Revenue recognition and timing of deductions
There are many options available to businesses to affect timing of when revenue and deductions are factored into taxable income.
Overall method of accounting: The broadest item to consider is the overall method of accounting – generally the cash or accrual methods. Consider whether your business is eligible for the expanded use of the cash method. The cash method is generally available to small businesses with average annual gross receipts of less than $26 million. The cash method is generally more tax efficient than the accrual method when accounts receivable exceeds accounts payable and certain accrued expenses.
Accrual method taxpayers have many options available to affect the timing of deductions. Businesses should review their accrued expenses to identify the most tax optimized method of accounting for these items to accelerate deductions. Common items where opportunities exist to accelerate deductions include accrued compensation (including, bonuses, vacation, sick pay, severance, etc.), accrued services, accrued taxes, self-insured accrued employee medical expenses, accrued insurance, prepaid insurance and prepaid real property taxes among others.
The current economic environment is creating challenges for many businesses. Obsolete inventory or falling costs, customers’ failure to pay invoices or going into default, increasing bad debt allowance reserves, disputes with customers over shipments of goods – all of these can all affect your business’s profitability. These factors may also yield opportunities to defer revenue or capture additional deductions in taxable income. Consider how the current challenging economy is affecting your business and discuss with your tax adviser the tax impact of these situations and how to minimize your taxable income.
Inventory and UNICAP
Inventory: As mentioned above, in the current environment opportunities may exist to capture additional deductions through your inventory valuation accounting methods, such as Subnormal Goods and Lower of Cost or Market (LCM).
“Subnormal goods” are generally inventory that cannot be sold in the normal way because of damage, imperfections, odd or broken lots, style changes or other similar causes. Meeting certain criteria, these items may be eligible for an inventory write-down, accelerating a tax deduction to 2020 that might otherwise not be realized until a later year.
Have you experienced falling prices in the market value of inventory? Businesses on a LCM inventory method may have an opportunity to write down the carrying cost of the inventory to a lower of cost or market value. The key is to identify inventory items with a market value less than the current carrying cost. Establishing the market value, however, is not arbitrary and requires establishing a value based on evidentiary market cost data.
Businesses that meet the fact patterns to claim an inventory write-down may be required to change their accounting method before claiming the deduction. Consult your tax adviser to discuss the process and your eligibility for changing your accounting methods to accelerate deductions for your inventories on-hand.
UNICAP: Businesses are often required to capitalize additional costs into ending inventory on top of what is capitalized for financial accounting purposes. This is referred to as Uniform Capitalization – UNICAP for short – or 263A costs. The finalized regulations were generally effective starting in 2019. This new guidance introduces a broad range of modifications to how inventory costs are computed under UNICAP.
Taxpayers most likely impacted by the final regulations include:
- Manufacturers with gross receipts for the prior three years in excess of $50 million
- Manufacturers with significant raw material or resale goods inventories compared to wok-in-progress (WIP) and finished goods inventories
- Taxpayers with significant book-tax adjustments impacting cost of goods sold accounts
- Taxpayers with any direct materials or direct labor costs not capitalized to inventory for financial statement purposes
- Taxpayers with any variance accounts which are not capitalized to inventory
The regulations introduced a new prescribed method of computing Section 263A costs on-hand: the modified simplified production method (MSPM). The MSPM allows manufacturers and manufacturer-resellers to derive tax benefits from a more favorable treatment of their raw materials and any resale inventories.
In addition to generating tax benefits, taxpayers may find that the MSPM offers a reduced administrative burden. By adopting the MSPM, taxpayers may avoid the Regulations’ more stringent restrictions on taxpayers using the Simplified Production Method – including the requirement to compute section book inventory costs on a tax basis and a restriction on using negative adjustments to remove costs not required to be capitalized.
Taxpayers may generally adopt the MSPM for tax years 2019 and forward. Businesses that have not determined the applicability or implemented these final regulations, should consult with their tax adviser to determine if tax savings opportunities exist.
Fixed assets and depreciation
Businesses are permitted generous opportunities to immediately deduct the cost of investments in certain fixed assets. These deductions are claimed through “bonus depreciation” and Section 179.
Bonus Depreciation: Certain business assets eligible for immediate deduction generally include machinery, equipment, furniture and fixtures, land improvements, software, Qualified Improvement Property and other non-building assets. Eligible assets are not required to be new purchases – as in the past – but now must only be “new to you.” There is no limit on the amount of bonus depreciation deduction that may be claimed to reduce taxable income.
Qualified improvement property (QIP) – QIP generally encompasses interior improvements made by the taxpayer to a building that does not include an enlargement, expansion or the building internal structural framework. Prior to 2020 and due to a drafting error in the TCJA, QIP was depreciated over 39 years and was not eligible for bonus depreciation. The CARES Act passed in early 2020 corrected this error, changing the depreciation period for QIP to 15 years, as well as making the assets eligible for bonus depreciation. The correction of this error was made retroactively to the beginning of 2018.
