Td 9942

254
§ 212.40

Federal Register / Vol. 86, No. 2 / Tuesday, January 5, 2021 / Rules and Regulations
Use of guidance documents.

Guidance documents cannot create
binding requirements that do not
already exist by statute or regulation.
Accordingly, non-compliance with
guidance documents cannot be used as
a basis for proving violations of
applicable law. Guidance documents
can do no more, with respect to
prohibition of conduct, than articulate
USAID’s understanding of how a statute
or regulation applies to particular
circumstances.
Ruth Buckley,
Acting Performance Improvement Officer/
Acting Office Director, Bureau for
Management Office of Management Policy,
Budget and Operational Performance.
[FR Doc. 2020–26352 Filed 1–4–21; 8:45 am]
BILLING CODE P

DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 9942]
RIN 1545–BP53

Small Business Taxpayer Exceptions
Under Sections 263A, 448, 460 and 471
Internal Revenue Service (IRS),
Treasury.
ACTION: Final regulations.
AGENCY:

This document contains final
regulations to implement legislative
changes to sections 263A, 448, 460, and
471 of the Internal Revenue Code (Code)
that simplify the application of those tax
accounting provisions for certain
businesses having average annual gross
receipts that do not exceed $25,000,000,
adjusted for inflation. This document
also contains final regulations regarding
certain special accounting rules for
long-term contracts under section 460 to
implement legislative changes
applicable to corporate taxpayers. The
final regulations generally affect
taxpayers with average annual gross
receipts of not more than $25 million,
as adjusted for inflation.
DATES:
Effective date: The regulations are
effective on January 5, 2021.
Applicability dates: For dates of
applicability, see §§ 1.263A–1(a)(2)(i),
1.263A–1(m)(6), 1.263A–2(g)(4),
1.263A–3(f)(2), 1.263A–4(g)(2), 1.263A–
7(a)(4)(ii), 1.381(c)(5)–1(f), 1.446–1(c)(3),
1.448–2(h), 1.448–3(h), 1.460–1(h)(3),
1.460–3(d), 1.460–4(i), 1.460–6(k), and
1.471–1(c).
FOR FURTHER INFORMATION CONTACT:
Concerning §§ 1.460–1 through 1.460–6,

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SUMMARY:

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Innessa Glazman, (202) 317–7006;
concerning all other regulations in this
document, Anna Gleysteen, (202) 317–
7007.
SUPPLEMENTARY INFORMATION:
Background
This document contains amendments
to the Income Tax Regulations (26 CFR
part 1) to implement statutory
amendments to sections 263A, 448, 460,
and 471 of the Code made by section
13102 of Public Law 115–97 (131 Stat.
2054), commonly referred to as the Tax
Cuts and Jobs Act (TCJA). These
statutory amendments generally
simplify the application of the method
of accounting rules under those
provisions to certain businesses (other
than tax shelters) with average annual
gross receipts that do not exceed
$25,000,000, adjusted for inflation.
The uniform capitalization (UNICAP)
rules of section 263A provide that, in
general, the direct costs and the
properly allocable share of the indirect
costs of real or tangible personal
property produced, or real or personal
property described in section 1221(a)(1)
acquired for resale, cannot be deducted
but must either be capitalized into the
basis of the property or included in
inventory costs, as applicable. Before
the enactment of the TCJA, certain types
of taxpayers and certain types of
property were exempt from UNICAP,
but there was no generally applicable
exemption based on gross receipts.
Section 448(a) generally prohibits C
corporations, partnerships with a C
corporation as a partner, and tax
shelters from using the cash receipts
and disbursements method of
accounting (cash method). However,
section 448(b)(3) provides that section
448(a) does not apply to C corporations
and partnerships with a C corporation
as a partner that meet the gross receipts
test of section 448(c). Prior to the TCJA’s
enactment, a taxpayer met the gross
receipts test of section 448(c) if, for all
taxable years preceding the current
taxable year, the average annual gross
receipts of the taxpayer (or any
predecessor) for any 3-taxable-year
period did not exceed $5 million.
Section 460(a) provides that income
from a long-term contract must be
determined using the percentage-ofcompletion method (PCM). A long-term
contract is defined in section 460(f) as
generally any contract for the
manufacture, building, installation, or
construction of property if such contract
is not completed within the taxable year
in which such contract is entered into.
Subject to special rules in section
460(b)(3), section 460(b)(1)(A) generally
provides that the percentage of

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completion of a long-term contract is
determined by comparing costs
allocated to the contract under section
460(c) and incurred before the close of
the taxable year with the estimated total
contract costs. Prior to the TCJA, section
460(e)(1)(B) provided an exemption
from the PCM for a long-term
construction contract of a taxpayer who
estimated that the contract would be
completed within the 2-year period
from the commencement of the contract
(two-year rule), and whose average
annual gross receipts for the 3-taxableyear period ending with the year
preceding the year the contract was
entered into did not exceed $10 million
(Section 460(e) gross receipts test).
Section 471(a) requires inventories to
be taken by a taxpayer when, in the
opinion of the Secretary of the Treasury
or his delegate (Secretary), taking an
inventory is necessary to determine the
income of the taxpayer. Section 1.471–
1 requires the taking of an inventory at
the beginning and end of each taxable
year in which the production, purchase,
or sale of merchandise is an incomeproducing factor. Additionally, when an
inventory is required to be taken,
§ 1.446–1(c)(1)(iv) and (c)(2) require that
an accrual method be used for
purchases and sales. Prior to the
enactment of the TCJA, there were no
regulatory exceptions from the
requirement to take an inventory under
§ 1.471–1.
The statutory amendments of the
TCJA increase the gross receipts test
amount under section 448(c) to
$25,000,000, adjusted for inflation, for
eligibility to use the cash method and
also exempt taxpayers, other than a tax
shelter under section 448(a)(3), meeting
the gross receipts test (Section 448(c)
Gross Receipts Test) from: (1) The
UNICAP rules under section 263A; (2)
the requirement to use the percentageof-completion method under section
460 provided other requirements of
section 460(e) are satisfied; and (3) the
requirement to take inventories under
section 471(a) if their inventory is
treated as non-incidental materials and
supplies, or if the method of accounting
for their inventory conforms with the
method reflected on their applicable
financial statement (AFS), or if they do
not have an AFS, their books and
records prepared in accordance with
their accounting procedures. These
amendments generally apply to taxable
years beginning after December 31,
2017. The amendments to section 460
apply to contracts entered into after
December 31, 2017, in taxable years
ending after December 31, 2017.
On August 20, 2018, the Department
of the Treasury (Treasury Department)

