Accountants routinely assist business owners to help accomplish the goal of minimizing taxes. But, to truly understand the value of the business and accurately project future cash flow, it is important to look beyond the tax returns to realize how the money is being spent.
Concerned about your financial future due to the COVID-19 Crisis? John Mills of Tax Centers of Georgia told members of the GABB about ways you can borrow from your retirement savings without penalty and other tax strategies.
As the COVID-19 virus wreaks havoc on our personal life and financial markets, Mills discussed little known strategies to help businesses and individuals negotiate current financial hardships. The Georgia Association of Business Brokers (GABB) is hosting weekly meetings to answer members’ questions during this pandemic.
Mr. Mills, a partner in Tax Centers of Georgia, said that the CARES Act provides an unusual opportunity to get access to your 401k or IRA investments without age restrictions or penalties.
He said many tax experts think “average” income earners could be paying as much as 37-54% in taxes in the near future. He discussed how and investor could add hundreds of thousands dollars of tax-free cash flow to retirement income without any additional savings.
Under the CARES Act, who can get money out of a 401k and/or IRA? Anyone:
- Who is diagnosed with COVID-19 by a test approved by the Centers for Disease Control and Prevention.
- Whose spouse is dependent (generally a qualifying child or relative who receives more than half of his or her support from you) is diagnosed with COVID-19 by such a test.
- Who experiences adverse financial consequences as a result of quarantine, furlough, layoff, or having work hours reduced due to COVID-19.
- Who is unable to work because of lack of child care due to COVID-19 and experiences adverse financial consequences as a result.
- Who owns or operates a business that has closed or had operating hours reduced due to COVID-19 and has experienced adverse financial consequences as a result.
- Who has experienced adverse financial consequences due to other COVID-19 related factors to be specified in future IRS guidance.
COVID-19 401k/IRA Plan Details
- Loans will move from 50% or $50,000 to 100% or $100,000 that you can borrow. This options ends on September 23rd. Your plans loan rates can vary from other plans. You then pay back the loan over 5 years (this can be done with payroll deduction and dramatically increase your savings above the IRS rules).
- If you qualify (based on COVID-19 rules) you can withdraw up to $100,000. You will not be subject to the IRS under 59 ½ rule requiring a 10% penalty. End date for this is 12/31.
- If taken as a distribution, taxes owed can be spread over three years or you can choose to pay the taxes lump sum at the end of three years and skip the tax now.
- This is a one-time opportunity, Mills said.
Option #1: Loan
- Take up to a $100,000 loan from your 401k plan or any other lesser amount.
- Pay back the loan through payroll deduction over 5 years or, in a lump sum at the end of five years. Be your own bank! If you can afford more than the $20,000 limit of your normal contribution, you can now deposit $40,000 per year into your 401(k) (normal contribution plus loan each year.
- Your interest rate may be PRIME (currently about 3.25%). Each plan can vary on the rate, but rates are at an all time low.
- You now have $100,000 in your hands, income tax free.
- Just because you could take a loan, doesn’t mean you should, Mills advised.
Option #2: Distribution
- Take” the full $100,000 as a distribution from your 401k or IRA
- This could be the only time in your lifetime that you can get money out of your pre-tax account while under 59 ½ without a 10% penalty.
- The tax can be spread over three years (Due April 2021, 2022 and 2023)
- Assuming a 24% tax rate, that would mean only $8,000 in tax each year. This can be paid from savings or any other non-qualified investment you may have. If pay in 4 installments (1 immediate and 3 more over 2021-23) it would mean 4 installments of only $6,000.
- How does that benefit you to pay these small taxes over 3 years?
Alternative #1: Roth Conversions
- There is no limit on the amount you can convert from IRA or 401K to Roth
- The CARES ACT however limits the amount you can draw out of your IRA or 401k without the 10% penalty ($100,000 “per person”)
- The Roth will still have the 10% penalty before age 59 ½ and even if over that age you must hold the Roth for 5 years before accessing any of the money.
- Depending on where you invest the Roth money (Stocks, Bonds, Mutual Fds etc.) you still carry all the risk as you did in the 401(k).
What else can you do with the money?
- What if we could get the money to grow tax-deferred (the $100,000) and have it come out 100% Tax-FREE (like the Roth)?
