This article discusses significant and time-sensitive accounting method developments potentially impacting a wide array of taxpayers in 2023. Items covered include important reminders concerning the small business taxpayer simplified methods and revenue recognition timing method changes and recent updates to the automatic accounting method change list and the alternative cost method (ACM) of accounting for common improvement costs of real estate developers.
Taxpayers are reminded to review their 2023 gross receipts levels and tax shelter status, if applicable, and be prepared to timely file Form(s) 3115 if necessary to avoid missed tax planning opportunities under the small business simplified methods.
The small business simplified methods, which are available to taxpayers that meet the gross receipts test (and are not a tax shelter), include the overall cash method and exceptions from onerous inventory accounting, UNICAP and PCM requirements. In addition to providing simplification benefits, these methods can also generate potentially significant cash tax savings. Small business taxpayer method changes are generally automatic and subject to an eligibility rule that prohibits filing an automatic change if the same change was made in the five prior tax years. A limited eligibility rule waiver is available provided the taxpayer changes from the small taxpayer method(s) in the first year it no longer qualifies as a small business taxpayer.
Taxpayers whose receipts have declined in 2023 or that previously exceeded the gross receipts threshold by a small margin should be aware that the threshold is increased to $29 million in 2023, up from $27 million in 2022. This presents an opportunity for newly eligible taxpayers to adopt or change to the favorable small business simplified method(s) in 2023, including a taxpayer that used these method(s) previously. However, taxpayers should be cognizant that the limitation applies at a group (not entity) level; so foreign, acquired and new entities should not be overlooked when applying the gross receipts limitation, especially if the taxpayer has restructured or made acquisitions during the year.
Conversely, a taxpayer that fails the gross receipts test or becomes a tax shelter in 2023 must file Form(s) 3115 to change to permissible nonsmall business methods for 2023. In particular, a taxpayer that expects to need the limited eligibility rule waiver (discussed above) to make another automatic small business method change in the near term (a common occurrence) must file a 3115 for 2023 timely to qualify for the waiver. However, a passthrough entity that is generally profitable but incurs an unusual loss and becomes a syndicate (i.e., tax shelter) in 2023 should consider making the annual election to use the prior year (2022) taxable income to determine eligibility as a small business taxpayer and thereby avoid having to change off the small business simplified method(s) for 2023. A former small business taxpayer that becomes subject to UNICAP should be aware that these changes can be complex and time-consuming to implement. Therefore, these taxpayers should allow sufficient lead time to perform the necessary analysis and prepare supporting UNICAP calculations in connection with this method change.
In summary, the popular and widely adopted small business simplified methods provide valuable simplification and tax savings benefits. Taxpayers looking to avail themselves of these benefits should carefully monitor eligibility for these favorable methods and be aware of the increased gross receipts threshold ($29 million in 2023) and limited automatic change eligibility waiver to maximize planning opportunities under the small business taxpayer simplified methods.
Taxpayers that still need to make changes to comply with the TCJA amendments to the “all events test” for recognizing revenue should be aware that the automatic change to comply with the new rule expires after 2023.
The amended “all events test” generally applies to an accrual basis taxpayer with an applicable financial statement (AFS), such as certified audited financial statements prepared under GAAP or IFRS. Under the amended “all events test”, income is recognized at the earliest of when it is received, due, earned or recognized in the AFS. Certain special methods are exempt from this rule (e.g., instalment sales, long term contracts, certain leases, mark to market transactions). Because it is a method of accounting, a Form 3115 filing (generally automatic) is required to comply with the new revenue recognition timing rule.
Thus, taxpayers that need to comply with the revenue recognition timing rule must act before the automatic change expires to avoid having to make the change non-automatically. Unlike an automatic change, a non-automatic change requires payment of a user fee (currently $11,500 per change) and a potentially lengthy IRS approval process, which most taxpayers prefer to avoid whenever possible.
Examples of common impermissible revenue recognition methods include deferring advance payments under the so-called two-year rule (now repealed), improperly following book PCM for long-term contracts, and forgetting to make mandatory adjustments to the AFS income amount. Mandatory tax adjustments to AFS income include increases for cost of goods sold and cost offsets and decreases for income amounts the taxpayer does not have an enforceable right to receive pursuant to the contract terms or under applicable law if the customer were to terminate the contract as of year-end. Additionally, taxpayers should be aware that other changes can trigger the new rule, such as issuing an AFS (e.g., where the financial statements were previously unaudited), or changing to the accrual method, such as a former small business taxpayer that must change from the cash overall method because it failed the gross receipts test.
