While many changes in the Tax Cuts and Jobs Act (TCJA) involved rewriting entire sections of the tax code, some of the most consequential changes resulted from a simple change in definition. By expanding the definition of a “small business,” the law enabled many companies to simplify their tax preparation—and often improve their cash flow as well.
Defining a Small Business
Complying with certain elements of the tax code has historically imposed a significant burden on small businesses. Recognizing this, many sections of Internal Revenue Code contain exceptions that excuse small businesses from their most complex accounting requirements.
Before the TCJA was passed, these small business exceptions generally were available only to pass-through entities such as S corporations and partnerships whose gross receipts had never exceeded $10 million in any given year. For C corporations the ceiling was even lower—$5 million. Once company revenues surpassed those levels, small business exceptions ended and the company would have to comply with the same accounting method requirements as the nation’s largest corporations.
The TCJA raised that threshold to $25 million for all types of businesses. It also changed the calculation so that companies are now evaluated based on their average gross receipts for the prior three years rather than the highest revenue they ever recorded in any year.
Four Important Small-Business Exceptions
Increasing the threshold and changing the evaluation method opened the way for more businesses to take advantage of some important small business exceptions. Companies below the new $25 million threshold can now:
- Use the cash method of accounting instead of the accrual method. Under the accrual method, businesses recognize income as soon as they have completed all steps that entitle them to be paid. Under the cash method, businesses do not recognize income until they receive the money—so they can defer federal income taxes until the money is in hand. This can help cash flow in companies where receivables are much greater than payables or if there is often a lag between billing and payment.
- Choose not to apply uniform capitalization (UNICAP) rules. For companies that produce or resell tangible property, UNICAP requires certain direct and indirect costs such as purchasing, storage, and handling costs to be included in inventory or capitalized into the basis of the property. The calculations can be cumbersome. Being exempted from these requirements will provide welcome relief to many small businesses.
- Be exempt from inventory accounting requirements. Before the TCJA, small businesses were required to account for inventories on their tax returns whenever the production, purchase, or sale of goods was an income-producing factor. Now, qualifying small businesses can choose to use an accounting method that treats inventories as nonincidental materials and supplies or a method that conforms to their other financial statement or accounting procedures.
- Change how they account for long-term construction contracts. When construction contracts extend beyond one tax reporting period, most construction companies must account for them using the percentage-of-completion method, which recognizes revenue in increments as they complete various interim milestones. Now, contractors below the $25 million threshold can use other methods such as the completed contract method, which allows them to defer revenue recognition for tax purposes.
A change in accounting method requires the consent of the IRS. Your accountant generally can handle this as part of your tax return. Call Holbrook & Manter today if you have questions about this or any other TCJA provisions.