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.
Related Read: The TCJA Limit On Interest Expense Deductions
Under the “cash method” of accounting, income is recognized when it is received and expenses are deducted when they are paid. Under the “accrual method,” income is recognized when it is earned and expenses are deducted when they are incurred regardless of the timing of cash receipts or disbursements.
Often, the accounts receivable and prepaid expenses of a business exceed its accounts payable and accrued expenses, and in these situations, companies using the cash method of accounting defer more taxable income than they would under the accrual method. In these cases, businesses that switch from the accrual method to the cash method can have 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 is required for larger companies, the completed-contract method allows a small business to defer the profit on the contract and the resulting income tax until the contract has been substantially completed.
Related Read: How Amending Previous Years’ Tax Returns Can Possibly Free Up Cash
The TCJA exempts small businesses from complex inventory accounting requirements and permits them to account for inventories by either:
- Treating them as non-incidental materials and supplies; or
- Conforming to the inventory method used in the business’s financial statements or books and records.
Treating inventories as non-incidental materials or supplies means deducting their cost in the year they are consumed and used by the business. While many manufacturers have interpreted “consumed or used” to mean used in the production process, proposed IRS regulations provide that an item is used or consumed when it is provided to the customer. However, proposed IRS regulations also indicate that small businesses can expense individual items costing under $2,500 in the year purchased.
Manufacturers considering taking advantage of this provision should be mindful of the final IRS regulations.
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 inventory, rather than expense, direct production costs and certain additional indirect costs. Not only does this additional capitalization of costs complicate tax reporting, but it can also increase a company’s taxable income and resulting tax liability.
- Exemption from Business Interest Deduction Limit
The TCJA limits deduction for net business interest expense to 30% of the company’s adjusted taxable income (temporarily increased by the CARES Act to 50% for 2019 and 2020). The limit does not apply to small businesses, so they are 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 be eligible for simplified reporting options that you did not qualify for in the past. Your ORBA tax advisor can help you evaluate the potential benefits of small business status and determine whether it would be advantageous to change your accounting methods.
For more information, contact Joel Herman at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Manufacturing and Distribution Group.