash without following the procedures to obtain written consent from the IRS. This means businesses trying to change back to the cash method after having been disqualified must follow the non-automatic consent procedures, which includes, among other things, filing a Form 3115 with the IRS during the year of change (ahead of the timely filed tax return) as well as paying a user fee.

If, however, the taxpayer is required to switch from cash to accrual because it failed the Gross Receipts Test or was considered a tax shelter, such a change is treated as a change made with the consent of the Commissioner, and can be implemented through the automatic consent procedures laid out in Revenue Procedure 2015-13, as amended. For automatic consent, Form 3115 needs to be filed with a taxpayer’s timely filed income tax return for that year, completed in accordance with the automatic consent procedures, but no user fee is required.

A taxpayer seeking to change its overall accounting method from accrual to cash because it now qualifies under the expanded Gross Receipts Test can use the automatic consent  procedures outlined in Revenue Procedures 2015-13 and 2018-31, as modified by Section 3 of Revenue Procedure 2018-40.

Disqualification for Being a Tax Shelter

Even if the Gross Receipts Test is met under the new threshold, a business may still be prevented from using the cash method of accounting if it is considered a tax shelter as defined in Code §448(d)(3). Under Code §448(a)(3), a “tax shelter” is prohibited from using the cash method of accounting. Prop. Reg. §1.448-2(b)(2)(i) provides the following list of “tax shelters”: 

1. an enterprise, other than a C corporation, if at any time (including tax year before January 1, 1987) interests in such enterprise have been offered for sale in any offering required to be registered with any Federal or state agency having authority to regulate the offering of securities for sale; 
2. a tax shelter (as defined in Code §6662(d)(2)(C)); or 
3. a syndicate (as defined in Code §1256(e)(3)(B)). 

 

Under Code §6662, a tax shelter is defined to include (1) a partnership or other entity, (2) any investment plan or arrangement, or (3) any other plan or arrangement if the significant purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of Federal income tax. Any entity meeting this definition would be prohibited from using the cash method of accounting. 

The most complicated definition of tax shelter is that of a “syndicate.” While the definition of syndicate in the proposed regulations is similar to that of Code §1256(e)(3)(B), it is defined in the proposed regulations as a partnership or other entity (other than a C corporation) if more than 35 percent of the losses of the entity during a taxable year are allocated to limited partners or limited entrepreneurs (the “35% Test”).  

In this definition, limited entrepreneurs are persons who have an interest in an enterprise other than as a limited partners and who do not actively participate in the management of the enterprise. In the proposed regulations, the IRS opted to continue to use the “allocated” test found in the prior Code §448 regulations, though Code §1256(e)(3)(B) itself uses the “allocable” test. As a result, if there is no loss for a taxable year, the entity will not be a syndicate for that year for purposes of the proposed regulations; however, it is important to note that, with this definition, if an entity has both profitable and unprofitable years, the entity can move into and out of the definition of syndicate depending on the amount of loss allocated to equity holders in such loss years. The proposed regulations provide that an entity must change its accounting method for the year it becomes a tax shelter.  Note that even if the loss is a one-time special event (like an accounting method change adjustment under Code §481(a)), the entity must change its accounting method for the year it is a tax shelter.

Generally, by default, a taxpayer tests for tax shelter status by using the current year’s tax return to see if it meets the 35% Test; however, the proposed regulations allow a taxpayer to elect to perform the 35% Test based on the prior taxable year’s activity. This election is binding on a taxpayer, unless the taxpayer obtains the IRS’s permission to change the election, which requires applying and paying for a private letter ruling. The proposed regulations also provide certain requirements and limitations for a taxpayer making this election. To make the election, taxpayer must attach a statement to its timely filed Federal income tax return (including extension) that this election is made beginning with that tax year. No late elections are allowed.  Additionally, a taxpayer cannot make an election by filing an amended return. 

Takeaways from Guidance Defining Tax Shelters Under Proposed Regulations

Taxpayers can elect to use their immediately preceding taxable year to determine their tax shelter status; however, that option comes with a major catch. Taxpayers making that choice must in future years continue to use their immediately preceding taxable year to determine their tax shelter status. The IRS does provide revocation options, but that revocation can be costly and time consuming because of the requirement for the taxpayer to apply and pay for a private letter ruling to revoke the election. Because of this requirement, the proposed regulations, as they relate to tax shelters, offer little more flexibility for businesses than prior regulations. If a business is planning to make the election, it needs to be sure it is ready to accept the consequences for the long haul, unless it can afford to spend the time and money necessary to obtain revocation.

Under the tax shelter proposed definition, it is possible that closely held and family-owned businesses in which the current generation of owners are not heavily involved may not be eligible for these accounting method changes and the simplification that could come with them. This is still an outstanding question for the IRS to address.