If you are contemplating a purchase of business assets, consider doing so before Dec. 31, 2020, to claim bonus depreciation. If you placed QIP or other bonus eligible assets into service in 2018 or 2019 and did not claim bonus depreciation, consider filing an accounting method change immediately to catch-up the missed deductions to factor into your 2020 quarterly estimated tax payments. If you acquired, renovated or substantially improved a building, consider implementing a cost segregation analysis to maximize the cost eligible for QIP and bonus depreciation. A cost segregation analysis can be implemented retroactively through an accounting method change – without amending tax returns – to capture depreciation deductions missed on prior tax returns.
Section 179: This is another asset expensing provision available only to small business taxpayers. It applies to similar types of property as bonus depreciation, generally non-building assets. The maximum deduction under this provision is $1,000,000 and begins to phase out once a taxpayer’s annual investment in eligible assets exceeds $2,500,000. The TCJA also expanded the definition of eligible Section 179 property to include the following improvements installed in a building after initial construction (i.e., not new construction): qualified improvement property (same definition as above under bonus depreciation), and certain improvements to non-residential property, including roofs, HVAC property, fire protection and alarm systems and security systems.
In addition to the enhanced bonus depreciation and section 179 asset expensing provisions, the TCJA also increased the depreciation deductions for passenger autos.
One of the less favorable changes enacted by the TCJA was the imposition of a limitation on the amount of deductible business interest. Under the TCJA, interest expense generally may not exceed 30 percent of taxable business income before depreciation, interest expense and amortization (also known as adjusted taxable income or ATI). In tax years beginning after 2022, this limitation becomes even more restrictive as the limitation will no longer be applied before the deduction for depreciation.
Relief provisions provided as part of the CARES Act made changes to the business interest limitations. The limitation for businesses other than partnerships was increased from 30 percent to 50 percent for tax years beginning in 2019 and 2020. The limitation on partnerships is also increased to 50 percent but only for tax years beginning in 2020. However, special deduction provisions are provided to partners for the 2020 tax year to allow greater deductibility of excess business interest expense carryforwards which were allocated to them for any taxable year beginning in 2019. Taxpayers are allowed to elect out of these changes and continue to apply the previously limitation levels should they so choose.
Taxpayers whose 2019 business interest expense deduction was computed using the pre-CARES Act limits should evaluate the potential benefit of filing amended returns to claim additional interest deductions for 2019.
In recognition of the fact that many businesses will have losses or at least significantly reduced net income levels in 2020, the CARES Act also allows taxpayers to elect to use their 2019 ATI in computing the business interest expense limitation for their 2020 tax year.
Also, during 2020, final regulations on the business interest limitation were issued along with additional proposed regulations providing guidance in areas previously unaddressed.
The final regulations contained many revisions which might be considered taxpayer friendly, including revisions to the types of expenditures considered to be interest subject to the limitation, changes in the computation of ATI for taxpayers subject to UNICAP and application of a singular qualification for the small business exemption at the entity level. Beyond this, potentially favorable changes were made with respect to multi-national businesses. Taxpayers whose business interest expense deductions for 2018 or 2019 were limited should consider evaluating their filing positions against the guidance of the final regulations and consider the potential benefit of filing amended returns to take positions aligned with the final regulations.
Taxpayers owning multiple pass-through entities with intercompany loans or who have made loans to their majority owned S-corporations may find their tax liability significantly impacted by the business interest expense limitations. For example, if an S-corporation shareholder loaned money to the S-corporation itself, additional tax may arise due to the potential mismatching of the income (investment interest income recognized by the shareholder) compared to the expense (limited business interest expense recognized by the S-corporation). A similar issue existed with respect to related party loans and the passive loss limitations under Section 469. However, the IRS issued regulations to favorably address and resolve the Section 469 mismatch issue. In late 2019 the IRS indicated it was considering issuance of similar regulations to favorably resolve the mismatch issue with respect to the business interest expense limitation. However, the recently issued proposed regulations provide relief solely with respect to loans made between a partner and partnership. Taxpayers with significant loans to their majority owned S-corporations or between related businesses should consider discussing the potential tax implications and restructuring options for minimizing tax distortions with their tax advisors in the event regulations are finalized in their current form.
Other issues addressed by the additional proposed regulations include interest tracing, particularly relating to debt financed distribution interest, treatment of interest on loans to acquire ownership in flow-through entities and application of the business interest expense limitations in the case of tiered partnerships.