- What if you passed away prematurely and your family then received a large sum, potentially 3 times the amount of money you took out, again…100% Tax-FREE?
- What if you had a chronic illness or required a Long-Term Care stay and you could have money to help cover your stay…100% TAX-FREE?
- What if you had a short-term financial need and you could access this same money again without any 10% governmental penalty or tax BEFORE age 59 ½ ?
Can I really do that?… YES
- Borrow OR take your distribution (or any part of the maximum) and place it in a 7702 plan using life insurance vehicles. Immediate potential benefit for your family should you pass of $336,000*
- Cash then grows tax-deferred and comes out tax free for your retirement or whenever you might need it **.
- Take your tax-free income for 10, 20 years or possibly longer in retirement.
- Receive proceeds in case of a chronic illness or Long-term care need…TAX-FREE.
- Cover a college education or wedding…TAX-FREE.
To find out more, Mills invites businesses and individuals to contact him.
Linked below is Mr. Mills’ PowerPoint presentation.Read More
The U.S. Internal Revenue Service issued the following, Notice 2020-32, to answer questions about how to handle the deductibility of certain expenses if a taxpayer gets a loan under the Paycheck Protection Program, created under the CARES Act.
The CARES Act, however, did not address whether the business expenses that result in PPP loan forgiveness will be deductible for tax purposes, according to a post by JD Supra, which posts a daily newsletter of news, commentary and analysis from leading lawyers and law firms. In this notice, released on April 30th, JD Supra concludes that “the IRS concludes that when the payment of business expenses results in the forgiveness of a PPP loan, such as payroll costs or rent, those business expenses will not be deductible for tax purposes. According to the IRS, this treatment prevents a “double tax benefit” and is consistent with Section 265(a)(1) of the Internal Revenue Code, which generally provides that no tax deduction is available for expenses that are paid with tax-exempt dollars.”
The full text of the IRS notice is reproduced below:
This notice provides guidance regarding the deductibility for Federal income tax purposes of certain otherwise deductible expenses incurred in a taxpayer’s trade or business when the taxpayer receives a loan (covered loan) pursuant to the Paycheck Protection Program under section 7(a)(36) of the Small Business Act (15 U.S.C. 636(a)(36)). Specifically, this notice clarifies that no deduction is allowed under the Internal Revenue Code (Code) for an expense that is otherwise deductible if the payment of the expense results in forgiveness of a covered loan pursuant to section 1106(b) of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), Public Law 116-136, 134 Stat. 281, 286-93 (March 27, 2020) and the income associated with the forgiveness is excluded from gross income for purposes of the Code pursuant to section 1106(i) of the CARES Act.
The Paycheck Protection Program was established by section 1102 of the CARES Act. Under the Paycheck Protection Program, a recipient of a covered loan may use the proceeds to pay (1) payroll costs, (2) certain employee benefits relating to healthcare, (3) interest on mortgage obligations, (4) rent, (5) utilities, and (6) interest on any other existing debt obligations. See section 7(a)(36)(F) of the Small Business Act (describing allowable uses of a covered loan). See also Q&A 2.r. in Part III of the interim final rule, Business Loan Program Temporary Changes; Paycheck Protection Program, Docket No. SBA-2020-0015, 85 Fed. Reg. 20811, 20814 (April 15, 2020).
Under section 1106(b) of the Cares Act, a recipient of a covered loan can receive forgiveness of indebtedness on the loan (covered loan forgiveness) in an amount equal to the sum of payments made for the following expenses during the 8-week “covered period” beginning on the covered loan’s origination date (each, an eligible section 1106 expense): (1) payroll costs, (2) any payment of interest on any covered mortgage obligation, (3) any payment on any covered rent obligation, and (4) any covered utility payment. See section 1106(a) (defining the terms “covered period”, “covered mortgage obligation,” “covered rent obligation,” “covered utility payment,” and “payroll costs”), (b) (regarding eligibility for covered loan forgiveness), and (g) (regarding covered loan forgiveness decisions). However, section 1106(d) of the CARES Act provides that the amount of the covered loan forgiveness is reduced if, during the covered period, (1) the average number of full-time equivalent employees of the recipient is reduced as compared to the number of full-time employees in a specified base period, or (2) the salary or wages of certain employees is reduced by more than 25 percent as compared to the last full quarter before the covered period. In addition, pursuant to an interim final rule issued by the Small Business Administration, no more than 25 percent of the amount forgiven can be attributable to non-payroll costs. See Q&A 2.o. in Part III of the interim final rule, Business Loan Program Temporary Changes; Paycheck Protection Program, Docket No. SBA-2020-0015, 85 Fed. Reg. 20811, 20813-20814 (April 15, 2020).