The widely applicable TCJA revenue recognition amendments can be complex and time-consuming to implement. Thus, taxpayers must allow sufficient lead time to analyze and apply the rules to their businesses and act promptly to file Form(s) 3115 to comply with new rule before the automatic change expires to avoid costly, onerous non-automatic changes.
Taxpayers are also reminded to consider revenue recognition tax planning opportunities to replace deductions lost under expired and expiring TCJA provisions, such as the reduced business interest expense limitation, the research and experimental (R&E) expense capitalization requirement and the phase down of bonus depreciation. Although bipartisan support exists in Congress to delay or repeal these unfavorable provisions, no legislative relief has been enacted to date and the prospects for near-term relief are highly uncertain at this point.
In the absence of legislative action, taxpayers not currently using the deferral method for advance payments should review their short-term deferred revenue accounts for eligible advance payments received for common items such as gift card subscriptions and sales of goods and services, among others, and consider making the easy to implement automatic method change to defer income and save taxes.
The IRS recently issued guidance containing an updated list of automatic accounting method changes, generally effective for applications filed on or after June 15, 2023 (now). While no new automatic changes were added (to the previously issued guidance), the list incorporates and modifies two recently issued automatic changes for R&E cost capitalization and the new natural gas safe harbor under the tangible property rules, revises numerous existing automatic changes, and deletes multiple obsolete changes and provisions.
Because many taxpayers will need to file automatic method changes for 2023 returns (e.g., to comply with TCJA provisions requiring R&E expense capitalization and amending the revenue recognition timing rule to make a mandatory change from the small business simplified methods), taxpayers and their advisors should act soon to familiarize themselves with the new guidance and be sure that 3115 filings comply with the updated procedures
The IRS recently issued updated procedural guidance for the alternative cost method (ACM) that real estate developers may elect to account for certain common improvement costs. The new procedures are effective for tax years beginning after Dec. 31, 2022. Former guidance may no longer be used after that date.
The ACM is an optional method for real estate developers to account for certain common improvement costs, such as infrastructure amenity items like sidewalks, sewer lines, playgrounds and tennis courts. Significantly, the ACM can only be used by accrual basis real estate developers that are contractually or legally obligated to provide the common improvements as part of a multi-unit commercial or residential project.
The ACM may accelerate deductions for common improvement costs, subject to certain limitations, and therefore may be preferable to accounting for these costs under the general economic performance rule. Despite the potential acceleration benefit, many taxpayers decline to elect the ACM due to the onerous reporting requirements (consents, annual statements and statute of limitation extensions).
However, taxpayers that have previously foregone the ACM may wish to reconsider because, although there are record retention requirements and the mechanics of the ACM calculation remain unchanged under the new ACM, the procedural aspects have been simplified, eliminating burdensome reporting requirements such as consents, annual statements and statute of limitation extensions. Additionally, the ACM is now treated as a method of accounting, which must be used for all qualified projects of the trade or business, thus eliminating the option under the old procedures to pick and choose projects. Significantly, the new procedures prohibit PCM contracts from using the ACM, and so taxpayers currently accounting for these contracts under the ACM will need to file Form 3115 to change to the all-events and economic performance tests. Three new automatic changes are added to make changes under the new ACM, including different options for taxpayers converting non-ACM projects to the new ACM. Certain changes and favorable temporary transition rules apply to the first tax year beginning after Dec. 31, 2022.
Real estate developers should reevaluate the ACM considering the simplified procedural guidance, but they should also be aware of the all-or-nothing approach and exclusion for PCM contracts. As noted, real estate developers not currently using the ACM may want to reconsider electing new ACM due to the reduced reporting requirements. Conversely, because the old ACM procedures may not be used for tax years beginning after Dec. 31, 2022, developers currently using this method should act soon to assess the tax impact of the new technical requirements, determine which method change(s) to make, and be ready to timely file Form 3115 to take advantage of temporary transition relief provisions provided under the new procedures.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.