With their smaller margins and limited resources, most small businesses will take any money-saving opportunity they can (lawfully) get. The Tax Cuts and Jobs Act (TCJA) introduced a number of provisions that reduced taxes for many small businesses. Some provisions are currently scheduled to expire at the end of 2025, but others are considered permanent and could be factored into your business’ next tax plan.
One permanent tax law involves the accounting methods available to small businesses. Most business owners have likely not thought about their accounting method since they started their business, but through TCJA, more businesses are now eligible to adopt the cash method. This method allows small businesses to report income and deduct expenses as cash actually changes hands. This differs from the accrual method where you report income in the year it is earned even if you receive payment much later, and you deduct expenses when they are incurred regardless of when you make the actual payments. Because the cash method is much simpler and cheaper to use, small businesses can often save money just by switching systems.
So what exactly changed under TCJA? Mainly, the income limit was raised for companies that can use the cash method. Previously the cap was set at $5 million in annual gross receipts, but now companies with up to $25 million in annual gross receipts are considered “small business taxpayers.” These businesses also receive a second benefit: they no longer have to account for their inventories.
In our last blog, we talked about the first method small businesses can use to handle inventory: the “non-incidental material and supplies” method. Today, we will discuss the second method, known as the “books and records” method.
Benefits of the Books and Records Method
This method of treating your business inventory can be used if you do not have an applicable financial statement. Some businesses may issue audited financial statements that are prepared in accordance with Generally Accepted Accounting Principles (GAAP) and filed with the Securities and Exchange Commission (SEC). If this does not apply to your business, you may be able to apply the method of accounting used in your books and records instead.
According to IRS regulations, “books and records” refers to all of your business’ documents and electronically stored data including work papers and physical counts of inventory. The “books and records” method allows the taxpayer to expense the inventory in the year that they purchase it. So if your business buys $500,000 in inventory and pays for it by December 31st, 2024, you can expense the full amount for tax year 2024.
However, to be eligible for the books and records method, your business cannot track inventory using a formal inventory system. If you have a point of sale (POS) system, this unfortunately disqualifies you. If your business wants to shift to a new status as not maintaining an inventory, you can work with your tax advisor to file Form 3115, which should prompt an automatic change.
A Real-Life Example
Let’s look at an example of a small business that earned $900,000 in one tax year. The business started out using the accrual method of accounting, but after TCJA was passed, their tax adviser saw that the business was now eligible to switch to the cash method of accounting. This would require the business to also switch from maintaining inventory records to not maintaining inventory records, but the payoff would be well worth it. By switching to the cash method of accounting, the business reduced its taxable income by $200,000. Even further, by changing to a new status of not using a formal inventory system, the business could use the books and records method to deduct all of their inventory purchases for that tax year. Combined, this reduced their taxable income by almost $700,000!
However, keep in mind that with any tax strategy, there are often trade-offs and limitations to be aware of. For instance, making a series of quick changes to your business structure could be flagged as suspicious by the IRS. The same is true if your business is an S corporation, and these changes suddenly cause the business to have significant losses that year. This is why working with a qualified tax professional is essential when applying sophisticated tax strategies.
How the Books and Records Method Affects Other Tax Deductions
In our last blog, we explained that you cannot use the de minimis safe harbor rule and the “non-incidental material and supplies” method at the same time. This rule is a popular one among business owners because it allows you to fully deduct small expenditures instead of capitalizing them over time. The good news is that if you use the books and records method you simply will not need the de minimis safe harbor rule—you will already be able to expense those costs for tax purposes. As long as you meet the qualifications for using the books and records method (including not using a POS system) you can benefit from these immediate deductions.
Summary
If your small business could benefit from deducting inventory expenses right away, consider whether shifting to the books and records method could be the right move. Though this does mean you cannot use a formal inventory system, the overall financial benefits of this method can be more than worthwhile. If you would like to learn more about this and other tax savings strategies, contact a Certified Tax Planner today.