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Federal Register / Vol. 86, No. 2 / Tuesday, January 5, 2021 / Rules and Regulations
and the IRS issued Revenue Procedure
2018–40 (2018–34 IRB 320), which
provided administrative procedures for
a taxpayer, other than a tax shelter
under section 448(a)(3), meeting the
requirements of section 448(c) to obtain
the consent to change the taxpayer’s
method of accounting to a method of
accounting permitted by section 263A,
448, 460 or 471. The revenue procedure
also requested comments for future
guidance regarding the implementation
of the TCJA modifications to sections
263A, 448, 460, and 471. The record of
public comments received in response
to Revenue Procedure 2018–40 may be
requested by sending an email to
[email protected].
On August 5, 2020, the Treasury
Department and the IRS published a
notice of proposed rulemaking (REG–
132766–18) in the Federal Register (85
FR 47608), correction published in the
Federal Register (85 FR 58307) on
September 18, 2020, containing
proposed regulations under sections
263A, 448, 460, and 471 (proposed
regulations). The proposed regulations
reflect consideration of the comments
that were received in response to
Revenue Procedure 2018–40.
The Treasury Department and the IRS
received nine written comments
responding to the proposed regulations.
The Treasury Department and the IRS
received one request to speak at a public
hearing, which was later withdrawn.
Therefore, no public hearing was held.
Comments received before these final
regulations were substantially
developed, including all comments
received on or before the deadline for
comments on September 14, 2020, were
carefully considered in developing these
final regulations.
Copies of the comments received are
available for public inspection at http://
www.regulations.gov or upon request.
After consideration of the comments
received, this Treasury decision adopts
the proposed regulations as revised in
response to such comments. Those
comments and the revisions are
discussed in the Summary of Comments
and Explanation of Revisions section of
this preamble.
Summary of Comments and
Explanation of Revisions

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I. Overview
This Summary of Comments and
Explanation of Revisions section
summarizes the formal written
comments that were received addressing
the proposed regulations. However,
comments merely summarizing or
interpreting the proposed regulations or
recommending statutory revisions

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255

A. Section 263A(i)

clarification is beyond the scope of
these regulations, which is to
implement section 263A(i) as enacted
by TCJA. For taxpayers that elect under
section 263A(i) to not apply section
263A, the requirement to capitalize
certain costs to self-constructed assets
comes from other provisions of the
Code, such as section 263(a). TCJA did
not amend such provisions and thus the
clarification of permissible
capitalization methods and the types of
costs required to be capitalized to selfconstructed assets under such
provisions is beyond the scope of these
final regulations.

1. Costing Rules for Self-Constructed
Assets
In response to Revenue Procedure
2018–40, a commenter stated that a
small business taxpayer that is
exempted from section 263A pursuant
to section 263A(i) would be subject to
the costing rules prior to the enactment
of section 263A (pre-section 263A
costing rules) for self-constructed assets
used in the taxpayer’s trade or business.
However, according to the commenter,
the pre-section 263A costing rules were
unclear as to what costs are
capitalizable to self-constructed assets.
In light of this comment, the preamble
to the proposed regulations requested
comments on specific clarifications
needed regarding the pre-section 263A
costing rules. Only one comment was
received in response to this request. The
sole commenter noted that one of the
reasons for the enactment of section
263A was that courts had reached
different conclusions as to the types of
costs that were required to be
capitalized under the pre-section 263A
costing rules. Compare Adolph Coors
Co. v. Commissioner, 519 F.2d 1280
(10th Cir. 1975), cert. denied 423 U.S.
1087 (1976) (requiring the full inclusion
of all overhead costs in the cost basis of
self-constructed assets) with Fort
Howard Paper Co. v. Commissioner, 49
T.C. 275 (1967) (requiring only the
inclusion of overhead costs directly
attributable to the self-constructed
asset). The commenter suggested that
taxpayers who used the exemption
under section 263A(i) to not capitalize
costs under section 263A be permitted
to use an incremental costing method to
determine the costs of self-constructed
assets, consistent with the approach in
Fort Howard Paper. The commenter
stated that identifying indirect costs not
directly attributable to the construction
of specific self-constructed assets would
be difficult.
After considering this comment, the
Treasury Department and the IRS have
determined that the requested

2. Changes to Regulations Under Section
448
Under section 448(a)(3), a tax shelter
is prohibited from using the cash
method. Section 448(d)(3) cross
references section 461(i)(3) to define the
term ‘‘tax shelter.’’ Section 461(i)(3)(B),
in turn, includes a cross reference to the
definition of ‘‘syndicate’’ in section
1256(e)(3)(B), which defines a syndicate
as a partnership or other entity (other
than a C corporation) if more than 35
percent of the losses of that entity
during the taxable year are allocable to
limited partners or limited
entrepreneurs. Sections 1.448–1T(b)(3)
(for taxable years beginning before
January 1, 2018) and proposed 1.448–
2(b)(2)(iii) (for taxable years beginning
after December 31, 2017) narrow this
definition by providing that a taxpayer
is a syndicate only if more than 35
percent of its losses are allocated to
limited partners or limited
entrepreneurs. Consequently, a
partnership or other entity (other than a
C corporation) may be considered a
syndicate under section 448 only for a
taxable year in which it has losses.
Proposed § 1.448–2(b)(2)(iii)(B)
permits a taxpayer to elect to use the
allocated taxable income or loss of the
immediately preceding taxable year to
determine whether the taxpayer is a
syndicate under section 448(d)(3) for the
current taxable year. Under the
proposed regulations, a taxpayer that
makes this election must apply the rule
to all subsequent taxable years, and for
all purposes for which status as a tax
shelter under section 448(d)(3) is
relevant, unless the Commissioner
permits a revocation of the election.
Several comments were received
concerning issues related to tax shelters,
including the definition of ‘‘syndicate,’’
under proposed § 1.448–2(b)(2)(i)(B).
Some commenters recommend using the
authority granted under section
1256(e)(3)(C)(v) to provide a deemed
active participation rule to disregard
certain interests held by limited

generally are not discussed in this
preamble. These final regulations
provide guidance under sections 263A,
448, 460, and 471 to implement the
TCJA’s amendments to those provisions.
These final regulations also modify
§§ 1.381(c)(5)–1 and 1.446–1 to reflect
these statutory amendments. The
rationale for provisions in these final
regulations that are not discussed in this
Explanation of Revisions remains the
same as described in the Explanation of
Provisions section of the preamble to
the proposed regulations.

