By changing from the accrual to cash method of accounting, small manufacturers and distributors may be able to simplify compliance and reap other tax benefits.
Two of the original goals of the tax reform framework were to simplify the tax system and provide tax relief for businesses, especially small businesses — and in particular, American manufacturing companies that could reinvest in domestic production. While many may not agree that simplification has been achieved in the final legislation, the new law does indeed allow for accounting method changes that will make things much simpler for small manufacturing and distribution companies.
To understand what a tax break for manufacturing can mean for the overall economy, consider the fact that manufacturing companies are responsible for employing more than 12 million Americans, with more than 98 percent of those jobs coming from small companies with 500 or fewer employees. Annually, the industry generates more than $2 trillion of value-add revenue, and every dollar in final sales of manufactured products supports $1.33 in output from other sectors. According to the Manufacturing Institute, that is the largest multiplier of any sector.
Given the positive impact manufacturers have on the U.S. economy, it’s easy to understand why there is a focus in the tax reform legislation on helping these businesses, particularly the small ones.
Several relief provisions in the final reform bill that are applicable to small businesses (defined as those with gross receipts under $25 million, based on the prior three year average) provide simplifying conventions with respect to tax accounting methods. These changes can also provide some accelerated tax benefits to manufacturers. Accounting methods generally refer to the regular practice or procedure for determining when to recognize items of income or expense.
We will illustrate strategic accounting method changes allowable under the bill ― accrual to cash method, including exemption from uniform capitalization ― that might benefit your manufacturing or distribution businesses.
Note that when making an accounting method change, an adjustment must be calculated to identify the accumulated amount of income or deduction generated by the old method versus the new method. This calculation is necessary to prevent duplication or omission of income/deduction as your business converts from one method of accounting to another. The adjustment is called a 481(a) adjustment and is computed based on the opening balance sheet for the year of change. A net positive (unfavorable) adjustment is taken into income over four years; a net negative (favorable) adjustment is claimed in the year of change.
Change in overall accounting methods: accrual to cash
Overview of overall accounting methods
Permissible overall methods of accounting include the cash receipts and disbursements method (cash method), an accrual method, or any other method (including a hybrid method) permitted under IRS regulations.
Taxpayers using the cash method generally recognize items of income when actually or constructively received, and items of expense when paid. The cash method is administratively easy and provides the taxpayer flexibility in the timing of income recognition. This method is frequently used by sole proprietorships and individuals.
Taxpayers using an accrual method generally accrue items of income when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy. Taxpayers using an accrual method of accounting generally may not deduct items of expense prior to when all events have occurred that fix the obligation to pay the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred.
Accrual methods of accounting generally result in a more accurate measure of economic income than does the cash method; however, it is much more administratively cumbersome. The accrual method is often used by businesses for financial accounting purposes.
Restrictions on use of the cash method before reform
C corporations, partnerships with a C corporation as a partner, and tax-exempt trusts or corporations with unrelated business income were generally precluded from using the cash method under pre-reform law. There were a few exceptions to the general rule, including for entities with average annual gross receipts of not more than $5 million for all prior years.
In addition, the cash method was generally not allowable if the purchase, production, or sale of merchandise was an income-producing factor. Such taxpayers typically are required to keep inventory records to determine costs of goods sold for the taxable year. Cost of goods sold is generally determined by adding the taxpayer’s inventory at the beginning of the period to the purchases made during the period, and then subtracting the sum of the taxpayer’s inventory at the end of the period.
An exception was available for small taxpayers with annual receipts less than $1 million. These small taxpayers were permitted to account for inventory as materials and supplies that were non-incidental, and a deduction is generally permitted for those materials and supplies in the taxable year in which they are first used or are consumed in the taxpayer’s operations. As a practical matter, the outlined restrictions prevented most manufacturing and distribution companies from utilizing the cash method of accounting and required such taxpayers to maintain inventories.
Uniform capitalization requirements
The uniform capitalization (UNICAP) rules of Section 263A require that certain costs that are normally expensed be capitalized as part of inventory for tax purposes. The UNICAP rules apply to those who, in the course of their trade or business:
- Produce real property for use in the business or activity,
- Produce real or tangible personal property for sale to customers, or
- Acquire property for resale
Section 263A is significant for manufacturing and distribution companies, as it requires certain direct and indirect costs to be included in inventory, deferring the deduction for such costs until the inventory is sold.
These could represent several direct and indirect costs that would have been deducted for financial reporting purposes, including, but not limited to: bidding costs, engineering and design costs, employee benefit expenses, handling costs, indirect labor costs, insurance, interest, officer’s compensation, pension and related costs, purchasing costs, quality control, rent, depreciation, repairs and maintenance, spoilage, storage costs, taxes, tools and equipment, and utilities.
Before tax reform, very few exceptions applied to manufacturers and distributors that were exempt from the general UNICAP requirements. One exception was available for certain small taxpayers who acquire property for resale and have $10 million or less of average annual gross receipts; such taxpayers are not required to include additional Section 263A costs in inventory. Note that this exception would only apply to small distributors. No such exception applied to taxpayers in the business of manufacturing, regardless of their revenue size.
