Limitation on use of cash method of accounting
Under the proposal, the cash method would be allowed only for taxpayers with average annual gross receipts of $10 million or less. Taxpayers with more than $10 million would be required to use the accrual method of accounting. Current-law exceptions would continue to apply for farming businesses and sole proprietors.
The provision would be effective for tax years beginning after 2014, and any positive adjustments to income resulting from the provision would be recognized in income in increasing increments over four years beginning in 2019 (or earlier, at the election of the taxpayer).
The proposed provisions would deny the cash method to a broader range of taxpayers (e.g., personal service corporations, partnerships with no inventory and no C corporation partners, etc.). According to the discussion draft, the provision is intended to strike a balance between the objectives that income be clearly reflected but that respects small business taxpayers’ need for simplicity.
Certain special rules for tax year of inclusion
Under this provision, a taxpayer on the accrual method of accounting for tax purposes would be required to include an item of income no later than the tax year in which such item is included for financial statement purposes. The provision also would provide that cash and accrual method taxpayers may defer the inclusion of advance payments for certain goods and services in income for tax purposes up to only one year (but not longer than any deferral for financial statement purposes).
Additionally, the provision would repeal special exceptions for crop insurance proceeds and disaster payments, livestock sales, and utility-restructuring transactions.
With some exceptions, the provision would be generally be effective for tax years beginning after 2014, with any adjustments resulting from accounting-method changes taken into account over the four years following the effective date.
This provision would affect any item for which tax deferral is currently allowed past the time that the income is included for financial statement purposes—for example, credit card fees and loan fees treated as original issue discount (OID).
Amortization of certain advertising expenses
Under the proposed provision, 50% of certain advertising expenses (over a $1 million threshold which would phase out starting at $1.5 million) would be currently deductible and 50% would be amortized ratably over a 10-year period. The provision would be effective for amounts paid or incurred in tax years beginning after 2014, but would be phased in for tax years beginning before 2018.
For this purpose, advertising expenses would include any amount paid or incurred for development, production, or placement (including any form of transmission, broadcast, publication, display, or distribution) of any communication to the general public intended to promote the taxpayer’s trade or business (including any service, facility, or product provided pursuant to such trade or business). In addition, advertising expenses would include wages paid to employees primarily engaged in activities related to advertising and the direct supervision of employees engaged in such activities. Advertising expenses, however, would not include: depreciable property, amortizable section 197 intangibles, discounts, certain communications on the taxpayer’s property, the creation of logos (and trade names), marketing research, business meals, and qualified sponsorship payments.
Under the proposed provision, no deduction of unamortized expenses would be allowed if any property with respect to which amortizable advertising expenses are paid or incurred is retired or abandoned during the 10-year amortization period. In addition, the current regulatory exception permitting the immediate deduction of package design costs would be repealed, and such costs would be capitalized into the cost of producing the packaging and recovered as the packaging (and products the packaging contains) are sold.
The provision would be effective for amounts paid or incurred in tax years beginning after 2014.
The Joint Committee on Taxation (JCT) has estimated that this provision would increase revenues by $169.0 billion from 2014 to 2023. Although the provision attempts to define “advertising” for this purpose, there would undoubtedly be uncertainty and controversy as to what costs fall into this bucket.
Under current law, sales accounted for on the installment method are subject to an interest charge on the resulting tax deferral to the extent that the taxpayer’s aggregate installment sales exceed $5 million.
The proposed provisions would eliminate the $5 million aggregation rule and subject any installment sale in excess of $150,000 to the interest charge rules. Special rules related to the sale of farm property, timeshares, and residential lots would also be eliminated. The provision would be effective for sales and other dispositions after 2014.
Under the proposed provision, the completed contract method of accounting (CCM) would be limited to construction contracts estimated to be completed within two years for taxpayers with average gross receipts of $10 million or less over a three-year period.
Exceptions for the use of the percentage of completion method for multi-unit housing and ship building contracts would be also repealed. The provision would be effective for contracts entered into after 2014.
While existing law allows large construction companies that are home builders to benefit from using the CCM, the proposed provision would limit the application of the method to small business construction contractors.
Expenditures for repairs in connection with casualty losses
Under the provision, taxpayers could elect either to claim a casualty loss for damaged property (with a corresponding decrease to the property’s basis) or to deduct the costs to repair such property, but not both. The provision would be effective for losses sustained after 2014.
The discussion draft states that, under current law, taxpayers have taken the position that both a casualty-loss deduction and the deduction for amounts paid or incurred for repairs may be claimed with respect to the same property damaged in a natural disaster. However, recently issued final regulations under 263(a) (effective for tax years beginning after 2013) provide that otherwise deductible repairs to property damaged in a casualty event do not have to be capitalized unless they exceed the adjusted basis of the property. Further, proposed regulations relating to dispositions of tangible property would make the recognition of a casualty loss mandatory.
Repeal of last-in, first-out (LIFO) inventory method
The proposal would repeal the use of the LIFO method for tax years beginning after December 31, 2014.
