How Tax Reform Impacts the Accounting Methods of Mold Shops
The Tax Cuts and Jobs Act of 2017 code may broaden the accounting methods available to mold builders with average annual gross receipts of less than $25 million for the prior three tax years.
The Tax Cuts and Jobs Act of 2017 (the “Act”) made numerous changes to the Internal Revenue Code that impacts mold builders. Guidance is available to help explain the new provisions of the expanded code, such as changes to the rules governing methods of accounting. Specifically, shops with average annual gross receipts for the prior three tax years that are less than $25 million have more flexibility with respect to four different accounting methods. Each of these changes is effective for tax years beginning after December 31, 2017, and all four will be favorable to shops. In fact, many mold builders falling below the average gross receipts threshold will benefit from all four changes in accounting methods in 2018.
The following provides an overview of the different methods that may now be available to mold builders with average annual gross receipts of less than $25 million for the prior three tax years.
Cash Method of Accounting
Historically, mold builders whose average gross receipts exceed $1 million must use the accrual method of accounting. Generally, this method recognizes revenue after all the events have occurred that indicate the right to receive income and then determines the amount with reasonable accuracy. That is, accrual-basis taxpayers pay tax on the income they collect and on the receivables. After all the events have occurred, shops also deduct expenditures, which determine the fact of a liability, the amount of such liability with reasonable accuracy and that the services or goods (or both) have been provided. That is, accrual-basis taxpayers may deduct their payables.
Cash-basis shops, on the other hand, pay tax when the income is actually or constructively received and deduct expenditures when the payable has been paid. The Act significantly broadened the number of shops eligible to use the cash method of accounting.
For tax years beginning after December 31, 2017, shops with average annual gross receipts of $25 million or less for the prior three tax years may use the cash method of accounting. This change is available regardless of the entity structure.
Shops that previously have been on the accrual method of accounting that wish to begin using the cash method of accounting in a tax year beginning after December 31, 2017, may file a Form 3115: Change in Accounting Method from the IRS to request this change. The change is automatic, which means that shops are not required to wait for IRS approval.
Shops making this change effectively adopt the new method of accounting at the beginning of the year in which the change is made. That is, they get to true-up and reconcile the difference in taxable income from their old method (accrual method of accounting) and their new method (cash method of accounting), and they may claim the difference in the year of the change (commonly known as a §481(a) adjustment).
For example, assume a $15-million mold shop has $2 million in receivables (for which tax has already been paid) and payables of $800,000 (for which the expenditures have already been deducted) on January 1, 2018. If the mold shop changes its method of accounting from the accrual method to the cash method, it will recognize its 2018 income using the cash basis of accounting and claim a deduction of $1.2 million. This is the difference between the receivables and the payables. For example, it is the amount of income for which income tax has already been paid.
Mold builders falling under the $25-million average annual gross receipts threshold and whose receivables generally exceed its payables are likely to benefit from this accounting method change.
Prior to the Act, mold shops with average annual gross receipts of $1 million or greater were required to account for their inventories in the traditional sense by deducting their cost of goods sold once the mold had been sold to the customer.
The Act significantly raised this threshold, allowing companies with less than $25 million of average annual gross receipts to avoid the general inventory rules and treat the inventory as materials and supplies that are not incidental to the shop. That is, they may deduct the cost of goods sold once the material is used in the work-in-process. In a fashion similar to an accrual to the cash-accounting method change conversion, shops are allowed to claim a §481(a) deduction that is equal to the difference in taxable income that is realized by the change.
Uniform Capitalization Rules
Prior to the Act, the uniform capitalization rules (UNICAP) required shops to include indirect and overhead costs in the cost of inventory at the end of the year. As a result, mold shops were required to review their indirect costs and capitalize some portion of these costs into ending inventory. This requirement resulted in greater inventory at year-end, less in the cost of the goods that were sold and ultimately, greater taxable income.
The Act removed this requirement for shops with average annual gross receipts of $25 million or less for the prior three years. Taxpayers changing to this method of accounting may claim the difference as a deduction under section §481(a).
Shops that begin a contract to manufacture a mold in one tax year and that complete the contract in a subsequent year have engaged in a long-term contract. Prior to the Act, a mold shop with average and gross receipts for the prior three years that exceeded $10 million that engaged in a long-term contract had to recognize its income and expenses related to that contract under the percentage-of-completion method in its recognition of income. That is, if a contract is 40 percent complete on December 31, 2017, the mold shop had to recognize 40 percent of the income related to the manufacturing of that mold.
The Act modifies the gross receipts threshold. Mold shops falling below the $25-million gross receipts threshold will be exempt from the requirement to use the percentage-of-completion method and will be allowed to use the completed-contract method for contracts entered into after December 31, 2017. Taxpayers will recognize the income related to the production of the mold once the contract has been completed.
Mold shops with average annual gross receipts of $25 million or less for the prior three tax years will want to review their methods of accounting to determine whether changing their method or methods would be beneficial.
About the Contributor
Michael J. Devereux II, CPA, CMP is a partner and director of manufacturing, distribution and plastics industry services at Mueller Prost.
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