The Tax Cuts and Jobs Act (TCJA) increased the number of taxpayers eligible to use the cash method of accounting. The TCJA also expanded the threshold for small businesses to use the cash method of accounting, which now includes those with average annual gross receipts for the prior three-year period of $25 million or less. This increase was significant from the previous thresholds of $5 or $10 million. On August 3, 2018, the IRS issued Revenue Procedure 2018-40, which provides the procedures by which an eligible small business can change their method of accounting to cash and obtain automatic consent. Taxpayers still need to notify the IRS by filing Form 3115 with their federal return, but they do not need to get prior approval to make the change.
Any eligible small business on an accounting method other than the cash method should consider a change to the cash method. The transition to a cash method could provide significant tax savings and/or deferrals to the business. However, it can be challenging to understand how to convert from a non-cash method to a cash method of accounting for tax purposes. Revenue Procedure 2018-40 has two sets of procedures to change from the accrual method to cash method.
The first conversion method is for taxpayers not subject to Section 460 (long-term contracts) that want to change to the cash method in 2018. This is best explained in two steps.
Step 1 of converting to the cash method of accounting
- Start from an accrual-based book’s net income and subtract the end-of-year (EOY) accounts receivable balance, EOY prepaid expense balance, beginning-of-year (BOY) accounts payable balance, and BOY accrued expenses balance.
- Add BOY accounts receivable balance, BOY prepaid expense balance, EOY accounts payable balance, and EOY accrued expenses balance. This converts the current year accrual basis net income into a cash basis net income.
Step 2 of converting to the cash method of accounting
- Calculate the 481(a) adjustment. To do this, start with 0 and subtract the BOY accounts receivable balance, subtract the BOY prepaid expense balance, add the BOY accounts payable balance and add BOY accrued expenses balance. If this is a positive number, then you can spread the adjustment over 4 years. If this is a negative number, you can take entire 481(a) adjustment in year 1.
The second conversion method is for taxpayers that are subject to Section 460, which means they will likely use percentage of completion accounting method. These taxpayers will use the cut-off method when changing from accrual to the cash method. Instead of going through the calculations above, these taxpayers simply start treating any new job that started after January 1, 2018 on the cash method and any old job that started prior to January 1, 2018 as percentage of completion.