PROTECTING SMALL BUSINESS, PROMOTING ENTREPRENEURSHIP

The Tax Tipping Point: $25 Million Gross in Receipts

By at 14 June, 2018, 9:38 am

By Barbara Weltman-

As a result of the Tax Cuts and Jobs Act, small businesses are now at an advantage for some tax rules…as long as they remain small. In this case, “small” means keeping revenues below a $25 million tax tipping point. The expansion and simplification of these rules allows many small businesses to continue deducting their interest and using the cash method of accounting in 2018.

Here’s what the $25 million tax tipping point means, where it applies, and what to do.

$25 million gross receipts test

For tax years beginning after December 31, 2017, the tax breaks that follow can be claimed by a business that meets a “gross receipts test.” This test requires having average annual gross receipts in the three prior years not exceeding $25 million.

For example, if annual gross receipts are $12 million in 2015, $15 million in 2016, and $18 million in 2017, average annual gross receipts for the three-year period ending in 2017 (the prior year) are $15 million, which is below the average annual gross receipts limit.

Here are some technicalities to help you navigate the new gross receipts test:

● Gross receipts are reduced by returns and allowances made during the year.

● If a company hasn’t been in business for three years, then simply use the years for which it has been in business.

● Companies with certain common ownership are aggregated for purposes of the dollar limit (i.e., you can’t qualify for the test simply by using separate companies).

● The dollar amount will be adjusted for inflation after 2018.

Interest deduction

Larger businesses are now subject to a limitation on the amount of business interest they can deduct annually. While the limitation is a little complicated, it essentially boils down to 30% of income.

But businesses that meet the gross receipts test are automatically exempt from the interest deduction limit. This means that small businesses can deduct all of their interest payments without regard to their revenues. They do not have to take any action; this exemption from the deduction limit is automatic.

However, farming and real estate businesses that don’t meet the gross receipts test can elect to be exempt from the interest deduction limit. If they do, then they must depreciate property using the alternative depreciation system (ADS) instead of the usual general depreciation system (GDS). This means slightly slower depreciation as a trade-off for unlimited interest deductions.

The gross receipts test is applied each year for purposes of the interest deduction limitation. So if a business fails to meet it in 2018, it can re-test in 2019. If it meets the test in that year, then interest deduction limit won’t apply.

Cash method option

As a general rule, C corporations and partnerships having a partner that is a C corporation are barred from using the cash method of accounting (a simple method of reporting income and expenses) and instead must use the accrual method (a more complicated method). The general rule has always had certain exemptions: farming businesses and personal service corporations (those involved in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting and that meet an ownership test) as well as other businesses meeting a modest gross receipts test.

Now, C corporations and partnerships with a C corporation partner can use the cash method of accounting if it meets the $25 million gross receipts test.

Inventory-based businesses

Businesses that maintain inventory usually must account for them as such. This means taking inventory at the beginning and end of each year to report the cost of goods sold. There had been a modest gross receipts test to exempt certain businesses from reporting inventory.

Now, inventory-based businesses that meet the $25 million gross receipts test can choose instead to treat their inventory as non-incidental materials and supplies. (Incidental materials and supplies are items such as pens and paper you don’t keep track of versus non-incidental items you keep an inventory of.) This means the cost of non-incidental materials and supplies can be deducted when used or consumed. For example, a hair salon meeting the gross receipts test can deduct the cost of hair products held for sale to customers when the products are actually sold to them.

UNICAP rules exemption

Producers and resellers of tangible property usually have to allocate certain costs, such as materials and labor, to inventory under the so-called UNICAP rules. However, if they meet the $25 million gross receipts test, they can be exempt from these rules. This can allow for a separate deduction of certain costs.

Long-term contracts-exemption from percentage-of-completion reporting

Contractors generally must account for long-term contracts using the percentage-of-completion method of accounting. Under this method, income is reported based on the percentage of the contract that has been completed.

Businesses that are now exempt under the $25 million gross receipts test can use the completed contract method, the exempt-contract percentage of completion method, or any other permissible method.

What to do

If a business meets the gross receipts test and wants to make a change—to use the cash method, avoid reporting inventory, or be exempt from the UNICAP rules and the percentage of completion method—it must make a change in accounting method. The IRS has not yet provided an automatic procedure for making this change, but has indicated it will announce something soon.

Don’t be hasty in making a change. Doing so may trigger additional income to pick up as a result of the change. And if the business is growing to the point where it’s approaching the $25 million tipping point, it may not pay to make a change for the short term. Work with your CPA or other tax advisor to determine whether a change is desirable and what you need to do to make it happen.

Barbara Weltman is a member of SBE Council’s advisory board, and has been a premier consultant for small businesses of every kind for over twenty years. She’s the founder of Big Ideas for Small Business and has written numerous books on small business operations, including J.K. Lasser’s Small Business Taxes, The Complete Idiot’s Guide to Starting a Home-Based Business, and The Rational Guide to Building Small Business Credit. Follow Barbara on Twitter @BarbaraWeltman

 

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