This article was originally published in July 2019. It was updated in March 2021 to reflect new information available.
Under the Tax Cuts and Jobs Act (TCJA) and the CARES Act, manufacturers, distributors, and retailers can take advantage of substantial tax incentives for small businesses with average gross receipts of $26 million or less (for the three prior years). These incentives are especially applicable to small businesses with inventories.
The three incentives the TCJA makes for small businesses are:
- Allows the cash method for tax purposes,
- Treats inventory costs as non-incidental materials, and
- Exempts the business from the interest expense limitation.
Using the Cash Method
Small businesses under $26 million may use the cash method for tax purposes, even though the business keeps its books and records on the accrual basis. Previously, businesses could not use the cash method if they had gross receipts over $10 million, maintained inventories, or were a C corporation or had a C corporation partner with gross receipts over $5 million.
When using the cash method for tax purposes, income is recognized when the cash is received, and expenses are deductible when they are paid. The cash method provides a better matching of cash flow with taxes paid and more flexibility in tax planning.
In the year the change is made, there is usually significant tax savings. C corporations have the flat tax rate of 21%, so there may be some planning needed if the cash method creates a loss. For S corporations, partnerships, and sole proprietorships, strategic planning can spread out the tax savings over two years by taking advantage of reducing taxes at higher tax rates. As a business grows, the tax savings increase. Changing to the cash method requires an Accounting Method Change (Form 3115).
Treating Inventories as Non-Incidental Materials
Small businesses may also treat inventories as non-incidental materials and supplies or conform to the method the business uses for financial statements or its books and records. This allows labor and overhead related to ending inventory to be expensed. Under the previous law, businesses were required to capitalize materials, labor, overhead, and related general and administrative expenses (uniform capitalization) for tax purposes. This change also requires an Accounting Method Change (Form 3115).
Exemption From the Interest Expense Limitation
Finally, small businesses are exempt from the interest expense limitation. The TCJA added a provision that limits interest expense that can be deducted. For 2019 through 2021, interest expense is deductible to the extent it is less than 50% of taxable income plus interest expense, depreciation, and amortization. After 2021, interest expense is deductible to the extent it is less than 30% of taxable income plus interest expense only.
There are many other tax incentives available to manufacturers, distributors, and retailers, such as the Section 179 expense election up to $1 million and 100% bonus depreciation, which allows the entire write-off of fixed assets additions. It is also important to consider what type of entity the business should use for tax purposes (C corporation, S corporation, LLC) with the different rate structures and limitations under the new tax law.
Opportunity to Carryback Net Operating Losses
For 2018 – 2020, businesses and individuals can carryback net operating losses five years. If there’s a net operating loss for 2020, or if a loss can be created by using bonus depreciation or an accounting method change, it might make sense to carryback the loss five years and get a refund of taxes paid, especially at higher tax rates. This refund could go a long way to improving the cash flow and sustainability for a business.
Businesses should give careful consideration to planning with the TCJA and CARES Acts. There are many incentives that can result in significant tax savings. Please contact your Clark Nuber professional or Rene Schaefer to understand how the TCJA and CARES Acts can help you.
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