Taxpayers would be required to change their method of inventory accounting, resulting in the inclusion of income of prior years’ LIFO reserves (the amount deferred under the LIFO method). The resulting section 481(a) adjustment, which is a one-time increase in gross income, would be taken into account over a four year period beginning with its first tax year after 2018, as follows—10% in 2019; 15% in 2020; 25% in 2021; and 50% in 2022.
An election could be made to elect to begin the four-year inclusion period in an earlier tax year. Special rules would apply for closely held entities (generally defined as having no more than 100 owners as of February 26, 2014), which would subject them to a reduced 7% tax rate on their LIFO reserves.
The repeal of LIFO would have the effect of triggering the deferred tax liability inherent in the LIFO inventory accounting method. The transition rule, allowing delayed inclusion of the LIFO reserve over a four-year period, is intended to mitigate the impact of the inclusion.
Aside from the proposal, if use of the International Financial Reporting Standards (IFRS) becomes mandatory, companies would be forced to discontinue using the LIFO method for financial reporting purposes, and as a consequence would be precluded from using the LIFO method for tax purposes due to the book conformity requirement.
JCT has estimated that this provision would increase revenues by $79.1 billion from 2014 to 2023.
Repeal of lower of cost or market (LCM) inventory method
The proposal would repeal the use of the LCM method (inclusive of the write-down of subnormal goods) for tax years beginning after December 31, 2014. Taxpayers would be required to change their method of determining the value of their ending inventory.
Any resulting positive section 481(a) adjustment would be taken into income over a four-year period beginning after 2018, as follows—10% in 2019; 15% in 2020; 25% in 2021; and 50% in 2022.
An election could be made to elect to begin the four-year inclusion period prior to 2019.
Modification of rules for capitalization and inclusion in inventory of certain expenses
Under this proposed provision, the exception to the uniform capitalization (UNICAP) rules for businesses with average annual gross receipts of $10 million or less that acquire property for resale would be expanded to include all types of property (e.g., real property and tangible personal property), whether produced or acquired by the taxpayer.
In addition, the provision would repeal the special exceptions for timber and certain trees, and for free-lance authors, photographers and artists. However, the provision’s expanded exemption from the UNICAP rules for qualifying businesses would still apply in these cases.
These changes would be effective for tax years beginning after 2014.
JCT has estimated that this provision would reduce revenues by $4.5 billion from 2014 to 2023.
Repeal of section 199 (deduction for income attributable to domestic production activities)
Under this proposed provision, the deduction for domestic production activities provided under section 199 would be phased out. The available deduction would be reduced to 6% for tax years beginning in 2015 and 3% for tax years beginning in 2016.
The deduction would be repealed and no longer available for tax years beginning after 2016.
The original intent of the section 199 deduction was to provide a corporate rate reduction that would allow U.S. companies to compete against international tax systems (while also drawing international companies to the United States and its tax structure). While this proposed provision would eliminate the rate reduction created by section 199, a separate provision of the discussion draft proposes an overall corporate rate reduction. JCT has estimated that this provision would increase revenues by $115.8 billion from 2014 to 2023.
Amortization of research and experimental expenditures
Under the proposed provision, all section 174 research and experimentation (R&E) expenses would be required to be capitalized and amortized over five years, beginning at the midpoint of the year paid or incurred.
Expenditures paid or incurred outside the United States, Puerto Rico, or a U.S. possession would be amortized over 15 years. The amortization period would continue regardless of whether there was a disposition of such property (i.e., retirement or abandonment).
Additionally, expenditures incurred for the development of software would be treated as section 174 R&E expenses and therefore subject to five-year amortization.
The provision would be effective for amounts paid or incurred in tax years beginning after 2014, and taxpayers would have the option of electing to apply the five-year amortization rule to all R&E expenses immediately, or phase-in as follows:
- For tax years beginning in 2015, a taxpayer could expense 60% and amortize 40% over two years
- For tax years beginning in 2016-2017, a taxpayer could expenses 40% and amortize 60% over three years
- For tax years beginning in 2018-2020, a taxpayer could expense 20% and amortize 80% over four years
When adding together the current year deductible amount with the amortizable expense amount (from prior years), the formula, in effect, permits a deduction of at least 80% of the amount that is deductible under current law.
Existing law allows an election to currently deduct certain R&E expenditures paid or incurred in connection with a trade or business. Under the proposed provision, this election would be considered repealed—as all R&E expenditures would be required to be capitalized and amortized. Additionally, although other sections of the discussion draft propose to remove software development expenses from qualification under the section 41 research credit (see discussion below), such software development expenses are includable as R&E expenses under section 174; however, such costs consequently would be subject to five-year amortization rather than current year deduction.
Another provision in the discussion draft would repeal an election that allows a taxpayer to choose each year to amortize all or a portion of its R&E expenditures, rather than expensing them, over a 10-year period.
Denial of deduction under section 174 for stock transferred pursuant to an incentive stock option (ISO)
Under this provision, the rules with respect to ISO plans and employee stock purchase plans (ESPP) would be clarified to deny a deduction under any provision of the Code for a transfer of stock to an individual under such plans.
