Beginning 1/1/18, for companies with annual average gross revenues in the prior three years is less than $25,000,000, you:
- Use the cash method of accounting,
- Are not subject to the Uniform Capitalization Rules of IRC Section 263A,
- Can use the completed contract method for long-term contracts,
- And are not subject the 30% limit on interest expense deductions under IRC Section 163(j)(1).
Any existing companies using the accrual method, subject to 263A, or using the percentage of completion method for long-term contracts can apply for automatic change in accounting method if they want to switch their method of accounting to any of the methods mentioned in the previous paragraph; this is accomplished by filing form 3115.
Any business using the cash method, not applying 263A, not using the percentage of completion method, or applying the interest expense deduction limitations under 163(j)(1) must switch to the accrual method, and apply the other provisions once their average 3-year gross revenues reach $25,000,000, unless they meet an exception.
Gross Revenue Test
In determining whether taxpayers meets gross revenue test, they must treat
members of a controlled group of corporations as a single entity aggregating their combined annual average gross revenue over the prior three years. For example, Tim is the 100% of three separate corporations, A, B, and C. Corporation’s A’s annual average gross receipts are $7,500,000, B’s are $12,000,000, and C’s are $8,000,000, for a combined average totaling $27,500,000. Since the aggregate average is greater than $25,000,000, Tim’s corporations are required to use the accrual method of accounting, are subject to the Rules of 263A, etc., unless each of the businesses meet an exception to the $25,000,000 rule.
Accrual Method of Accounting
Under an accrual method of accounting, you generally report income in the year earned and deduct or capitalize expenses in the year incurred. The purpose of an accrual method of accounting is to match income and expenses in the correct year. All companies with inventory can only deduction the cost of inventory when sold. Personal Service C Corporations in one of eight professional fields can use the cash method of accounting even if they fail to pass the average gross revenue test.
IRC Section 263A
IRC Section 263A requires taxpayer’s to allocate all direct and indirect costs to cost of property it manufactured, constructed, produced or acquired for resale. For instance, a manufacturer of office equipment that fails the gross receipts test must allocate a direct and indirect labor, utilities, rent, property plant and equipment maintenance and depreciation as part of the cost of office equipment inventory and cost of goods sold.
Completed Contract versus Percentage of Completion Method
The completed contract method or the percentage-of-completion method generally applies to construction contractors. Under the completed contracted method, a contractor does not report revenue until the contract in completed.
The percentage of completion method is an accounting method in which the revenues and expenses of long-term contracts are recognized as a percentage of the work completed during the period. For example, a commercial building contractor is hired to build a shopping center. The project will take 3 years, will cost $100,000,000, and will generate revenue of $150,000.000. After year 1, the contractor incurred $30,0000,000 in costs on the project. Under the percentage of completion method, for year 1 the contractor must recognize income of $45,000,000 ($30,000,000 year 1 cost divided by $100,000,000 total estimated cost of the project times $150,000,000 total revenue from the contract).