New Tax Loophole May Allow Small Businesses to Claim Large Tax Write-Offs For Inventory
Congress, either intentionally or unintentionally, as part of the Tax Cuts and Jobs Act provided for a potentially huge tax write off for many small businesses that have inventory –(basically any company that has physical products they intend to sell to a customer). Prior to the new tax law (before 1/1/2018), if your company kept an inventory you generally couldn’t claim a tax deduction for inventory until the inventory was sold. As a result of the Tax Cuts and Jobs Act (TCJA), savvy small businesses may be able to take advantage of a new loophole that could provide a large tax windfall by completely expensing their ending inventory in the year purchased starting with returns that are about to be filed in 2019 (for the 2018 tax year).
For taxpayers and CPAs able to piece together several sections of the Tax Code and Regulations the new law creates a huge opportunity and marks a significant change from prior tax accounting for inventories which didn’t allow for tax deductions for inventory until sold. There are a number of hoops to jump through and hurdles to overcome before companies can write off ending inventory, but will likely provide immediate tax savings to a large percentage of taxpayers that keep an inventory with a cost of less than $2,500 per inventory item. According to Donna Beatty, CPA, we may even see those companies that are able to take advantage of this loophole manage their tax bill via purchase of inventory before the end of their tax year.
Cash Method Now Allowed For Small Business –Even Those With Inventory
It works like this. The Tax Cuts and Jobs Act generally effective as of January 1, 2018 provides that generally taxpayers with less than $25 Million in gross receipts (average of past 3 years gross receipts) can now use the cash method of accounting, even if they keep an inventory. This is a major shift from prior law that required many companies with inventory to use the accrual method of accounting. This rule alone does not provide that businesses under the $25 Million threshold can simply start expensing their inventory as purchased – there are several additional nuances before a cash basis taxpayer can expense inventory when purchased.
First, if you are under the $25 Million average gross receipts threshold and currently using the “accrual method” of accounting, and think you qualify to expense inventory based on all other parameters below, or just want to start using the cash method of accounting for some other reason, you will need to file a “change in accounting method” with the IRS to begin filing tax returns on the cash basis. If you are already using the “cash method” of accounting for tax purposes that’s great –you don’t need to file a change with the IRS. If you need to file with the IRS to change your accounting method don’t worry, the IRS has provided for a simplified filing requirement for small businesses rather than forcing you to complete the normal Form 3115 with all of its required schedules and disclosures. After you change your company accounting method to the cash method with the IRS you still ARE NOT home free! There are additional steps to take before you can expense inventory as purchased –keep reading.
Required Tax Elections
Once you are on the cash method of accounting one of the two keys that makes this work is what’s called the “de minimis safe harbor election”. If you want to get technical, the election can be found at Treasury Regulation Section 1.263(a)-1(f), and provides that items under $2,500 per unit can be expensed if this election is made and your company accounting records are also in compliance (see next heading). Before the tax cuts and jobs act this election did not apply to inventory.
As a result of the Tax Cuts and Jobs Act, either deliberately or inadvertently, Congress provided that when small businesses meeting the $25 Million gross receipts test use the cash method of accounting they can also elect to treat inventory as “non-incidental materials and supplies”. What’s the big deal with this you might ask? When you apply the “de minimis safe harbor election” to “non-incidental materials and supplies” companies can then expense all items under $2,500 per unit if properly accounted for. That’s right, the “de minimis safe harbor election” that allows all companies to expense items under $2,500 per item also applies to “non-incidental materials and supplies”. There are also a number of rules here that are highly technical in nature dealing with the definition of inventory and definition of items qualifying for the “de minimis safe harbor election” that are beyond the scope of this article that companies should consult with a knowledgeable CPA about.
The “de minimis safe harbor election” is a very simple election that companies can have their CPAs make on their annual tax returns. The election to treat inventory as “non-incidental materials and supplies” on the other hand is not so simple. This election requires a change in accounting method with the IRS on a Form 3115. Again, just as with the change from the accrual method to the cash method noted above, the IRS has provided for a simplified Form 3115 filing requirement for small businesses making this change.
Required Financial Reporting
Ok, your company is now on the cash basis for tax purposes, filed the change in accounting method to elect to treat inventory as “non-incidental materials and supplies”, and ready to include the “de minimis safe harbor election” on your annual tax return. You still aren’t home free! There are a few more considerations before you can claim that big tax write off for all the inventory you purchased last year (instead of leaving it out on the balance sheet only to deduct whenever it’s sold to customers).
The magic that makes all of the above work is a little bookkeeping and financial reporting. To expense all your company purchases under $2,500 per unit using the “de minimis safe harbor election” the Regulations mandate that you also expense these items on your financial statements and not just your tax returns. If your small business has no requirements to issue GAAP basis financial statements (audit, review, compilation) there may be an opportunity to implement this strategy. If you are required to issue GAAP financials, or for some other reason can’t expense inventory as purchased on your financials, you will be prevented from using this strategy. GAAP will not allow a company to expense inventory; instead, ending inventory under GAAP must stay on the company balance sheet and be expensed as it is sold.
If your company is like many small businesses with no external stakeholders to be accountable to, and you don’t mind expensing inventory as purchased you may have an opportunity to expense all inventory otherwise sitting on your balance sheet at year end. To clarify, the rules dictate that you expense inventory on your financials –they do not prevent you from tracking inventory as you always have for your internal management purposes. The unit cost of each item must be included on the invoice from your vendors as well. Best practice would be to create an internal written accounting policy to expense all inventory purchases. Additional rules apply to labor and materials of manufacturing companies that produce their own inventory for sale to customers.
Putting It All Together
As you can see, the expansion of using the cash method of accounting for small business coupled with allowing small companies to elect to treat inventory as “non-incidental materials and supplies” may provide a large tax benefit when coupled with the “de minimis safe harbor election”. According to Donna Beatty, CPA, the tax professional industry is anxiously waiting on further guidance on this issue. In fact, the American Institute of Certified Public Accountants (AICPA) submitting their recommendation on the above issue to tax policy makers in Washington in a letter dated July 23, 2018. The AICPA recommended that the IRS and Treasury permit a small taxpayer to make a “de minimis safe harbor election” that would allow them to expense inventory. Although still awaiting further guidance, the way the law is currently written some believe many small business taxpayers will take advantage of this potential loophole and expense all of their inventory. For example, we may see many small local retailers with maybe $100,000 – $200,000 of inventory at December 31, 2018 completely expense those amounts using this strategy –that would provide an average Federal tax savings of $37,000 – $74,000 (even more considering state income tax). Companies with a bit larger inventory of lower priced items under $2,500 per unit would experience even higher tax savings –and may even create taxable losses.
There are a number of rules and items not mentioned in this article, especially how the above might apply to production labor and overhead costs applicable to manufacturing companies. Accounting method changes, tax elections, and tax returns all have deadlines and must be properly and timely filed and reported –that could all impact the strategy discussed above. As with anything tax related, there are probably other unique items related to your business that would affect the tax strategy discussed in this article. This is a highly technical area of tax law which is very fluid, and this article may not be cited as authority, and is no substitute for counsel with your tax attorney or CPA.
How Can Frazier & Help? Involve Frazier & Deeter early in the process of working through this tax strategy to determine if you qualify, and help to quantify the tax savings and potential risks.
Contributed by Andrew Moore, CPA, Senior Tax Manager at Frazier & Deeter (Atlanta, GA).