The world of small business tax deductions looked very different before and after the Tax Cuts and Jobs Act (TCJA) of 2017. A number of the changes introduced through TCJA permanently shifted which businesses were eligible for which types of deductions. One important shift involved new rules around methods of accounting. TCJA widened eligibility for using the cash method of accounting—a simpler method that allows businesses to report income in the tax year they receive it and deduct expenses in the tax year they pay them.
Previously, only corporations or partnerships with less than $5 million in annual gross receipts could use the cash method. After TCJA, businesses with less than $25 million in annual gross receipts were considered “small businesses” and became eligible for the cash method. Additionally, small businesses also no longer had to account for their inventories. Both changes provide new avenues for tax savings.
In a previous blog, we looked at the first method of treating inventory—the “non-incidental material and supplies” (NIMS) method. Below, we will discuss the second option, which we call the “books and records” method.
The second option for how small businesses can treat their inventories has two variations. Tax law says that the taxpayer can either:
• Conform to their method of accounting in an applicable financial statement, or
• If they do not have applicable financial statements, use the method of accounting used in their books and records
The first option will not likely apply to many of your clients. An “applicable financial statement” is prepared in accordance with Generally Accepted Accounting Principles (GAAP) and filed with the Securities and Exchange Commission (SEC). More likely than not, most of your client base will not issue audited financial statements.
The second option is much more commonly used. If the taxpayer does not have an applicable financial statement, we turn to the books and records. That language is inherently vague, but the final regulations provided later clarify that “books and records” includes the totality of the taxpayer’s documents and electronically stored data. This generally includes both work papers and physical counts of inventory.
The major benefit of the “books and records” method is that it allows the taxpayer to expense the inventory when they buy it. This means that if a small business buys $500,000 worth of inventory in December 2024 and pays for it by December 31st, they can expense that amount of inventory for tax year 2024.
However, there is one very important caveat: the business cannot have a practice of tracking their inventory using a formal inventory system. If the business owner has a point of sale (POS) system, this method is not an option. When a business counts and costs inventory in their books and records, they have to use that methodology for tax purposes. If your client’s business wants to shift from maintaining an inventory to a new status as not maintaining an inventory, they will need to file Form 3115, which should prompt an automatic change.
A “Books and Records” Success Story
Let’s take a quick look at a real-life example. A small business earned about $900,000 in one tax year. Previously, the business had been using the accrual method of accounting, but because their tax advisor was familiar with the provisions of TCJA, that tax professional recommended A) switching to the cash method of accounting and B) changing from maintaining inventory records to not maintaining inventory records.
The switch from accrual to cash method took over $200,000 off of their taxable income. By no longer maintaining inventory records, the business was also able to use the “books and records” method and deduct the cost of all their inventory purchases within that year. In total, this reduced their taxable income by almost $700,000!
Of course, as a tax planner, you will want to be cautious about the timing of these changes. If your client has an S corporation, for example, by shifting to a cash method and away from tracking inventory too suddenly, you may put that business in a significant loss position. This could unfortunately trigger an IRS audit. Sometimes simply making these two changes in different tax years can help prevent this problem.
The De Minimis Safe Harbor Rule
As discussed in our last blog, you cannot use the de minimis safe harbor rule and the NIMS method at the same time. The de minimis safe harbor rule allows businesses to deduct small expenditures that would otherwise need to be capitalized. However, if you use the books and records method, you have no need for the de minimis safe harbor rule. This is because small business taxpayers who expense inventory costs in their applicable financial statements or books and records can generally expense that cost for federal income tax purposes. So if a small business expenses the cost of freight in its books and records, they can expense that item for federal income tax purposes.
Summary
Small businesses that do not use a formal inventory system (or that can shift to operating without one) could be candidates for the books and records method—and the tax benefits that come with it. As tax professionals, we can provide our clients with unexpected value by educating them on this opportunity to enjoy tax deductions without significant changes to their business.
Looking to boost your knowledge on how recent—and upcoming—tax law changes can benefit your clients? Sign up to become a Certified Tax Planner today.
