Under the Tax Cuts and Jobs Act of 2017 (TCJA), effective for tax years beginning after Dec. 31, 2017, more taxpayers are now eligible to use the cash method of accounting as the definition of a small business taxpayer has been expanded. A small business taxpayer is any taxpayer (other than a tax shelter—see discussion below) having average annual gross receipts for the previous three tax years that do not exceed $25 million (up from the prior law threshold of $5 million). Special rules apply for businesses that have not been in existence for the entire three-year period, or if any of the prior three years were short years.
In addition to the advantage of the cash method of accounting being simpler to use than the accrual method, the cash basis of accounting can allow taxpayers to defer income because revenue or income is only recognized in the year you receive cash payments. And, you record expenses when cash payments are made. The accrual method of accounting, in contrast, recognizes income when earned even if cash has not been received—and likewise, expenses are recognized when incurred, even if not yet paid.
Typically, a change from the accrual to cash method of accounting is beneficial if a taxpayer has more accounts receivables and prepaid expenses compared to accounts payable and accrued expenses. The largest favorable impact is usually in the year of the method change.
Businesses are subject to aggregation rules to determine if they meet the $25 million gross receipts test for a given year. The gross receipts from multiple businesses must be aggregated where they meet a “controlled group” ownership test or an affiliated service group test. A controlled group generally exists when there is greater than 50 percent common control (based upon identical ownership of five or fewer individuals, estates, or trusts) among each business.
Another important note is the broad definition of a tax shelter, whereby many small businesses that would otherwise qualify are not eligible for the cash method of accounting. A tax shelter may exist where more than 35 percent of an entity’s losses are allocated to owners who do not actively participate in management. Even one loss year after several years of consistent profitability could cause a business to be considered a tax shelter for that loss year.
Some small business taxpayers may not use the cash method if they are required to use another method of accounting under certain provisions of the Code such as Sec. 475 (Mark to Market) and Sec. 1272 (Original Issue Discount).
Taxpayers who might qualify for the new higher gross receipts threshold should evaluate their accounting methods since adopting the cash method of accounting can potentially provide an immediate tax benefit.
Eligible small business taxpayers that have been using the accrual method but now want to switch to the cash method will need to file Form 3115, Application for Change in Accounting Method by the due date (including extensions) of the tax return for the year of change. On Aug. 3, 2018, the IRS released Rev. Proc. 2018-40 which provides guidance on requesting an accounting method change as a small business taxpayer as a result of the TCJA.