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entrepreneurs or limited partners for
applying the Section 448(c) Gross
Receipts Test if certain conditions were
met. For example, conditions of the rule
could include that the entity had not
been classified as a syndicate within the
last three taxable years, and that the
average taxable income of the entity for
that period was greater than zero.
The final regulations do not adopt this
recommendation. The Treasury
Department and the IRS have
determined that it would be
inappropriate to provide an exception to
the active participation rules in section
1256(e)(3)(C)(v) by ‘‘deeming’’ active
participation for small business
taxpayers. The Treasury Department
and the IRS believe that the deeming of
active participation in this context
would be overbroad and would run
counter to Congressional intent.
Sections 448(b)(3) and (d)(3), 461(i)(3)
and 1256(e)(3)(C) were not modified by
the TCJA, and the legislative history to
section 13012 of the TCJA does not
indicate any Congressional intent to
modify the definition of ‘‘tax shelter’’ or
‘‘syndicate.’’ By not modifying those
provisions, Congress presumably meant
to exclude tax shelters, including
syndicates, from being eligible to use
the cash method of accounting and the
small business taxpayer exemptions in
section 13102 of the TCJA, even while
otherwise expanding eligibility to meet
the Section 448(c) Gross Receipts Test.
Other comments requested
clarification generally of what ‘‘active
participation’’ means and the
circumstances, if any, under which a
member of a limited liability company
is treated as a ‘‘limited partner’’ or
‘‘limited entrepreneur’’ under section
461(k)(4). The Treasury Department and
the IRS have determined that such
guidance is outside the scope of these
final regulations, which are to
implement the changes made by section
13102 of the TCJA.
The Treasury Department and the IRS
remain aware of the increased relevance
of the definition of tax shelter under
section 448(d)(3) after enactment of the
TCJA and the practical concerns
regarding the determination of tax
shelter status for the taxable year. To
ameliorate these practical concerns,
these final regulations modify the
syndicate election provided in proposed
§ 1.448–2(b)(2)(iii)(B) to provide
additional relief by making the election
an annual election. The Treasury
Department and the IRS have
determined that an annual election
appropriately balances the statutory
language with the consistency
requirement for use of a method of
accounting under section 446(a) and

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§ 1.446–1. A cash method taxpayer that
is generally profitable year-to-year may
experience an unforeseen taxable loss
for an anomalous year but return to its
profitable position in subsequent years.
If the taxpayer allocated more than 35
percent of the taxable loss to limited
partners or limited entrepreneurs, the
taxpayer would be required to change
from the cash method to another
method for the anomalous year in
accordance with section 448(a)(3).
However, that taxpayer would otherwise
not be prohibited under section
448(a)(3) to use the cash method in the
next profitable taxable year. An annual
election under § 1.448–2(b)(2)(iii)(B)
allows a taxpayer to elect in the loss
year to use the allocated taxable income
or loss of the immediately preceding
taxable year to determine whether the
taxpayer is a syndicate under section
448(d)(3) for the current taxable year.
The Treasury Department and the IRS
have determined that permitting
taxpayers to continue to use the cash
method, as well as other methods
impacted by a determination under
section 448(d)(3), in such situations is
consistent with the requirements under
section 446(a).
This election applies for all
provisions of the Code that specifically
refer to section 448(a)(3) to define tax
shelter, such as the small business
exemptions under sections 163(j)(3),
263A(i)(1), 460(e)(1)(B) and 471(c)(1). A
taxpayer is required to file a statement
with the original timely filed Federal
income tax return, with extensions, to
affirmatively make this election under
§ 1.448–2(b)(2)(iii)(B) for such taxable
year. The election is valid only for the
taxable year for which it is made, and
once made, cannot be revoked. The
Treasury Department and the IRS intend
to issue procedural guidance to address
the revocation of an election made
under proposed § 1.448–2(b)(2)(iii)(B) as
a result of the application of the final
regulations.
Other commenters noted for some
taxpayers who took advantage of the
small business exception in section
448(b)(3) to change to the cash method,
the change in method of accounting
resulted in a negative section 481(a)
adjustment, which triggered an
allocated loss and made the taxpayer a
tax shelter under section 448(a)(3). As a
result, the taxpayers became ineligible
to use the cash method for the year in
which the negative section 481(a)
adjustment was recognized but may be
otherwise eligible to use the cash
method for future years. Under
proposed § 1.448–2(g)(3), these
taxpayers would be ineligible for the
automatic change procedures to make a

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subsequent change back to the cash
method once they are no longer tax
shelters within a five-year period. The
commenters recommend relief for
taxpayers with this situation.
The commenters propose an
exception to the tax shelter rules for a
taxpayer that satisfies the Section 448
Gross Receipts Test if a negative section
481(a) adjustment from a change in
method of accounting under the small
business taxpayer exemptions (for
example, sections 263A(i), 471(c),
448(b)) results in the taxpayer being
considered a tax shelter under section
448(d)(3) and proposed § 1.448–
2(b)(2)(iii). These final regulations do
not adopt this suggestion. As described
in the Preamble to the proposed
regulations, the Treasury Department
and the IRS have determined that no
exception was provided in the TCJA to
limit the definition of tax shelter in
section 448(d)(3) for taxpayers making
method changes related to the small
business taxpayer exemptions.
However, the Treasury Department and
the IRS expect that the annual election
under § 1.448–2(b)(2)(iii)(B), described
earlier, will provide relief for many
taxpayers in this situation.
Additionally, the Treasury
Department and the IRS have
reconsidered the 5-year restriction on
automatic method changes in light of
these comments. Section 446(a),
unmodified by the TCJA, provides that
taxable income shall be computed under
the method of accounting on the basis
of which the taxpayer regularly
computes his income in keeping his
books. A taxpayer that changes its
method of accounting for the same item
with regular frequency (for example,
annually or every other taxable year) is
not adhering to the consistency
requirement of section 446. The
consistency requirement of section
446(a) is distinct from the authority
granted the Commissioner under section
446(b) to determine whether the method
of accounting used by a taxpayer clearly
reflects income. See e.g., Advertisers
Exchange, Inc. v. Commissioner, 25 T.C.
1086, 1092 (1956) (‘‘Consistency is the
key and is required regardless of the
method or system of accounting used.’’)
(citations omitted); Huntington
Securities Corporation v. Busey, 112
F.2d 368, 370 (1940) (‘‘. . . whatever
method the taxpayer adopts must be
consistent from year to year unless the
Commissioner authorizes a change.’’)
The Treasury Department and the IRS
are aware that the 5-year restriction in
proposed § 1.448–2(g)(3) could be
burdensome for a small business
taxpayer that was required to change
from the cash method as a result of

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section 448(a)(3) or not meeting the
Section 448 Gross Receipts Test in a
taxable year but that becomes eligible to
use the cash method under section 448
in the subsequent taxable year.
Proposed § 1.448–2(g)(3) would have
required this small business taxpayer to
request consent to change back to the
cash method using the non-automatic
change procedures in Revenue
Procedure 2015–13 (or successor). These
final regulations remove the 5-year
restriction on making automatic method
changes for certain situations.
Sections 263A(i)(3), 448(d)(7),
460(e)(2)(B) and 471(c)(4) provide that
certain changes in method of accounting
for the small business exemptions are
made with the consent of the Secretary.
A taxpayer must follow the applicable
administrative procedures related to a
change in method of accounting
notwithstanding the deemed consent of
the Secretary. See, e.g., Capital One
Financial Corporation and Subsidiaries
v. Commissioner of Internal Revenue,
130 T.C. 147, 157 (2008) (‘‘a taxpayer
forced to change its method of
accounting under section 448 must still
file a Form 3115 with its return’’). The
Treasury Department and the IRS intend
to provide procedural rules relating to
changes in method of accounting to
implement the final regulations using
the automatic method change
procedures of Revenue Procedure 2015–
13. Those procedural rules will address
whether a waiver of the 5-year overall
method eligibility rule in section
5.01(1)(e) of Revenue Procedure 2015–
13 is appropriate for small business
taxpayers that were required to change
from the cash method in one taxable
year but are not subsequently limited by
section 448.
The Treasury Department and the IRS
have determined that taxpayers that are
voluntarily changing (that is, not
required by section 448 to no longer use
the cash method) between overall
methods are distinguishable from
taxpayers that are required to change
from the cash method to another
method because they no longer meet the
Section 448(c) Gross Receipts Test or
become a tax shelter under section
448(d)(3). The procedural guidance is
expected to address both fact patterns.
Additionally, the Treasury Department
and the IRS intend for the procedural
guidance to address similar fact patterns
for taxpayers making changes related to
the regulations under sections 263A(i),
460(e)(1)(B) and 471(c), as discussed in
this Summary of Comments and
Explanation of Revisions.