Application of the cash method after reform
The new legislation expands the universe of taxpayers that can use the cash method of accounting for tax years beginning in 2018. The cash method of accounting may now be used by taxpayers with average annual gross receipts (based on the prior three years) of less than $25 million, regardless of whether the purchase, production, or sale of merchandise is an income-producing factor. Furthermore, small businesses under this gross receipts threshold are not required to account for inventories, but rather may:
- Treat inventories as non-incidental materials and supplies, or
- Conform to the taxpayer’s financial accounting treatment of inventories
This provision effectively opens the door for small manufacturing companies to utilize the cash method of accounting and ease recordkeeping requirements with respect to inventories. It also expands the exception from the uniform capitalization rules for small taxpayers. If the cash method of accounting is elected, and if the taxpayer is treating inventories as non-incidental materials and supplies, the taxpayer is also exempted from the application of Section 263A.
Impact of the accrual-to-cash method change for a typical manufacturer
Here is an illustration of the tax benefit a small manufacturing company (less than $25 million in annual revenues) could secure in 2018 as a result of making a change to the cash method of accounting. Assume a typical balance sheet:
| Assets | 12/31/2017 |
|---|---|
| Cash | $31,000 |
| Accounts receivable, net | $736,000 |
| Inventory raw material | $1,750,000 |
| Inventory work in process ― labor and overhead | $250,000 |
| Inventory ― materials and supplies | $100,000 |
| Prepaid expenses | $75,000 |
| Property, plant, and equipment, net | $450,000 |
| Total assets | $3,392,000 |
| Liabilities and Equity | |
| Accounts payable | $303,000 |
| Mortgage payable | $1,290,000 |
| Accrued payroll | $150,000 |
| Customer deposits | $300,000 |
| Capital stock | $200,000 |
| Retained earnings | $1,149,000 |
| Total liabilities and equity | $3,392,000 |
Assume also that the manufacturing company above had $250,000 of costs capitalized to ending inventory under the Section 263A requirements. These costs could be deducted upon adoption of the cash-to-accrual accounting method change and will continue to be deducted as incurred.
The favorable deduction as a result of a 481(a) adjustment in 2018 would be as follows:
| Deduct Assets | |
|---|---|
| Accounts receivable | (736,000) |
| Inventory ― work in process ― labor and overhead | (250,000) |
| Prepaid expenses | (75,000) |
| Addback Accrued Liabilities | |
| Accounts payable | 303,000 |
| Accrued payroll | 150,000 |
| Deduct: 263A costs | (250,000) |
| Net 481(a) adjustment | (858,000) |
As illustrated above, this method change can provide significant value in the first year adopted and be a powerful tax deferral tool for manufacturers and distributors under the new reform legislation.
Thinking beyond the tax benefits
A change in accounting method can benefit your business in more ways than the initial tax deferral discussed above. Most manufacturing businesses take a myopic approach to cost accounting in an attempt to determine the actual cost of manufacturing a product by looking at all expenses in the supply chain. The unit cost drives the cost of inventory presented on the balance sheet and cost of goods sold on the income statement. This is achieved with techniques such as the allocation of manufacturing overhead costs and through the use of job-order costing systems. The intentions are good, but taken too far, focusing on traditional cost accounting in a vacuum can lead to bad business decisions.
Said differently, within this traditional costing and pricing system, many manufacturers fall victim to the pitfalls of common industry paradigms:
- Costs are incurred per job
- Pricing drives profitability
- The higher the job/customer gross margin, the more profitable the business
The reality is that the nonmaterial cost structure of most manufacturers is highly fixed, and very few costs actually vary by job. Therefore, it takes a combination of pricing and capacity management to improve profitability.
Capacity management, however, is usually a much bigger success driver. All too often, manufacturers turn away jobs because the gross margin is below their standard, yet they are operating with significant excess capacity.
The most profitable manufacturers use value-added revenue versus gross margin to drive profitability. Value-added revenue is a calculation of what a company earns for the service of converting material into a finished product. It is the dollars available to cover inside costs after paying for outside costs (i.e., material and subcontract). The value-add approach:
- Isolates what we get paid from what we pay outside vendors to take on new work (outside costs are variable)
- Creates clarity on how inside costs (people, plant, equipment) behave within given levels of capacity
- Makes financial results highly predictable when combined with capacity measures
Let’s use a simple example to clarify this concept, comparing three different customers on a gross margin versus earned rate per hour measurement:
| Revenue | Gross Margin | Margin % | Value-Added Revenue | Earned Rate Per Hour | |
|---|---|---|---|---|---|
| Customer 1 | $7,620,745 | $1,195,003 | 25% | $4,853,289 | $60.03 |
| Customer 2 | $1,773,321 | (726,734) | -41% | $1,182,914 | $66.29 |
| Customer 3 | $1,077,883 | (133,331) | -12% | $638,871 | $80.09 |
As this table illustrates, there is very little correlation between margin percentage and earned rate per hour. Frequently, negative/low margins are driven by material mark-up that artificially increases costs and margin.
Companies that can capitalize on a value-add approach focus on their earned rate per hour along with margin percentage to understand whether or not their quotes are within market for the work being performed. Then, they can focus on filling the shop and actively monitoring capacity.
The great news is that the value-add approach aligns nicely with the tax accounting method changes. Under the new law, small manufacturers only have to inventory the materials and supplies. They can break free of the cost accounting approach that perhaps skews decision making, and focus on value-add reporting for both financial and tax decisions.
This discussion illustrates strategic accounting method changes that are available to small manufacturing and distribution companies beginning in 2018. Not only do these methods help provide administrative simplicity to small manufacturing and distribution companies with respect to tax compliance, they can also provide significant tax benefits upon adoption via favorable 481(a) deductions. These accounting methods must be adopted by filing Form 3115, Application for Change in Accounting Method.
How we can help
The manufacturing and distribution team at CLA has tools that can help you quantify the impact of adopting these methods and can assist with the application to request the accounting method change.