If you own a business, you may qualify for a variety of small business tax breaks that can slash your tax bill and reduce your administrative costs. And thanks to the Tax Cuts and Jobs Act, “small” is a lot bigger than it used to be.
Previously, for tax purposes, small businesses ranged from $1 million to $10 million in gross receipts, depending on which section of the tax code was involved. But now, small businesses are uniformly defined as companies (other than tax shelters, see below) with average annual gross receipts of $25 million or less for the prior three-year period. And this threshold is adjusted for inflation — currently, businesses with gross receipts up to $26 million are eligible.
Small business tax breaks
If your business qualifies as “small,” you enjoy several small business tax breaks, including:
Cash accounting. You’re permitted to use the cash method of accounting for tax purposes, even if you have inventories or use the accrual method for financial reporting. With certain exceptions, larger businesses — particularly those that carry inventory — must use accrual accounting. In many cases, the use of the cash method allows you to defer more taxable income than you would under the accrual method.
Inventory simplification. You’re generally exempt from complex inventory accounting rules and may account for inventories by:
- Treating them as nonincidental materials and supplies, or
- Conforming to the inventory method you use in your financial statements or books and records.
Treating inventories as nonincidental materials or supplies allows you to deduct their cost when they’re “used or consumed.” Recently finalized regulations clarify that materials aren’t used and consumed until the inventory is sold. Many companies had hoped to treat raw materials as used and consumed when converted into work-in-progress or finished goods, allowing them to deduct the cost earlier.
Relief from UNICAP rules. You’re exempt from the uniform capitalization (UNICAP) rules, which require companies to capitalize certain direct and indirect production costs to inventory, rather than deduct them when incurred. Not only can these rules increase your tax liability, but they also make tax reporting more complex.
Unlimited business interest deductions. You’re not subject to the cap on business interest write-offs, which generally limits deductions of net business interest expense to 30% of adjusted taxable income (50% for 2019 and 2020).
Completed contract method. If your business is in construction, manufacturing or another industry where long-term contracts are common, you may use the completed contract method rather than the percentage-of-completion method to account for long-term contracts expected to be completed within two years. The completed contract method makes it possible to defer tax until the contract is substantially complete, while the percentage-of-completion method can accelerate the tax.
Computing gross receipts
As noted, your company is considered a small business in a given tax year if its average gross receipts for the prior three-year period are $26 million or less. Under previous rules, a company wouldn’t qualify as a small business if it failed the gross receipts test in any prior year. So, for example, a company with average gross receipts for the three-year period (ending December 31, 2020), of $20 million, wouldn’t qualify if its average gross receipts for the three-year period ending December 31, 2018 were $27 million.
Current rules, however, only take into account gross receipts for the three-year period immediately preceding the current tax year. So, the company in the above example would qualify as a small business. Special rules apply to companies in existence less than three years. Keep in mind, that when determining your company’s gross receipts, you may need to include those earned by certain related entities, such as those with common control.
Sizing up your business
If your company passes the less-than-$26 million gross receipts test, you should explore the potential benefits of small business status. To claim these benefits, it may be necessary to file Form 3115 — Application for Change in Accounting Method — with the IRS.
Tax shelters need not apply
Tax shelters don’t qualify for “small business” status, even if their gross receipts are below the threshold. And while the term usually connotes an investment vehicle that shields earnings from taxes, the definition is broad enough to encompass ordinary businesses.
For example, tax shelters include “syndicates,” defined as entities other than C corporations (that is, partnerships, S corporations or LLCs) in which more than 35% of their losses are allocable to limited partners and “limited entrepreneurs.” Very generally, a limited entrepreneur is a person who owns an interest — other than as a limited partner — and doesn’t actively participate in management.
Because a business can only be a syndicate in a year that it suffers a loss, this definition can be burdensome to businesses that meet the definition one year but not the next year (because it’s profitable). To ease this burden, the final regulations give businesses the option to use the prior year’s income, rather than the current year, to determine tax shelter status.
See the small picture
If your company’s average gross receipts are $26 million or less, consult our tax advisors to find out whether you are eligible for these small business tax breaks. If it is, determine whether a change in accounting methods may be worthwhile to take advantage of these benefits. If it’s not currently eligible, there may be planning opportunities to qualify for small business tax breaks in the future.