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3. Section 471 Small Business
Taxpayer Exemptions
A. Inventory Treated as Non-Incidental
Materials and Supplies
The preamble to the proposed
regulations notes that the Treasury
Department and the IRS interpret the
statutory language of section
471(c)(1)(B) to mean that the property
excepted from section 471(a) by that
provision continues to be inventory
property even though the general
inventory rules under section 471(a) are
not required to be applied to that
property. Section 471(c)(1)(B) provides
that a qualifying taxpayer’s ‘‘method of
accounting for inventory for such
taxable year’’ (emphasis added) will not
be treated as failing to clearly reflect
income if the method ‘‘treats inventory
as non-incidental materials and
supplies’’ (emphasis added). The
Treasury Department and the IRS read
the repeated use of the word
‘‘inventory’’ to mean that Congress
intended that inventory property
remains inventory property while
relieving taxpayers from the general
inventory rules of section 471(a). To
reduce confusion about the nature of
property treated as non-incidental
materials and supplies under section
471(c)(1)(B)(i), these final regulations
refer to the method under that provision
of the Code as the ‘‘section 471(c) NIMS
inventory method.’’
The Treasury Department and the IRS
interpret section 471(c)(1)(B)(i) as
providing three distinct benefits for
taxpayers. First, the provision
significantly expanded the types of
taxpayers permitted to treat their
inventory as non-incidental materials
and supplies. Under prior
administrative guidance, as discussed
later in section 3.A.i of this Summary of
Comments and Explanation of
Revisions, taxpayers with gross receipts
of no more than $1 million and
taxpayers in certain industries
(generally not producers or resellers)
with gross receipts of no more than $10
million were permitted to treat their
inventory as non-incidental materials
and supplies. Section 471(c) greatly
expanded the availability of this method
of accounting to taxpayers in all types
of trades or businesses, including
producers and resellers, by reference to
the increased cap on gross receipts
under the Section 448(c) Gross Receipts
Test. Second, treating inventory as nonincidental materials and supplies under
§ 1.471–1(b)(5) provides simplification
and burden reduction for taxpayers by
requiring only certain costs to be
capitalized to inventory. For example, a
taxpayer using the section 471(c) NIMS

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257

inventory method does not capitalize
direct labor costs or any indirect costs
to inventory costs. See discussion of
direct labor costs later in section 3.A.iii
of this Summary of Comments and
Explanation of Revisions. Simplification
does not indicate that the nature of the
property was changed by the TCJA, or
that the intent of Congress was to
provide immediate expensing of
inventory costs. Thirdly, taxpayers,
other than a tax shelter under section
448(a)(3), treating inventory as nonincidental materials and supplies under
§ 1.471–1(b)(5) are eligible to use the
overall cash method of accounting for
purchases and sales of merchandise,
rather than being required to use an
accrual method. See § 1.446–1(a)(4)(i).
i. Definition of the Term ‘‘Used or
Consumed’’
The preamble to the proposed
regulations provides that the Treasury
Department and IRS interpret section
471(c)(1)(B)(i) as generally codifying the
administrative guidance existing at the
time of its enactment (that is, Revenue
Procedure 2001–10 (2001–2 IRB 272)
and Revenue Procedure 2002–28 (2002–
18 IRB 815)) and making that method
available to significantly more
taxpayers. Accordingly, the proposed
regulations provided that items of
inventory treated as materials and
supplies under section 471(c) are used
or consumed in the taxable year in
which the taxpayer provides the item to
a customer, and the cost of such item is
recovered in that taxable year or the
taxable year in which the taxpayer pays
for or incurs such cost, whichever is
later.
Comments were received on the
definition of ‘‘used or consumed’’ in
proposed § 1.471–1(b)(4)(i) as it relates
to producers. A commenter asserted that
the meaning of the term ‘‘used or
consumed’’ for a producer using the
section 471(c) NIMS inventory supplies
method should be consistent with the
meaning of the term ‘‘used or
consumed’’ in § 1.162–3. The
commenter states that a producer’s raw
materials are ‘‘used or consumed’’ when
the raw materials enter the taxpayer’s
production process. The commenter
states that under section 471(c)(1)(B)(i)
and § 1.162–3(a)(1), only section 263A
would limit a producer’s ability to
recover the cost of its raw materials
when the raw materials are first used in
the production process, and the final
regulations should be modified to
provide that a producer does not wait
until the finished product is provided to
a customer to recover the costs of its raw
materials. In addition, the commenter
states that the policy considerations

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underlying this provision were to
provide small business taxpayers with
simplification, and the definition of
‘‘used or consumed’’ for producers in
proposed § 1.471–1(b)(4)(i) does not
result in simplification.
The Treasury Department and IRS
decline to change the definition of used
or consumed for a producer in these
final regulations. As discussed
previously, the Treasury Department
and the IRS interpret section
471(c)(1)(B)(i) as generally codifying the
administrative guidance existing at the
time of enactment of TCJA (that is,
Revenue Procedure 2001–10 and
Revenue Procedure 2002–28) and
making it applicable to significantly
more taxpayers, in addition to the other
benefits discussed in section 3.A of this
Summary of Comments and Explanation
of Revisions. The commenter’s
recommendation that the term ‘‘used or
consumed’’ for a producer should be
treated as occurring when the raw
material is used or consumed in the
taxpayer’s production process would
allow a producer to recover production
costs earlier than was previously
allowed under the administrative
guidance of Revenue Procedure 2001–10
and Revenue Procedure 2002–28.
Additionally, the commenter’s
recommendation suggests that the term
‘‘used or consumed’’ should be
interpreted literally by looking to actual
use or consumption by the taxpayer.
However, under such an interpretation
a reseller, unlike a producer, would not
be able to recover any inventory costs as
a reseller does not acquire raw materials
for use in a production process nor does
it use or consume finished inventory;
rather a reseller acquires and resells
finished inventory, unchanged, to
customers. The Treasury Department
and the IRS have determined that the
statute and legislative history do not
support a reading of the provision that
would provide such a disparity in the
recovery of inventory costs between
producers and resellers.
In addition, the commenter’s
argument interprets the words
‘‘inventory treated as non-incidental
materials and supplies’’ to mean that the
components used to produce the
finished goods inventory, rather than
the finished goods inventory itself, are
treated as materials and supplies. The
interpretation advocated by the
commenter would result in producers
being permitted to recover the cost
inputs of their units of inventory in the
same manner as they recover the costs
of their materials and supplies (that is,
when the cost input is used or
consumed in producing the unit of
inventory). The Treasury Department