Section 1106(i) of the CARES Act addresses certain Federal income tax consequences resulting from covered loan forgiveness. Specifically, that subsection provides that, for purposes of the Code, any amount that (but for that subsection) would be includible in gross income of the recipient by reason of forgiveness described in section 1106(b) “shall be excluded from gross income.” Thus, section 1106(i) of the CARES Act operates to exclude from the gross income of a recipient any category of income that may arise from covered loan forgiveness, regardless of whether such income would be (1) properly characterized as income from the discharge of indebtedness under section 61(a)(11) of the Code, or (2) otherwise includible in gross income under section 61 of the Code.
II. Deductibility of Eligible Section 1106 Expenses
Neither section 1106(i) of the CARES Act nor any other provision of the CARES Act addresses whether deductions otherwise allowable under the Code for payments of eligible section 1106 expenses by a recipient of a covered loan are allowed if the covered loan is subsequently forgiven under section 1106(b) of the CARES Act as a result of the payment of those expenses. This Notice addresses the effect of covered loan forgiveness on the deductibility of payments of eligible section 1106 expenses.
III. Summary of Relevant Law
Section 161 of the Code provides that, in computing taxable income under section 63 of the Code, there shall be allowed as deductions the items specified in part VI, subchapter B, chapter 1 of the Code (for example, sections 162 and 163). However, section 161 of the Code provides that the allowance of these deductions is subject to the exceptions provided in part IX, subchapter B, chapter 1 of the Code. These exceptions include section 265 of the Code. See also section 261.
In general, section 162 of the Code provides for a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Covered rent obligations, covered utility payments, and payroll costs consisting of wages and benefits paid to employees comprise typical trade or business expenses for which a deduction under section 162 of the Code generally is appropriate. Section 163(a) of the Code provides a deduction for certain interest paid or accrued during the taxable year on indebtedness, including interest paid or incurred on a mortgage obligation of a trade or business.
However, section 265(a)(1) of the Code and §1.265-1 of the Income Tax Regulations provide that no deduction is allowed to a taxpayer for any amount otherwise allowable as a deduction to such taxpayer that is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by subtitle A of the Code. See generally section 265(a)(1); §1.265-1. The term “class of exempt income” means any class of income (whether or not any amount of income of such class is received or accrued) that is either wholly excluded from gross income under any provision of subtitle A of the Code or wholly exempt from the taxes imposed by subtitle A of the Code under the provisions of any other law. See §1.265-1(b)(1). The purpose of section 265 of the Code is to prevent a double tax benefit.
Section 265(a)(1) of the Code applies to otherwise deductible expenses incurred for the purpose of earning or otherwise producing tax-exempt income. It also applies where tax exempt income is earmarked for a specific purpose and deductions are incurred in carrying out that purpose. In such event, it is proper to conclude that some or all of the deductions are allocable to the tax-exempt income. See Christian v. United States, 201 F. Supp. 155 (E.D. La. 1962) (school teacher was denied deductions for expenses incurred for a literary research trip to England because the expenses were allocable to a tax-exempt gift and fellowship grant); Banks v. Commissioner, 17 T.C. 1386 (1952) (certain educational expenses paid by the Veterans’ Administration that were exempt from income tax, were not deductible); Heffelfinger v. Commissioner, 5 T.C. 985 (1945), (Canadian income taxes on income exempt from U.S. tax are not deductible in computing U.S. taxable income); and Rev. Rul. 74-140, 1974-1 C.B. 50, (the portion of a state income tax paid by a taxpayer that is allocable to the cost-of-living allowance, a class of income wholly exempt under section 912, is nondeductible under section 265).