During 2020, many businesses have increased debt levels to finance operations and the additional cost of COVID-19 safety measures. Now more than ever, taxpayers need to consult with their tax advisors to better understand how the business interest expense limitations will affect them and what impact it will have on their after-tax financing costs.
Conversions to qualified small business stock
Holders of C-corporation stock which is qualified small business stock (QBS) may be able to exclude all or part of the gains from the sale or exchange of the stock if they have held the stock more for more than five years.
Due to recent economic disruptions, private equity and other small business equity investors may now be looking at holding on to their ownership in various operating companies longer than originally intended. In some instances, it may make sense for controlling equity investors to consider restructuring a company as a corporation in order to qualify the investment for treatment as qualified small business stock at a future date.
Equity investors considering this strategy will want to consider their anticipated exit date as well as the tax trade-offs associated with operating as a C-corporation going forward – including giving consideration to any tax rates changes they believe are likely to occur in the next five to six years. Tax proposals put forth by former Vice President Biden have included a proposed increase in the corporate tax rate from the current 21 percent to 28 percent and the imposition of a corporate minimum tax. While a change to the corporate tax rate is not included in the second term agenda outline released by President Trump’s campaign, the President recently made comments in an interview indicating he might reduce the corporate tax rate to 20 percent.
Navigating the rules governing qualified small business stock and the associated gain exclusions can be complicated. Investors interested in exploring conversion should work with their tax advisor to better understand the requirements and assess the potential in their specific situation.
 For further information, please reference information provided from the Tax Foundation and Biden’s website regarding tax policies.
PPP loans and expenses
If your business received a PPP loan and you received an official forgiveness decision from your financial institution, the resulting cancellation of debt income may be excluded from gross income.
The IRS has issued guidance clarifying its position that covered expenses will not be deductible to the extent of the resulting covered loan forgiveness. While there have been indications from certain members of Congress that this was not the result intended, taxpayers should plan on the expenses becoming non-deductible until or unless additional legislation is issued. The appropriate timing of the disallowance was not directly addressed by the guidance and remains somewhat uncertain in cases where forgiveness reviews and decisions will not be made until the 2021 calendar year.
As part of year-end planning, taxpayers who have received Paycheck Protection Program (PPP) loans and anticipate they will not receive forgiveness decisions prior to their year-end should discuss their specific facts and circumstances with their tax advisor.
State and local tax
Most businesses have experienced a shift to a remote work from home environment with respect to a significant portion of their workforce during 2020. In some instances, employees working from home may live in state and local jurisdictions where the business would not normally have a physical presence. Additionally, businesses may have seen shifts in their customer base as they have shifted to more of a virtual sales and delivery model. Physical presence in a jurisdiction can be sufficient to create a filing obligation. Furthermore, in many jurisdictions, simply exceeding a threshold of sales into the jurisdiction can create a filing obligation. Businesses impacted by these types of changes during 2020 should work closely with their tax advisors to ensure they are in compliance with the various state and local jurisdictions for purposes of income tax, franchise tax, gross receipts and other taxes.
When filing state and local returns this year, businesses will also want to consult with their advisor to determine if there are any special apportionment elections available that might reduce their overall state tax burden. Businesses that have revenue from services and intangibles will also want to consider the proper revenue sourcing rules in each state. Since the laws vary state to state, it is possible for scenarios to exist that the same revenue is attributable to multiple states or certain items of revenue might not be attributable to any state.
Related business groups, including groups filing consolidated federal returns, should also consider whether they are utilizing the appropriate statutory filing methodologies (combined, consolidated, separate, etc.) as well as whether there are any elective filing methodologies available that might yield tax savings.
State and local tax credits and incentives
As businesses continue to adapt and make changes to how they operate, it is important to continually consider what activities they may have in a jurisdiction that might create the opportunity for statutory or negotiated credits or incentives. Increased head count, capital expenditures, research and development, training expenses, etc., are all items that have the potential to generate state and local tax credits. Some of these credits can offset tax types other than income tax (i.e., withholding).
Sales and use tax
Sales and use tax liabilities may also be impacted by the recent shifts to remote work and customer base. Physical presence or a threshold level of sales can create a filing obligation in virtually every jurisdiction. As a result, businesses should consider whether they are properly registered for sales and use tax in each jurisdiction and are collecting and remitting to the appropriate jurisdictions.
Most states economic nexus threshold is either $100,000 or $250,000. For more information, DHG has a complete list of economic nexus thresholds.
The sales and use tax area is an evolving landscape with many jurisdictions now subjecting digital products, SAAS, services, etc., to tax. In addition to registering and filing in the appropriate jurisdictions, businesses also need to consider the taxability of products and services sold. Businesses should also consider whether they are taking full advantage of all exemptions available to them on items purchased for use in their business. Identifying the available exemptions in each jurisdiction can reduce tax burdens going forward and generate potential refunds from prior years.