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and the IRS do not believe Congress
intended to break down the traditional
definition of the word ‘‘inventory,’’
particularly since that position benefits
only a certain group of taxpayers
(producers). The Treasury Department
and the IRS determined that the
definition for used or consumed should
provide an equitable rule for the timing
of the recovery of the inventory between
producers and resellers. Accordingly,
these final regulations adopt the
proposed regulations without change.
ii. De Minimis Safe Harbor Under
§ 1.263(a)–1(f)
Several comments were received
regarding the applicability of the de
minimis safe harbor under § 1.263(a)–
1(f) (de minimis safe harbor) to
inventory treated as non-incidental
materials and supplies. The commenters
assert that the final regulations should
permit a taxpayer that uses the section
471(c) NIMS inventory method to use
the de minimis safe harbor for its
inventory treated as non-incidental
materials and supplies. The commenters
point to footnote 465 of the Bluebook,
which described the law, both before
and after TCJA, as generally permitting
deduction of the cost of non-incidental
materials and supplies in the taxable
year in which they are first used or are
consumed in the taxpayer’s operations
in accordance with § 1.162–3(a)(1).
Furthermore, under § 1.162–3(a)(1), a
taxpayer may also be able to elect to
deduct such non-incidental materials
and supplies in the taxable year the
amount is paid under the de minimis
safe harbor election under § 1.263(a)–
1(f). General Explanation of Public Law
115–97, at 113 fn. 465.
The Treasury Department and the IRS
were aware of footnote 465 in the
Bluebook when drafting the proposed
regulations, but have a different
understanding of the rule for ‘‘inventory
treated as non-incidental materials and
supplies’’ under Section 471(c)(1)(B)(i)
as explained in section 3.A.i of this
Summary of Comments and Explanation
of Revisions. The Treasury Department
and the IRS interpret section
471(c)(1)(B)(i) as generally codifying the
administrative procedures that
established the non-incidental materials
and supplies method for inventoriable
items, and prior pronouncements of
§§ 1.162–3 and 1.263(a)–1(f) that these
regulations do not apply to inventory
property, including inventory property
treated as non-incidental materials and
supplies. See, e.g., Tangible Property
Regulations—Frequently Asked
Questions, available at https://
www.irs.gov/businesses/small-

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businesses-self-employed/tangibleproperty-final-regulations#Ademinimis.
A commenter states that the de
minimis safe harbor was created after
Revenue Procedure 2001–10 and
Revenue Procedure 2002–28 were
released, and therefore, did not address
the issue of the applicability of the de
minimis safe harbor. The Treasury
Department and the IRS agree with the
timeline described by the commenter.
However, as discussed in the
immediately preceding paragraph, the
IRS’ position on the de minimis safe
harbor has been addressed in a prior
pronouncement. As described
previously in section 3.A of this
Summary of Comments and Explanation
of Revisions, inventory treated as nonincidental materials and supplies
retains its character as inventory
property. The de minimis safe harbor,
which is a regulatory election rather
than a statutory one, does not apply to
inventory. Section 1.263(a)–1(f)(2)(i).
Finally, the Treasury Department and
the IRS note that for amounts paid to
qualify for the de minimis safe harbor,
the amounts must have been expensed
on the taxpayer’s applicable financial
statement or books and records, as
applicable. Sections 1.263(a)–
1(f)(1)(i)(B) and (ii)(B). This applicable
financial statement or books and records
expensing requirement under
§ 1.263(a)–1(f) would be an impediment
to the application of the de minimis safe
harbor under the section 471(c) NIMS
inventory method for taxpayers who
maintain records of their inventory in
their applicable financial statement or
books and records, even if the section
471(c) NIMS inventory method
permitted the use of the de minimis safe
harbor method. In addition, there is no
need for the separate de minimis safe
harbor because small business taxpayers
may use the inventory method provided
in section 471(c)(1)(B) which generally
provides that a taxpayer who expenses
inventory costs in its applicable
financial statement or books and records
may generally expense that cost for
Federal income tax purposes. For
example, a small business taxpayer that
expenses the cost of ‘‘freight-in’’ in its
books and records and wants to expense
the item for Federal income tax
purposes may generally do so using the
non-AFS section 471(c) inventory
method, as permitted by section
471(c)(1)(B)(ii) and discussed later in
section 3.C.ii of this Summary of
Comments and Explanation of
Revisions.
iii. Direct Labor
Proposed § 1.471–1(b)(4)(ii) provides
that inventory costs includible in the

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Federal Register / Vol. 86, No. 2 / Tuesday, January 5, 2021 / Rules and Regulations
section 471(c) NIMS inventory method
are the direct costs of the property
produced or property acquired for
resale. However, an inventory cost does
not include a cost for which a deduction
would be disallowed or that is not
otherwise recoverable, in whole or in
part, but for § 1.471–1(b)(4), under
another provision of the Code.
Some comments were received on the
types of direct costs required to be
included as an inventory cost under the
section 471(c) NIMS inventory method.
These commenters recommended the
final regulations exclude direct labor
costs from the definition of an inventory
cost under proposed § 1.471–1(b)(4)(ii).
The commenters reasoned that the
preamble to the proposed regulation
indicated that section 471(c)(1)(B)(i) was
generally a codification of Revenue
Procedure 2001–10 and Revenue
Procedure 2002–28. However, the
commenters point out that this
administrative guidance did not provide
for direct labor or overhead costs to be
included in the non-incidental materials
and supplies method.
One commenter asserted that
inventory treated as non-incidental
materials and supplies are not inventory
property but are to be characterized as
a material and supply. The commenter
discussed Example 1, in Section III.D of
Notice 88–86 (1988–2 CB 401) to
determine the treatment of nonincidental materials and supplies prior
to the enactment of section 263A.
Example 1 involves an architect
providing design services that include
blueprints and drawings and deals with
the provision of de minimis amounts of
property by a service provider. This
commenter cites to Notice 88–86 to
provide, by analogy, that inventory
treated as non-incidental materials and
supplies under section 471(c)(1)(B)(i)
should not include direct labor costs.
The Treasury Department and the IRS
disagree with the application by analogy
to Example 1 in Section III.D of Notice
88–86. That example illustrates that an
individual providing services, such as
an architect, is not a producer despite
providing a de minimis amount of
property to the client as part of the
provision of services. As discussed in
section 3.A of this Summary of
Comments and Explanation of
Revisions, the Treasury Department and
the IRS believe that inventory property
treated as non-incidental materials and
supplies retains its character as
inventory property, and so Example 1 is
inapposite.
The Treasury Department and the IRS
acknowledge that there was uncertainty
under Revenue Procedure 2001–10 and
Revenue Procedure 2002–28 as to