In Manocchio v. Commissioner, 78 T.C. 989 (1982), a taxpayer attended a flight-training course that maintained and improved skills required in the taxpayer’s trade or business. As a veteran, the taxpayer was entitled to an educational assistance allowance from the Veterans’ Administration pursuant to 38 U.S.C. section 1677 (1976) equal to 90 percent of the costs incurred. Because the payments received were exempt from taxation under 38 U.S.C. section 310(a) (1976), the taxpayer did not report them as income. The taxpayer did, however, deduct the entire cost of the flight training course, including the portion that had been reimbursed by the Veterans’ Administration. In a reviewed opinion, the court held that the reimbursed flight-training expenses were nondeductible under section 265(a)(1) of the Code.
NON-DEDUCTIBILITY OF PAYMENTS TO THE EXTENT INCOME RESULTING FROM LOAN FORGIVENESS IS EXCLUDED UNDER SECTION 1106(i) OF THE CARES ACT
To the extent that section 1106(i) of the CARES Act operates to exclude from gross income the amount of a covered loan forgiven under section 1106(b) of the CARES Act, the application of section 1106(i) results in a “class of exempt income” under §1.265- 1(b)(1) of the Regulations. Accordingly, section 265(a)(1) of the Code disallows any otherwise allowable deduction under any provision of the Code, including sections 162 and 163, for the amount of any payment of an eligible section 1106 expense to the extent of the resulting covered loan forgiveness (up to the aggregate amount forgiven) because such payment is allocable to tax-exempt income. Consistent with the purpose of section 265, this treatment prevents a double tax benefit.
This conclusion is consistent with prior guidance of the IRS that addresses the application of section 265(a) to otherwise deductible payments. In particular, Rev. Rul. 83-3, 1983-1 C.B. 72, provides that, where tax exempt income is earmarked for a specific purpose, and deductions are incurred in carrying out that purpose, section 265(a) applies because such deductions are allocable to the tax-exempt income. In accordance with the analysis set forth in Rev. Rul. 83-3, the direct link between (1) the amount of tax exempt covered loan forgiveness that a recipient receives pursuant to section 1106 of the CARES Act, and (2) an equivalent amount of the otherwise deductible payments made by a recipient for eligible section 1106 expenses, constitutes a sufficient connection for section 265(a) to apply to disallow deductions for such payments under any provision of the Code, including sections 162 and 163, to the extent of the income excluded under section 1106(i) of the CARES Act.
The deductibility of payments of eligible section 1106 expenses that result in loan forgiveness under section 1106(b) of the CARES Act is also subject to disallowance under case law and published rulings that deny deductions for otherwise deductible payments for which the taxpayer receives reimbursement. See, e.g., Burnett v. Commissioner, 356 F.2d 755, 759-60 (5th Cir. 1966); Wolfers v. Commissioner, 69 T.C. 975 (1978); Charles Baloian Co. v. Commissioner, 68 T.C. 620 (1977); Rev. Rul. 80-348, 1980-2 C.B. 31; Rev. Rul. 80-173, 1980-2 C.B. 60.
The principal authors of this notice are Sarah Daya and Patrick Clinton of the Office of Associate Chief Counsel (Income Tax & Accounting). For further information regarding the application of sections 161, 162, 163, and 261 please contact Ms. Daya at (202) 317-4891 (not a toll-free call); for further information regarding the application of section 265, please contact Mr. Clinton at (202) 317-7005 (not a toll-free call).Read More
The cannabis industry might be one of the largest industries in the next decade, but right now, it’s risky, expensive and faces uncertain legal and tax hurdles, says an accountant who specializes in the cannabis industry.
Matthew Foster CPA, a partner with Frazier & Deeter, LLC and the firm’s National Practice Leader for the Cannabis Industry, spoke about accounting and the cannabis industry earlier this year at the Georgia Association of Business Brokers.
“This is not an industry for the faint of heart,” warned Foster. “If you have a very low risk tolerance, I would just advise you to stop right now and wait until the feds open it up in about five or six years, possibly longer.”
The biggest risk? The whole industry is illegal in the eyes of the federal government.
“From a federal perspective, every one of these companies that are in cannabis are lawless citizens of the U.S.,” said Foster. “They’re all breaking the law.” Federal officials could “come in at any moment and break them up if they wanted to.”
If the company is in one of the many states that has legalized cannabis, most assume that federal officials won’t intervene, “unless they do something really out of line,” Foster said.
