Even with the new depreciation options and qualified business income deduction available in the wake of recent tax reform, there are always circumstances in which a taxpayer could require additional current-year deductions. With the help of another element of the Tax Cuts and Jobs Act (TCJA) that took effect in 2018, certain small businesses accounting for inventory could have a one-time election to use to reduce taxable income.
The TCJA amended the Section 448 definition of a small business taxpayer from a partnership or corporation with average annual receipts over the prior three-year period not exceeding $5 million to a business with average annual receipts not exceeding $25 million. This threshold increase has greatly expanded the number of entities that can now report income on a cash basis rather than being forced into accrual reporting.
As a consequence of this new available reporting method, entities can now file two Forms 3115 (application for change in accounting method) to write off existing balances of accounts receivable, accounts payable and inventory, thereby creating a potentially large negative adjustment to taxable income that can be claimed in the year of the change filing.
To write off an inventory balance, an entity must file both a cash-basis accounting method change and change in the method of accounting for inventory items. While Form 3115 appears to be a complicated, eight-page form with numerous supporting statements and schedules, not all of the sections are required to formalize these adjustments. These changes fall under the automatic change request category due to their common and standardized nature, which means a much more streamlined process. Rev. Proc. 2018-40 provides background on the two accounting method changes along with the specific items on Form 3115 that must be completed in the reduced filing requirement subsection. This summary document, along with the itemized IRS instructions to Form 3115, should be enough to prepare your complete filings.
The form consists primarily of straightforward yes-or-no questions about the nature of the business and accounting method change. For changes 233 (cash method) and 235 (inventory), entities must report their exact gross receipts totals reported for the past three years to prove they comply with the new Section 448 definition. Schedule A – Part I provides a worksheet section for calculating the net adjustment attributable to all accrual items removed with the change. For any accrual calculations or inventory amounts, be sure to use balances reported for the prior year. The accounting method change theoretically takes effect at the beginning of the tax year of the filing, so no inventory activity or changes to accounts receivable should be considered past that point.
The most difficult questions require written explanations — such as Part II, Question 15a, which requests a detailed and complete description of the business, or Schedule A – Part I, which requires supporting breakdowns of the numbers entered in the worksheet. Careful consideration should be given to the presentation of Part II, Question 14 for the inventory filing. It’s critical the bookkeeping procedures related to inventory and cost of goods sold conform with the proposed descriptions outlined in this response or the resulting accounting method change and related deduction could be invalidated. Whether the new method treats former inventory items as non-incidental materials and supplies under Section 1.162-3 or conforms to a different taxpayer method, the books need to reflect that.
Once all responses are finalized on both Form 3115 filings, you’ll need to obtain a signed power of attorney for each and have the taxpayer sign both Forms 3115. The complete change request packets will then be both mailed to the appropriate address indicated in the 3115 instructions and attached to the timely filed tax return for that year. The deduction description reported in the tax return should indicate the automatic change number of the filing (233 or 235).
As with any accounting method change, taxpayers should first consider the full scope of the adjustment. If a large accounts payable balance would make this an unfavorable adjustment or the entity would benefit from continuing to track inventory and cost of goods sold, the change won’t help. If these changes simplify the balance sheet and create a much-needed deduction, however, the mechanics are simple enough to execute without too much of a headache.