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whether direct labor and overhead costs
were required to be capitalized under
the non-incidental materials and
supplies method permitted by those
revenue procedures. The Treasury
Department and the IRS are also aware
that tracking of direct labor costs may be
burdensome, and in some cases,
difficult to do for many small
businesses. The Treasury Department
and the IRS agree with the commenters’
request that direct labor costs be
excluded from the inventory costs
required to be included in inventory
treated as non-incidental materials and
supplies. As a result, these final
regulations provide that inventory costs
includible in the section 471(c) NIMS
inventory method are direct material
costs of the property produced or the
costs of property acquired for resale.
B. Treatment of Inventory by Taxpayers
With an Applicable Financial Statement
(AFS)
Under proposed § 1.471–1(b)(5), a
taxpayer other than a tax shelter, that
has an AFS and that meets the Section
448(c) Gross Receipts Test is not
required to take an inventory under
section 471(a), and may choose to treat
its inventory as reflected in its AFS.
Proposed § 1.471–1(b)(5)(ii) defines AFS
by reference to section 451(b)(3) and the
accompanying regulations, which
included the additional AFS rules
provided in proposed § 1.451–3(h).
In section 4.C.i of the preamble to the
proposed regulations, the Treasury
Department and the IRS requested
comments on a proposed consistency
rule for a taxpayer with an AFS that has
a financial accounting year that differs
from the taxpayer’s taxable year, and on
other issues related to the application of
proposed § 1.451–3(h) to the AFS
section 471(c) inventory method. The
Treasury Department and the IRS
proposed to require a taxpayer with an
AFS that uses the AFS section 471(c)
inventory method to consistently apply
the same mismatched reportable period
method of accounting provided in
proposed § 1.451–3(h)(4) for its AFS
section 471(c) inventory method of
accounting that is used for section 451
purposes. No comments were received
on the consistency rule or other issues
related to the application of proposed
§ 1.451–3(h) to the AFS section 471(c)
inventory method.
These final regulations adopt this
consistency rule. The Treasury
Department and the IRS have
determined that a taxpayer using an
accrual method with an AFS that has a
mismatched reporting period with its
taxable year should apply the same
mismatched reportable period method

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259

of accounting for revenue recognition
purposes and inventory purposes
because there is better matching of
income and cost of goods sold by
applying the same reportable period
method.
C. Treatment of Inventory by Taxpayers
Without an AFS
Under proposed § 1.471–1(b)(6), a
taxpayer, other than a tax shelter, that
does not have an AFS and that meets
the Section 448(c) Gross Receipts Test is
not required to take an inventory under
section 471(a), and may choose to use
the non-AFS section 471(c) inventory
method to account for its inventory. The
non-AFS section 471(c) inventory
method is the method of accounting for
inventory reflected in the taxpayer’s
books and records that are prepared in
accordance with the taxpayer’s
accounting procedures and that
properly reflect the taxpayer’s business
activities for non-tax purposes. For
example, a books and records method
that determines ending inventory and
cost of goods sold that properly reflects
the taxpayer’s business activities for
non-Federal income tax purposes is to
be used under the taxpayer’s non-AFS
section 471(c) inventory method.
(i) Definition of Books and Records
Some comments were received on the
non-AFS section 471(c) inventory
method and the standard used in
proposed § 1.471–1(b)(6) for ‘‘books and
records.’’ One commenter reasoned that
the purpose of section 471(c)(1)(B)(ii)
was to provide simplification, and the
reliance on the definition of books and
records used in case law is too complex,
creates audit risks, and uncertainties as
to what books and records means. The
commenter recommended using a
standard in which ‘‘books and records’’
is a flexible term and something the
taxpayer and his accounting
professional can agree on that is
consistent from year to year. For
example, the commenter suggests that
any financial statement reporting of
inventory that is consistently applied be
acceptable as books and records.
Some comments discuss the issue of
work papers and physical counts of
inventory, and whether either should be
used if a taxpayer is expensing these
items for books and records purposes.
The commenters asserted that even
though a taxpayer takes a physical count
of inventory, the taxpayer should be
allowed to expense the inventory for
Federal income tax purposes if the
inventory is expensed on its books and
records.
The Treasury Department and the IRS
decline to change the definition of the

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term ‘‘books and records’’ in these final
regulations, and the rules continue to
generally include both work papers and
physical counts of inventory. The term
books and records is used elsewhere in
the Code and regulations, and there is
no indication in the statute or legislative
history to section 471(c)(1)(B)(ii) that a
different definition is intended from the
general usage of this term used
elsewhere in the Code. Consequently,
these final regulations use the wellestablished definition of books and
records of a taxpayer, which includes
the totality of the taxpayer’s documents
and electronically-stored data. See, for
example, United States v. Euge, 444
U.S. 707 (1980). See also Digby v.
Commissioner, 103 T.C. 441 (1994), and
§ 1.6001–1(a).
Certain commenters requested that
the final regulations provide additional
clarification on the significance of the
taking of a physical count of inventory
under the non-AFS section 471(c)
inventory method. For example,
commenters requested that Example 1
in proposed § 1.471–1(b)(6)(iii) be
modified to provide that the physical
count is ignored if the taxpayer does not
provide inventory information to a
creditor. These final regulations provide
additional examples, including
variations on Example 1, to clarify the
relevance of a physical count of
inventory under the non-AFS section
471(c) inventory method. For example,
a taxpayer that takes a physical count of
inventory for reordering purposes but
does not allocate cost to such inventory
is not required to use the physical count
for the non-AFS section 471(c)
inventory method, regardless of whether
the information is otherwise used for an
internal report purpose or provided to
an external third party, such as a
creditor. Alternatively, a taxpayer that
takes an end-of-year physical count and
uses this information in its accounting
procedures to allocate costs to inventory
is required to use this inventory
information for the non-AFS section
471(c) inventory method regardless of
whether the taxpayer makes reconciling
entries to expense these costs in its
financial statements. Thus, the
examples in these final regulations
clarify the principle that a taxpayer may
not ignore its regular accounting
procedures or portions of its books and
records under the non-AFS section
471(c) inventory method.
(ii) Inventory Costs
The proposed regulations defined
‘‘inventory costs’’ for the non-AFS
section 471(c) inventory method
generally as costs that the taxpayer
capitalizes to property produced or