Georgia’s Cannabis industry
Georgia’s cannabis industry is poised for growth because the state recently passed a law legalizing the production and manufacturing of low THC CBD oil, defined as anything with a THC content of 5% or less. That’s just strong enough for medicinal use, and not strong enough for intoxication. The new law allows up to six licenses for growing medical marijuana, plus licenses to the University of Georgia and Fort Valley State University for research.
Of the six private licenses, two will be for large productions, up to 100,000 square feet, and four for up to 50,000 square feet. There’s a $25,000 non-refundable application fee for a large license, along with an initial $200,000 licensing fee and $100,000 annual renewal fee. The smaller licenses carry a $5,000 non-refundable application fee, along with an initial $100,000 licensing fee and $50,000 annual renewal fee.
“So you need a lot of capital just to hold the license in Georgia,” Foster said. “That’s before you even start with the production and the costing and everything else.”
Recently Flourish, an Atlanta-based supply chain management startup that helps cannabis companies monitor logistics, raised $2.1 million in a seed round led by 7thirty Opportunity Fund, the Atlanta Business Chronicle reported.
Georgia has made cannabis companies ineligible for any state tax incentives. “You are going to pay tax on every single dollar that you make here in Georgia,” Foster said.
Which means that companies in the cannabis industry right now must be highly capitalized. “You have to have a lot of money at your disposal to weather the storm until the feds open it up,” said Foster.
Frazier & Deeter works with clients to set up inventory methodologies that will move as many expenses as they can under current tax law from their overhead into the cost of inventory.
Another obstacle for the industry is banking. Under current laws, federally insured banks are not allowed to do business with cannabis companies.
“These companies can bank with state-sponsored banks, with credit unions, if those banks decide they want to work with this industry. But they can’t bank with FDIC-insured banking institutions, your Wells Fargo, your Bank of America, your Chase, because they are federally regulated,” Foster said.
Cannabis industry investors are lobbying legislators to pass a law that would make cannabis similar to hemp, which would open up a more traditional taxation and banking.
Foster predicted that Congress will act on banking before legalization because right now, the federal government is losing lots of potential tax revenue from the industry.
Cannabis VS Industrial Hemp
Cannabis and industrial hemp represent different segments of the market. For example, industrial hemp is becoming a very attractive option for people to invest in thanks to last November’s farm bill. The farm bill, in essence, descheduled industrial hemp, defined as a product with a less than 0.3% THC content per gram. Hemp fiber and oilseed can be used in variety of industrial and consumer products. What the bill did was deschedule hemp, meaning it’s still illegal at the federal level, unless you are producing and working in a state that has legalized industrial hemp.
Cannabis is still illegal from a federal standpoint, despite being legal for medicinal uses in 33 states and the District of Columbia, and in 11 states and D.C. for recreational uses. Because cannabis is included in Schedule I of the Controlled Substances Act, it falls under section 280E of the IRS code. “That means cannabis businesses cannot deduct any necessary or ordinary business expenses for federal income tax purposes, nor can they claim any Federal credits,” Foster said.
“You can deduct your cost of goods sold, but everything else in your return is non-deductible,” Foster said. “You can’t have R&D credits, you can’t have business credits, and you can’t have jobs credits. Take your revenues, deduct your cost of goods sold, get your gross profit, and that’s your taxable income: your gross profit.”
But companies with shrewd accountants can take advantage of certain sections of the IRS code that allow companies to capitalize their overhead, which would allow them to deduct some of the expenses for rents, utilities, property taxes, salaries, depreciation, etc.
Managing Cannabis Finances
Foster recommends that their traditional cannabis clients do full financial statement audits which allows for an opinion on what’s capitalized into the cost of inventory and what’s being deducted as cost of goods sold. If the IRS does come in and audit, “we have a lot of support for the position that we have taken.”
Cannabis companies should NOT use the name of the plant in their company name, Foster recommended, to try to minimize the red flags that the IRS will see on these companies.
“First and foremost, the words cannabis, hemp, and marijuana should not appear on your tax return, anywhere,” said Foster.
Also, these companies should not get creative in taking deductions, Foster said. If you go that way, “start putting money aside because you’re going to get audited.”
He also recommends that anybody in this space should operate as a C Corp, mainly because it’s the lowest tax rate that you can find on federal level right now. Also a C Corp allows a company to “put up a corporate wall around your investors.”
If the IRS starts attacking the company, the investors are only out what they put into the company. It won’t be able to go after their personal assets. He also recommends portioning off different sections of the business into separate entities for real estate, equipment or intellectual property.
