Cash Method of Accounting: Changes Under the Tax Cuts and Jobs Act (TCJA)
The Tax Cuts and Jobs Act (TCJA) brought significant changes to income taxes with its amendments to the Internal Revenue Code of 1986. Among these changes were reliefs to small business taxpayers in order to simplify certain restrictions previously imposed on them, which were limiting their ability to utilize the cash basis method of accounting for income tax purposes. Prior to the TCJA, limitations included: inventory requirements, gross receipts requirements and ineligibility due to specific trade or business activities. Effective for the tax years beginning in 2018 and ending in 2025, more small businesses have the ability to utilize the overall cash basis method of accounting for income tax purposes.
How Does the TCJA Help Manufacturers?
Under the pre-TCJA rules, the cash basis method of accounting was generally available to most service businesses and for certain small business taxpayers in other industries, with several special rules and exclusions. One rule that eliminated the ability of most manufacturing entities to utilize the cash basis method of accounting was the inventory rule. This rule essentially stated that entities who maintained inventory records were required to use the accrual basis method of accounting for income tax purposes. Taxpayers were generally required to maintain inventory records if they were engaged in production, purchase, or sale of merchandise and those activities were a material income-producing factor, thus eliminating most manufacturers.
For years beginning in 2018, the TCJA amended this inventory rule. The amended rule provides that the taxpayer’s method of accounting for inventory will not limit their ability to utilize the cash basis method of accounting, so long that they:
- Treat inventory as non-incidental materials and supplies; or
- Inventory for tax purposes conforms to the taxpayer’s method of accounting reflected in an applicable financial statement (audited financial statement) of the taxpayer with respect to the tax year being filed or if the taxpayer does not have an applicable financial statement, the books and records of the taxpayer are prepared in accordance with the taxpayer’s accounting procedures.
As a result, for taxpayers without an applicable financial statement (audited financial statement), inventories can be treated as non-incidental materials and supplies, and thus allowing taxpayers to utilize the cash basis method of accounting for income tax purposes. This change essentially allows most manufacturers with average annual gross receipts of less than $25,000,000 to potentially convert from the accrual to cash basis method of accounting for income tax purposes for periods beginning on or after January 1, 2018. While this conversion may not make sense for every taxpayer, it is important to perform this exercise on an annual basis to ensure significant tax savings are not missed.
Dannible & McKee, LLP has worked closely with our clients in assessing whether the rules under the TCJA and change to the overall cash method of accounting for income tax purposes is beneficial to their businesses. Companies in the manufacturing and production industries, in particular, should be looking into the impact of these changes to determine whether it could improve tax position, operating efficiency, and cash flow performance