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property acquired for resale in its books
and records. Certain commenters
requested that the final regulations
clarify how a taxpayer treats costs to
acquire or produce tangible property
that the taxpayer does not capitalize in
its books and records because the
proposed regulations did not
specifically address these costs.
These final regulations clarify in
§ 1.471–1(b)(6)(i) that costs that are
generally required to be capitalized to
inventory under section 471(a) but that
the taxpayer is not capitalizing in its
books and records are not required to be
capitalized to inventory. The Treasury
Department and the IRS have also
determined that, under this method,
such costs are not treated as amounts
paid to acquire or produce tangible
property under § 1.263(a)–2, and
therefore, are generally deductible when
they are paid or incurred if such costs
may be otherwise deducted or recovered
notwithstanding § 1.471–1(b)(4) under
another provision of the Code and
Regulations. Additionally, these final
regulations clarify that costs capitalized
for the non-AFS section 471(c)
inventory method are those costs that
related to the production or resale of the
inventory to which they are capitalized
in the taxpayer’s books and records.
Similar clarifications have been made in
§ 1.471–1(b)(5) regarding the AFS
section 471(c) inventory method.
Applicability Dates
These final regulations are applicable
for taxable years beginning on or after
January 5, 2021. However, a taxpayer
may apply these regulations for a
taxable year beginning after December
31, 2017, and before January 5, 2021,
provided that if the taxpayer applies any
aspect of these final regulations under a
particular Code provision, the taxpayer
must follow all the applicable rules
contained in these regulations that
relate to that Code provision for such
taxable year and all subsequent taxable
years, and must follow the
administrative procedures for filing a
change in method of accounting in
accordance with § 1.446–1(e)(3)(ii). For
example, a taxpayer that wants to apply
§ 1.263A–1(j) to be exempt from
capitalizing costs under section 263A
must apply § 1.448–2 to determine
whether it is eligible for the exemption.
The same taxpayer must apply § 1.448–
2 to determine whether it is eligible to
apply § 1.471–1(b) to be exempt from
the general inventory rules under
section 471(a). However, it may choose
not to apply § 1.471–1(b) even though it
chooses to apply § 1.263A–1(j) and
§ 1.448–2.

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Alternatively, a taxpayer may rely on
the proposed regulations for a taxable
year beginning after December 31, 2017
and before January 5, 2021, provided
that if the taxpayer applies any aspect
of the proposed regulations under a
particular Code provision, the taxpayer
must follow all of the applicable rules
contained in the proposed regulations
that relate to that Code provision for
such taxable year, and follow the
administrative procedures for filing a
change in method of accounting in
accordance with § 1.446–1(e)(3)(ii).
Statement of Availability of IRS
Documents
The IRS notices, revenue rulings, and
revenue procedures cited in this
preamble are published in the Internal
Revenue Bulletin (or Cumulative
Bulletin) and are available from the
Superintendent of Documents, U.S.
Government Publishing Office,
Washington, DC 20402, or by visiting
the IRS website at http://www.irs.gov.
Special Analyses
This regulation is not subject to
review under section 6(b) of Executive
Order 12866 pursuant to the
Memorandum of Agreement (April 11,
2018) between the Treasury Department
and the Office of Management and
Budget regarding review of tax
regulations.
I. Paperwork Reduction Act
Section 1.448–2(b)(2)(iii)(B) imposes a
collection of information for an election
to use prior year’s allocated taxable
income or loss to determine whether a
partnership or other entity (other than a
C corporation) is a ‘‘syndicate’’ for
purposes of section 448(d)(3) for the
current tax year. The election is made
by attaching a statement to the
taxpayer’s original Federal income tax
return (including extensions) for the
taxable year that the election is made.
The election is an annual election and,
if made for a taxable year, cannot be
revoked. The collection of information
is voluntary for purposes of obtaining a
benefit under the proposed regulations.
The likely respondents are businesses or
other for-profit institutions, and small
businesses or organizations.
Estimated total annual reporting
burden: 224,165 hours.
Estimated average annual burden
hours per respondent: 1 hour.
Estimated number of respondents:
224,165.
Estimated annual frequency of
responses: Once.
Other than the election statement,
these regulations do not impose any
additional information collection

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Federal Register / Vol. 86, No. 2 / Tuesday, January 5, 2021 / Rules and Regulations
requirements in the form of reporting,
recordkeeping requirements or thirdparty disclosure statements. However,
because the exemptions in sections
263A, 448, 460 and 471 are methods of
accounting under the statute, taxpayers
are required to request the consent of
the Commissioner for a change in
method of accounting under section
446(e) to implement the statutory
exemptions. The IRS expects that these
taxpayers will request this consent by
filing Form 3115, Application for
Change in Accounting Method.
Taxpayers may request these changes
using reduced filing requirements by
completing only certain parts of Form
3115. See Revenue Procedure 2018–40
(2018–34 IRB 320). Revenue Procedure
2018–40 provides procedures for a
taxpayer to make a change in method of
accounting using the automatic change
procedures of Revenue Procedure 2015–
13 (2015–5 IRB 419) in order to use the
exemptions provided in sections 263A,
460 and/or 471. See also the revenue
procedure accompanying these
regulations for similar method change
procedures to make a change in method
of accounting to comply with these final
regulations.
For purposes of the Paperwork
Reduction Act of 1995 (44 U.S.C.
3507(c)) (PRA), the reporting burden
associated with the collection of
information for the election statement
and Form 3115 will be reflected in the
PRA submission associated with the
income tax returns under the OMB
control number 1545–0074 (in the case
of individual filers of Form 3115) and
1545–0123 (in the case of business filers
of Form 3115).
In 2018, the IRS released and invited
comment on a draft of Form 3115 in
order to give members of the public the
opportunity to benefit from certain
specific provisions made to the Code.
The IRS received no comments on the
forms during the comment period.
Consequently, the IRS made the forms
available in January 2019 for use by the
public. The IRS notes that Form 3115
applies to changes of accounting
methods generally and is therefore
broader than sections 263A, 448, 460
and 471.
As discussed earlier, the reporting
burdens associated with the proposed
regulations are included in the
aggregated burden estimates for OMB
control numbers 1545–0074 (in the case
of individual filers of Form 3115), 1545–
0123 (in the case of business filers of
Form 3115 subject to Revenue
Procedure 2019–43 and business filers
that make the election under proposed
§ 1.448–2(b)(2)(iii)(B)). The overall
burden estimates associated with these