Potential Profits Huge
Returns on investment are a mystifying 10 to 30 multiples on revenue streams in the industry. “I haven’t quite figured out what’s going on in this space,” Foster said. “This must be Toad’s Wild Ride for investors.” But last year, a lot of people made a lot of money.
“So, it depends on when you get in, what you get in to, and how long you’re willing to ride this roller coaster,” Foster said.
Big U.S. companies are awaiting new banking regulations that will ease investment into this industry. Foster said “They’re either waiting to go public, or they’re waiting for big pharma, big tobacco, or big alcohol to come in and buy them up.”Read More
New Tax Loophole May Allow Many Small Businesses to Claim Large Tax Write-Offs For Inventory In The Year Purchased! Can it be true? How do Companies Sign Up?
Senior Tax Manager at Frazier & Deeter (Atlanta, GA)
Congress, either intentionally or unintentionally, as part of the Tax Cuts and Jobs Act provided for a potentially huge tax write-off for many small businesses that have inventory –basically any company that has physical products they intend to sell to a customer. Prior to the new tax law (before 1/1/2018), if your company kept an inventory, you generally couldn’t claim a tax deduction for inventory until the inventory was sold. As a result of the Tax Cuts and Jobs Act (TCJA), savvy small businesses may be able to take advantage of a new loophole that could provide a large tax windfall by completely expensing their ending inventory in the year purchased starting with returns that are about to be filed in 2019 (for the 2018 tax year).
For taxpayers and CPAs able to piece together several sections of the Tax Code and Regulations, the new law creates a huge opportunity and marks a significant change from prior tax accounting for inventories that didn’t allow for tax deductions for inventory until sold. There are a number of hoops to jump through and hurdles to overcome before companies can write off ending inventory, but will likely provide immediate tax savings to a large percentage of taxpayers who keep an inventory with a cost of less than $2,500 per inventory item. According to Donna Beatty, CPA, we may even see those companies that are able to take advantage of this loophole manage their tax bill via purchase of inventory before the end of their tax year.
Cash Method Now Allowed For Small Business –Even Those With Inventory
It works like this. The Tax Cuts and Jobs Act generally effective as of January 1, 2018, provides that taxpayers, in general, with less than $25 Million in gross receipts (average of past 3 years gross receipts) can now use the cash method of accounting, even if they keep an inventory. This is a major shift from prior law that required many companies with inventory to use the accrual method of accounting. This rule alone does not provide that businesses under the $25 Million threshold can simply start expensing their inventory as purchased – there are several additional nuances before a cash basis taxpayer can expense inventory when purchased.
First, if you are under the $25 Million average gross receipts threshold and currently using the “accrual method” of accounting, and you think you qualify to expense inventory based on all other parameters below, or you just want to start using the cash method of accounting for some other reason, you will need to file a “change in accounting method” with the IRS to begin filing tax returns on the cash basis. If you are already using the “cash method” of accounting for tax purposes that’s great – you don’t need to file a change with the IRS. If you need to file with the IRS to change your accounting method, don’t worry, the IRS has provided for a simplified filing requirement for small businesses rather than forcing you to complete the normal Form 3115 with all of its required schedules and disclosures. After you change your company accounting method to the cash method with the IRS, you still ARE NOT home free! There are additional steps to take before you can expense inventory as purchased – keep reading.
Required Tax Elections
Once you are on the cash method of accounting one of the two keys that makes this work is what’s called the “de minimis safe harbor election.” If you want to get technical, the election can be found at Treasury Regulation Section 1.263(a)-1(f), and provides that items under $2,500 per unit can be expensed if this election is made and your company accounting records are also in compliance (see next heading). Before the Tax Cuts and Jobs Act, this election did not apply to inventory.
As a result of the Tax Cuts and Jobs Act, either deliberately or inadvertently, Congress provided that when small businesses meeting the $25 Million gross receipts test use the cash method of accounting they can also elect to treat inventory as “non-incidental materials and supplies.” What’s the big deal with this you might ask? When you apply the “de minimis safe harbor election” to “non-incidental materials and supplies,” companies can then expense all items under $2,500 per unit if properly accounted for. That’s right, the “de minimis safe harbor election” that allows all companies to expense items under $2,500 per item also applies to “non-incidental materials and supplies.” There are also a number of rules here that are highly technical in nature dealing with the definition of inventory and definition of items qualifying for the “de minimis safe harbor election” that are beyond the scope of this article. Companies should consult with a knowledgeable CPA about these.
