By Lisa M. Loychik and Jonathan R. Williamson at The Tax Adviser on August 1, 2019
Various exceptions are available to small business taxpayers to help them avoid some of the Internal Revenue Code's more burdensome and complex requirements. Although these exceptions are meant to simplify tax law implementation, the rules for evaluating whether a business qualifies for the exceptions can be convoluted and highly computational. Although small taxpayer testing may be time-consuming, the tax and time benefits of a small taxpayer classification may be critical to certain taxpayers.
Summary of small taxpayer exceptions
The exceptions are meant more to reduce compliance costs rather than to reduce taxes, but they often do both. Small business taxpayer exceptions include:
Cash-basis accounting method: Although the cash method of accounting is considered a permissible method under Sec. 446(c)(1), Sec. 448 disallows a C corporation or a partnership that has a C corporation as a partner from using it. In addition, if the purchase, production, or sale of merchandise is an income-producing factor, the taxpayer cannot use the cash method of accounting. Sec. 448(b) provides exceptions to this limitation for farming businesses, qualified personal service corporations, and entities that meet the gross receipts test under Sec. 448(c) (commonly known as the small taxpayer gross receipts test).
Exception from Sec. 263A: Newly established under the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, Sec. 263A(i) allows an exemption from the capitalization requirements of Sec. 263A for any taxpayer that meets the gross receipts test of Sec. 448(c).
Exception from the requirement to account for inventories: Sec. 471(c) exempts certain small businesses from the general inventory accounting requirements. These small business taxpayers may either:
- Treat inventory as nonincidental materials and supplies under Regs. Sec. 1.162-3(a)(1) that are eligible to be deducted in the tax year in which the materials and supplies are first used in the taxpayer's operations; or
- Use a method that conforms to the taxpayer's method of accounting for inventories, as reflected in the taxpayer's applicable financial statement or, lacking one, in its books and records.
Exclusion from the Sec. 163(j) limitation: The TCJA's new business interest expense limitation allows an exception in Sec. 163(j)(3) for certain small businesses that meet the gross receipts test of Sec. 448(c).
Completed-contract accounting method: Generally, a taxpayer must use the percentage-of-completion method for long-term contracts, which recognizes revenue as production occurs. Sec. 460(e)(1)(B), however, allows taxpayers that meet the gross receipts test of Sec. 448(c) to account for long-term contracts by the completed-contract accounting method for any contracts estimated to be completed within two years.