Cash versus accrual

What’s right for you?

| February/March 2019 Footnote

Unsurprisingly, most CPAs and clients have focused on the Section 199A deduction for business clients due to its complexity. However, it is also important to pay attention to a potentially very significant set of tax benefits available to small-business clients: the special accounting method simplifications found in the Tax Cuts and Jobs Act, Section 13012.

This provision allows small businesses (those with average gross receipts that don’t exceed $25 million for the prior three years) to make the following accounting method changes:
  • Use of the cash basis of accounting.1
  • No longer use the uniform capitalization (UNICAP) rules under IRC Section 263A.2
  • Exemption from the otherwise mandatory use of traditional tax inventory methods.3 
  • Be treated as a small contractor exempt from the required use of the percentage of completion method of accounting for contracts with an expected period to complete of less than two years.4

The taxpayer obtains the IRS’s consent to a change by completing and filing Form 3115, Application for Change in Accounting Method. For these changes, the taxpayer follows the specific guidance provided for the particular automatic method change listed in Revenue Procedure 2018-40. Three of the changes will lead to a Section 481(a) adjustment.

A Section 481(a) adjustment is the difference between total net taxable income reported by the taxpayer since inception, as compared to the amount that would have been reported had the new method been used instead in that period.5 For the changes other than the one for small contractors, if the taxpayer has reported more net income under the old method than under the new one, the negative adjustment is taken into account all in the year of change.

Changes to the methods


The first change found in the Tax Cuts and Jobs Act (TCJA) provided that all taxpayers with no more than $25 million in average revenue could use the cash basis of accounting.6

Congress also used the same $25 million limit to carve out the option to use a special inventory rule. Instead of having to use tax-based inventory methods under IRC Section 471(a), taxpayers who meet the revenue test can elect to account for what would be inventory as non-incidental materials and supplies;7 or conforms to the method of accounting used either in the taxpayer’s applicable financial statement (as defined by IRC Section 451(b)(3)); or, if no applicable financial statement exists for the taxpayer, the method used by the taxpayer for his/her books and records.8

When the taxpayer uses the non-incidental materials and supplies treatment, the item is initially capitalized and then deducted when it is used in the taxpayer’s operations or consumed in the taxpayer’s trade or business.9

The third accounting method choice offered to taxpayers with less than $25 million in average revenue is the ability to opt out of using the UNICAP rules under IRC Section 263A.10 Prior to the law change, all manufacturers were required to use the UNICAP rules for inventory. Retailers with average revenues of more than $10 million were also required to use the UNICAP rules under the pre-TCJA law.

Finally, those involved with long-term construction contracts with revenue less than the $25 million limit can elect to use methods other than the percentage of completion method for contracts with an expected term of less than two years under the TCJA revised law.11 Previously, the small contractor exception was only available when gross revenues were less than $10 million.

Revenue Procedure 2018-40 provides the process for taxpayers wishing to elect to use these methods to obtain automatic consent for the change. Under the automatic consent procedures, the Form 3115 is attached to the tax return for the year in question and an additional copy sent to the IRS Center in Covington, Kentucky, at the time the return is filed.

Steps for changes


For those electing to change to the cash basis of accounting for tax purposes, the following portions of Form 3115 are to be filled out:
  • The identification section of page 1 (above Part I).
  • The signature section at the bottom of page 1.
  • Part I.
  • Part II, all lines except line 16.
  • Part IV, all lines except line 25.
  • Schedule A, Part I, all lines except lines 3, 4 and 5.12

The taxpayer will compute a Section 481(a) adjustment for the year of change and report it as an item of income or deduction in accordance with the standard rules for voluntary taxpayer-initiated adjustments.13

For taxpayers making the election to use the special inventory methods, the following portions of the Form 3115 must be filled out:
  • The identification section of page 1 (above Part I).
  • The signature section at the bottom of page 1.
  • Part I.
  • Part II, all lines except line 16.
  • Part IV, all lines except line 25.14

As with the first change, this one will use the standard methods for recognizing a Section 481(a) adjustment.

Taxpayers electing not to continue to use Section 263A UNICAP methods should complete the following portions of the Form 3115:
  • The identification section of page 1 (above Part I).
  • The signature section at the bottom of page 1.
  • Part I.
  • Part II, all lines except line 16.
  • Part IV, all lines except line 25.15

Again, the standard Section 481(a) adjustment methods and periods are used.

These three changes can all be made using a single Form 3115 to request the change.16

The small contractor method change differs from the others in two major respects. First, the request to change to the small contractor methods cannot be made on the same Form 3115 as any of the other small taxpayer changes discussed earlier.17

Second, this change is accounted for on a cut-off basis without a Section 481(a) adjustment.18 Contracts entered into before the year of change will be accounted for using the percentage of completion method, with new contracts using the new method chosen by the taxpayer.19

Taxpayers requesting a change to end the use of the percentage of completion method for qualifying contracts complete the following portions of Form 3115:
  • The identification section of page 1 (above Part I).
  • The signature section at the bottom of page 1.
  • Part I.
  • Part II, all lines except line 16.
  • Part IV, line 25.
  • Schedule D, Part I.20

Final thoughts to consider


One potential complication for taxpayers wishing to elect to change to these methods is that the entity may have been forced to change methods under the old law, when the limits were lower. Normally, a taxpayer cannot make a change to a method within five years of having made a previous change. However, so long as the change is made in the first, second or third tax year beginning after Dec. 31, 2017, the five-year rule will not apply.21

As well, if the taxpayer has a Section 481(a) adjustment remaining from the prior change, the taxpayer may either net that adjustment against the new adjustment created with the new change, or continue to spread the old change over the remaining period and separately deal with the just-created change.22 Be mindful of these changes as you work into the future.

Ed Zollars, CPA is a partner with the firm Thomas, Zollars & Lynch, Ltd., a firm based in Phoenix, Arizona. An MNCPA member, he is a frequent speaker on federal tax topics and technology issues. In addition to speaking, he has published articles in The Tax Advisor and Practical Tax Strategies.

IRC §448(b)(3), (c)
IRC §263A(i)
IRC §471(c)
IRC §460(e)(1)(B)
IRC §481(a)
IRC §448(c)
IRC §471(c)(1)(B)(i)
IRC §471(c)(1)(B)(ii)
Reg. §1.263(a)-3(a)(1)
10 IRC §263A(i)
11 IRC §460(e)(1)(B)
12 Revenue Procedure 2018-40
13 All recognized in the year of change for negative adjustments and spread over four years beginning with the year of change for positive adjustments.
14  Revenue Procedure 2018-40
15  Revenue Procedure 2018-40
16  Revenue Procedure 2018-40
17  Revenue Procedure 2018-40
18  Revenue Procedure 2018-40
19  Revenue Procedure 2018-40
20  Revenue Procedure 2018-40
21  Revenue Procedure 2018-40
22  Revenue Procedure 2018-40