Under current law, an employer that transfers stock to an individual pursuant to an ISO plan or ESPP may not claim a deduction as an ordinary and necessary business expense. Nonetheless, some taxpayers have taken the position that a deduction is permitted for wages paid with respect to research expenditures under section 174.
Research credit modified and made permanent
This proposed provision would modify and make permanent the research credit provided by section 41 and make the Alternative Simplified Credit (ASC) the only methodology available for calculating the credit. The general 20% credit would be repealed, as well as the 20% credit for amounts paid for basic research and the 20% credit for amounts paid to an energy research consortium.
Under this proposed provision, the research credit would equal:
- 15% of the qualified research expenses for the tax year that exceed 50% of the average qualified research expenses for the three tax years preceding the tax year for which the credit is determined, plus
- 15% of the basic research payments for the tax year that exceed 50% of the average basic research payments for the three tax years preceding the tax year for which the credit is determined.
The proposed provision would retain the rule under the ASC that allows a taxpayer to claim a reduced research credit if the taxpayer has no qualified research expenses in any one of the three preceding tax years. In these situations, taxpayers would be allowed a credit of 10% of the qualified research expenditures incurred in the tax year for which the credit is determined.
This proposed provision would also make changes to the type and amount of certain costs that can be claimed as qualified research expenditures. Amounts paid for supplies or for the development of computer software would no longer qualify as qualified research expenses.
In addition, the special rule allowing 75% percent of amounts paid to a qualified research consortium and 100% percent of amounts paid to eligible small businesses, universities, and federal laboratories to qualify as contract research expenses would be repealed. However, these amounts would still qualify as contract research expenses subject to the 65% inclusion rule.
Finally, this provision would repeal the election under section 280C(c) to claim a reduced research credit in lieu of reducing deductions otherwise allowed.
These changes would be effective for tax years beginning after 2013, and for amounts paid and incurred after 2013.
Making the ASC the only methodology available for calculating the credit is generally expected to eliminate some of the administrative burdens and controversy that has been associated with the general credit methodology. Further, a permanent research credit would provide businesses with greater certainty of available tax incentives when considering investments in research and development.
This proposed provision would eliminate the 20% credit provided under the general methodology while only increasing the credit available under the ASC methodology from 14% to 15%. Given this and the proposed removal of certain expenditures such as supplies from the research credit calculation, taxpayers that have historically used the general credit methodology may experience significant decreases in their research credit amounts as they move to the ASC.
Repeal of credit for clinical testing expenses for certain drugs for rare diseases or conditions
The discussion draft proposal would repeal the “orphan drug tax credit.” The provision would be effective for amounts paid or incurred in tax years beginning after 2014.
Qualifying clinical testing expenses that would have otherwise been qualifying under the orphan drug credit, may be eligible as qualifying research expenses under the section 41 research credit. Furthermore, taxpayers that previously may not have claimed a section 41 research tax credit (either due to more benefit under the orphan drug credit or due to not generating a section 41 research tax credit as result of an inflated base amount due to the requirement to add back orphan drug credit expenses to the section 41 base amount) may now find benefit under the section 41 research tax credit.
The orphan drug credit has been allowed for some clinical testing expenses outside the United States, if there is an insufficient testing population in the United States. These foreign expenses would not qualify under the research tax credit.
The discussion draft proposal also includes provisions that would:
- Codify the IRS guidance with respect to determining whether a taxpayer has adopted a method of accounting (i.e., use in one tax year for a proper method, use on two consecutive returns for an improper method)
- Repeal the special rules for deferral of prepaid subscription income and prepaid membership dues
- Repeal the special rule for exclusion from gross income of magazines, paperbacks, and records returned after the close of the tax year
- Codify the judicial standards for determining the treatment of patent or trademark infringement awards—i.e., damages constitute ordinary income relating to lost profits unless the taxpayer can demonstrate that such payments reflect damages relating to impairment of capital (i.e., goodwill)
- Allow for recovery of environmental remediation costs ratably over 40 years beginning with the tax year paid or incurred
- Allow for recovery of circulation expenditures for newspapers, magazines or other periodicals over 36 months
- Unify the deduction for start-up and organization expenditures, and increase the first-year deductible amount to $10,000.
- Repeal the recurring item exception for spuddng of oil and gas wells
- Repeal the special rules for recoveries of damages from antitrust violations
- Repeal the deduction for local lobbying expenses
- Repeal the special 20% tax rate for nuclear decommissiong reserve funds
- Repeal the averaging to compute tax liability of farming income
- Repeal the redundant rules with respect to the election to capitalize taxes and carrying charges under section 266
- Repeal the provisions relating to Empowerment Zones and Enterprise Communities, DC Zones, renewal communities, and various short-term regional benefits
- Repeal the the qualifying therapeutic discovery project credit
- Repeal section 118 (regarding exclusion of non-shareholder contributions to capital)
- Modify the net operating loss (NOL) rules
- Extend the amortization period for section 197 intangibles
For more information, contact a tax professional with KPMG’s Washington National Tax Income Tax and Accounting group:
For more information about the R&E expense and credit provisions, contact: