Small Manufacturers May Opt To Use Simplified Reporting Methods
The Tax Cuts and Jobs Act (TCJA) expanded the tax code’s definition of “small business” to include those with average annual gross receipts of $25 million or less (adjusted for inflation) for the three preceding tax years. Both the 2020 and 2021 inflation-adjusted threshold is $26 million. Manufacturers that qualify as small businesses may be eligible for simpler reporting methods that could also defer federal income taxes. Let’s take a closer look.
Under the cash method of accounting, income is recognized when it’s received, and expenses are deducted when they’re paid. Under the accrual method, income is recognized when it’s earned, and expenses are deducted when they’re incurred, regardless of the timing of cash receipts or payments.
Typically, businesses that use the cash method can defer more taxable income than they would under the accrual method. And businesses that switch from the accrual method to the cash method often enjoy significant tax savings in the year they make the change.
In addition, manufacturers that qualify as small businesses may elect to use the completed-contract method to account for long-term contracts expected to be completed within two years. Compared to the more complicated percentage-of-completion method that’s required for larger companies, the completed-contract method allows a small business to defer tax until the contract has been substantially completed.
The TCJA exempts small businesses from complex inventory accounting requirements and permits them to account for inventories by either:
- Treating them as nonincidental materials and supplies, or
- Conforming to the inventory method used in the business’s financial statements or books and records.
Treating inventories as nonincidental materials or supplies means deducting their cost in the year they’re consumed and used by the business. Many manufacturers interpreted “used or consumed” to mean “used in the production process.” However, proposed IRS regulations provide that an item is used or consumed when it’s provided to the customer.
Manufacturers who take advantage of this provision should watch for the final regulations. If the proposal is finalized in its current form, manufacturers may not be able to deduct inventory costs as early as they had hoped.
More TCJA Exemptions
The TCJA provides two more exemptions for small businesses:
- Exemption from uniform capitalization rules. Manufacturers that qualify as small businesses are exempt from the uniform capitalization rules. Those rules require a business to capitalize to inventory, rather than expense, direct production costs and certain indirect costs. Not only does this process complicate tax reporting, but it can also increase a company’s tax liability.
- Exemption from business interest deduction limit. The TCJA limits deductions for net business interest expense to 30% of adjusted taxable income (temporarily increased by the CARES Act to 50% for 2019 and 2020). The limit doesn’t apply to small businesses, so they’re allowed to deduct 100% of their business interest in the current tax year.
Does your company qualify as a small business for federal tax purposes? If so, you may now be eligible for simplified reporting options that you didn’t qualify for in the past. Contact us to help evaluate the potential benefits of small business status and determine whether it would be advantageous to change your accounting methods.