The “de minimis safe harbor election” is a very simple election that companies can have their CPAs make on their annual tax returns. The election to treat inventory as “non-incidental materials and supplies” on the other hand is not so simple. This election requires a change in accounting method with the IRS on a Form 3115. Again, just as with the change from the accrual method to the cash method noted above, the IRS has provided for a simplified Form 3115 filing requirement for small businesses making this change.
Required Financial Reporting
Ok, your company is now on the cash basis for tax purposes, filed the change in accounting method to elect to treat inventory as “non-incidental materials and supplies,” and ready to include the “de minimis safe harbor election” on your annual tax return. You still aren’t home free! There are a few more considerations before you can claim that big tax write off for all the inventory you purchased last year (instead of leaving it out on the balance sheet only to deduct whenever it’s sold to customers).
The magic that makes all of the above work is a little bookkeeping and financial reporting. To expense all your company purchases under $2,500 per unit using the “de minimis safe harbor election,” the Regulations mandate that you also expense these items on your financial statements and not just your tax returns. If your small business has no requirements to issue GAAP basis financial statements (audit, review, compilation) there may be an opportunity to implement this strategy. If you are required to issue GAAP financials, or for some other reason can’t expense inventory as purchased on your financials, you will be prevented from using this strategy. GAAP will not allow a company to expense inventory; instead, ending inventory under GAAP must stay on the company balance sheet and be expensed as it is sold.
If your company is like many small businesses with no external stakeholders to be accountable to, and you don’t mind expensing inventory as purchased, you may have an opportunity to expense all inventory otherwise sitting on your balance sheet at year end. To clarify, the rules dictate that you expense inventory on your financials – they do not prevent you from tracking inventory as you always have for your internal management purposes. The unit cost of each item must be included on the invoice from your vendors as well. Best practice would be to create an internal written accounting policy to expense all inventory purchases. Additional rules apply to labor and materials of manufacturing companies that produce their own inventory for sale to customers.
Putting It All Together
As you can see, the expansion of using the cash method of accounting for small business coupled with allowing small companies to elect to treat inventory as “non-incidental materials and supplies” may provide a large tax benefit when coupled with the “de minimis safe harbor election.” According to Donna Beatty, CPA, the tax professional industry is anxiously waiting on further guidance on this issue. In fact, the American Institute of Certified Public Accountants (AICPA) submitted their recommendation on the above issue to tax policy makers in Washington in a letter dated July 23, 2018. The AICPA recommended that the IRS and Treasury permit a small taxpayer to make a “de minimis safe harbor election” that would allow them to expense inventory. Although still awaiting further guidance, the way the law is currently written, some believe many small business taxpayers will take advantage of this potential loophole and expense all of their inventory. For example, we may see many small local retailers with maybe $100,000 – $200,000 of inventory at December 31, 2018 completely expense those amounts using this strategy –that would provide an average Federal tax savings of $37,000 – $74,000 (even more considering state income tax). Companies with a bit larger inventory of lower priced items under $2,500 per unit would experience even higher tax savings –and may even create taxable losses.
There are a number of rules and items not mentioned in this article, especially how the above might apply to production labor and overhead costs applicable to manufacturing companies. Accounting method changes, tax elections, and tax returns all have deadlines and must be properly and timely filed and reported – that could all impact the strategy discussed above. As with anything tax related, there are probably other unique items related to your business that would affect the tax strategy discussed in this article. This is a highly technical area of tax law which is very fluid, and this article may not be cited as authority, and is no substitute for counsel with your tax attorney or CPA.
How Can Frazier & Deeter help? Involve Frazier & Deeter early in the process of working through this tax strategy to determine if you qualify, and help to quantify the tax savings and potential risks.
If you have questions regarding this strategy or any other tax planning strategies feel free to reach out to one of the Frazier & Deeter Tax professionals: Andrew Moore at 404-573-4336 (Andrew.Moore@FrazierDeeter.com) or Donna Beatty at 404-573-4098 (Donna.Beatty@Frazier.Deeter.com).Read More