The Tax Cuts and Jobs Act (TCJA) brought about far-reaching changes in the world of tax law. Though recent conversations have fixated on the soon-to-expire tax provisions, TCJA also introduced permanent changes that tax professionals can lean on to bring tax savings to their clients.
One significant benefit to small business owners was the introduction of new rules surrounding the cash method of accounting. Prior to TCJA, corporations or partnerships that had over $5 million in annual gross receipts were not allowed to use the cash method. This was an unfortunate limitation for many businesses, since the cash method often offers significant tax benefits because you report income in the tax year you receive it and deduct expenses in the tax year you pay them.
However, once TCJA was enacted, a “small business taxpayer” was redefined to companies with less than $25 million in annual gross receipts. Now these small businesses were allowed to use the cash method of accounting, and they were no longer required to account for their inventories. TCJA also upheld the existing law that allows certain entity types to use the cash method unless their business requires them to maintain inventory—including S corporations, qualified personal service corporations, and partnerships without corporate partners.
The new rules around inventory provide small businesses with new tax savings potential. To unpack how this works, we will look at one of the two main methods of treating inventory: the “non-incidental material and supplies” (NIMS) method.
The “NIMS method” treats inventory as supplies used in business, or as “non-incidental materials and supplies.” This method provides small businesses with a deduction for their inventory in the year that the inventory is either paid for or “used or consumed”—whichever comes later. This means that if your client buys inventory in December 2024 but does not provide it to customers until January 2025, they have to deduct the inventory cost for tax year 2025.
This method also allows small businesses to deduct labor and overhead expenses as they are incurred. Previously, small businesses were required to capitalize these expenses, spreading out the cost over a longer period of time like you would do with an asset. Under the new law, businesses can accelerate these deductions and receive the full amount in one tax year.
After issuing the final regulations for the NIMS method, the Treasury and IRS highlighted three key benefits that come with these new tax rules:
1. Wider Eligibility
The TCJA provision significantly expanded the types of taxpayers permitted to use the NIMS method. Previously, only businesses in certain industries and those with less than $1 million in gross receipts could treat their inventory as non-incidental materials and supplies. One exception was for contractions with less than $10 million in gross receipts who could also be eligible. Producers and resellers typically were not eligible at all.
The new law expanded the availability of the NIMS method to all types of trades or businesses, including producers and resellers, and increased the cap to $25 million in gross receipts.
2. Burden Reduction
Second, treating inventory as non-incidental materials and supplies makes life simpler for small businesses and reduces their tax burden. Under the new law, only certain costs need to be capitalized as inventory. Direct labor costs or indirect costs like overhead can be expensed immediately instead of being tracked and capitalized over the course of years. Because the accounting process is much less complicated, small business owners may not need as much outside assistance and can save money on accounting expenses.
3. Cash Method for Purchases and Sales of Merchandise
Lastly, taxpayers who are eligible for using the NIMS method are eligible to use the overall cash method of accounting for purchases and sales of merchandise instead of the accrual method. This allows businesses to receive a larger tax deduction sooner, but remember that “sooner” is not the same as “immediately.” Again, under the NIMS method the business will expense the inventory either when it is paid for or when it is provided to the customers. Be sure to clarify this rule when recommending this method to your clients.
The De Minimis Safe Harbor Rule
When recommending the NIMS method, some taxpayers (and tax professionals) may be tempted to treat their inventory as non-incidental and also expense individual items of inventory. This is typically allowed under the “de minimis safe harbor,” which permits businesses to deduct expenditures under $2500 instead of capitalizing them. However, once a business opts into the NIMS method, the final regulations clearly prohibit this: a taxpayer cannot use the de minimis safe harbor and treat their inventory as non-incidental at the same time.
Summary
Small business owners are often unaware of the new rules around the cash method of accounting and treatment of inventory—or they may not truly understand the tax savings opportunities hidden here. This is where the help of a tax professional comes in. By walking your clients through the benefits of switching to the cash method (for eligible businesses) and changing how they treat inventory, they may be able to reduce their tax bill with very little change to their day-to-day operations.
To learn more about how TCJA and other recent tax legislation can benefit your clients, sign up to become a Certified Tax Planner today.