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OMB control numbers are aggregate
amounts related to the entire package of
forms associated with the applicable
OMB control number and will include,
but not isolate, the estimated burden of
the tax forms that will be created or
revised as a result of the information
collections in these regulations. These
numbers are therefore not specific to the
burden imposed by these regulations.
The burdens have been reported for
other income tax regulations that rely on
the same information collections and
the Treasury Department and the IRS
urge readers to recognize that these
numbers are duplicates and to guard
against overcounting the burdens
imposed by tax provisions prior to the
TCJA. No burden estimates specific to
the forms affected by the regulations are
currently available. For the OMB control
numbers discussed in the preceding
paragraphs, the Treasury Department
and the IRS estimate PRA burdens on a
taxpayer-type basis rather than a
provision-specific basis. Those
estimates capture both changes made by
the TCJA and those that arise out of
discretionary authority exercised in the
final regulations and other regulations
that affect the compliance burden for
that form.
II. Regulatory Flexibility Act
The Regulatory Flexibility Act (5
U.S.C. 601 et seq.) (RFA) imposes
certain requirements with respect to
federal rules that are subject to the
notice and comment requirements of
section 553(b) of the Administrative
Procedure Act (5 U.S.C. 551 et seq.) and
that are likely to have a significant
economic impact on a substantial
number of small entities. Unless an
agency determines that a proposal is not
likely to have a significant economic
impact on a substantial number of small
entities, section 603 of the RFA requires
the agency to present an initial
regulatory flexibility analysis (IRFA) of
the proposed rules. At the proposed rule
stage, the Treasury Department and the
IRS had not determined whether the
proposed rules, when finalized, would
likely have a significant economic
impact on a substantial number of small
entities. The determination of whether
the voluntary exemptions under
sections 263A, 448, 460, and 471, and
the regulations providing guidance with
respect to such exemptions, will have a
significant economic impact on a
substantial number of small entities
requires further study. However,
because there is a possibility of
significant economic impact on a
substantial number of small entities, an
IRFA was provided at the proposed rule
stage. In accordance with section 604 of

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the RFA, following is the final
regulatory flexibility analysis.
1. Reasons for and Objectives of the
Rule
As discussed earlier in the preamble,
these regulations largely implement
voluntary exemptions that relieve small
business taxpayers from otherwise
applicable restrictions and requirements
under sections 263A, 448, 460, and 471.
Section 448 provides a general
restriction for C corporations and
partnerships with C corporation
partners from using the cash method of
accounting, and sections 263A, 460 and
471 impose specific rules on uniform
capitalization of direct and indirect
production costs, the percentage of
completion method for long-term
contracts, and accounting for inventory
costs, respectively. Section 13102 of
TCJA provided new statutory
exemptions from certain of these rules
and expanded the scope of existing
statutory exemptions from certain of
these rules to reduce compliance
burdens for small taxpayers. The
regulations clarify the exemption
qualification requirements and provide
guidance with respect to the applicable
methods of accounting should a
taxpayer choose to apply one or more
exemptions.
The objective of the regulations is to
provide clarity and certainty for small
business taxpayers implementing the
exemptions. Under the Code, small
business taxpayers were able to
implement these provisions for taxable
years beginning after December 31, 2017
(or, in the case of section 460, for
contracts entered into after December
31, 2017) even in the absence of these
regulations. Thus, the Treasury
Department and the IRS expect that, at
the time these regulations are published,
many small business taxpayers may
have already implemented some aspects
of the regulations.
2. Significant Issues Raised by the
Public Comments in Response to the
IRFA and Comments Filed by the Chief
Counsel for Advocacy of the Small
Business Administration
No public comments were received in
response to the IRFA. Additionally, no
comments were filed by the Chief
Counsel for Advocacy of the Small
Business Administration in response to
the proposed regulations.
3. Affected Small Entities
The voluntary exemptions under
sections 263A, 448, 460 and 471
generally apply to taxpayers that meet
the $25 million (adjusted for inflation)
gross receipts test in section 448(c) and

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are otherwise subject to general rules
under sections 263A, 448, 460, or 471.
A. Section 263A
The Treasury Department and the IRS
expect that the addition of section
263A(i) will expand the number of
small business taxpayers exempted from
the requirement to capitalize costs,
including interest, under section 263A.
Under section 263A(i), taxpayers (other
than tax shelters) that meet the $25
million (adjusted for inflation) gross
receipts test in section 448(c) can
choose to deduct certain costs that are
otherwise required to be capitalized to
the basis of property. Section 263A
applies to taxpayers that are producers,
resellers, and taxpayers with selfconstructed assets. The Treasury
Department and the IRS estimate that
there are between 3,200,000 and
3,575,000 respondents with gross
receipts of not more than $25 million
(adjusted for inflation) that have
inventories. The Treasury Department
and the IRS estimate that of these
taxpayers there are between 28,900 and
38,900 respondents with gross receipts
of not more than $25 million (adjusted
for inflation) that are eligible to change
their method of accounting to no longer
capitalize costs under section 263A.
These estimates come from information
collected on: Form 1125–A, Cost of
Goods Sold, and attached to Form 1120,
U.S. Corporation Income Tax Return,
Form 1065, U.S. Return of Partnership
Income or Form 1120–S, U.S. Income
Tax Return for an S Corporation, on
which the taxpayer also indicated it had
additional section 263A costs. The
Treasury Department and the IRS do not
have readily available data to measure
the prevalence of entities with selfconstructed assets. In addition, these
data also do not include other business
entities, such as a business reported on
Schedule C, Profit or Loss Form
Business, of an individual’s Form 1040,
U.S. Individual Income Tax Return.
Under section 263A, as modified by
the TCJA, small business entities that
qualified for Section 263A small reseller
exception will no longer be able to use
this exception. The Treasury
Department and the IRS estimate that
nearly all taxpayers that qualified for
the small reseller exception will qualify
for the small business taxpayer
exemption under section 263A(i) since
the small reseller exception utilized a
$10 million gross receipts test. The
Treasury Department and the IRS
estimate that there are between 28,900
and 38,900 respondents with gross
receipts of not more than $25 million
that are eligible for the exemption under
section 263A(i). These estimates come

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from information collected on: Form
1125–A, Cost of Goods Sold, and
attached to Form 1120, U.S. Corporation
Income Tax Return, Form 1065, U.S.
Return of Partnership Income or Form
1120–S, U.S. Income Tax Return for an
S Corporation on which the taxpayer
also indicated it had additional section
263A costs. These data provide an
upper bound for the number of
taxpayers affected by the repeal of the
small reseller exception and enactment
of section 263A(i) because the data
includes taxpayers that were not
previously eligible for the small reseller
exception, such as producers and
taxpayers with gross receipts of more
than $10 million.
The regulations modify the $50
million gross receipts test in § 1.263A–
1(d)(3)(ii)(B)(1) by using the Section 448
Gross Receipts Test. The $50 million
gross receipts amount is used by
taxpayers to determine whether they are
eligible to treat negative adjustments as
additional section 263A costs for
purposes of the simplified production
method (SPM) under section 263A. The
Treasury Department and the IRS do not
have readily available data to measure
the prevalence of entities using the
SPM.
Section 1.263A–9 modifies the
current regulation to increase the
eligibility threshold to $25 million for
the election permitting taxpayers to use
the highest applicable Federal rate as a
substitute for the weighted average
interest rate when tracing debt for
purposes of capitalizing interest under
section 263A(f). The Treasury
Department and the IRS estimate that
there are between 28,900 and 38,900
respondents with gross receipts of not
more than $25 million that are eligible
to make this election. These estimates
come from information collected on:
Form 1125–A, Cost of Goods Sold,
attached to Form 1120, U.S. Corporation
Income Tax Return, Form 1065, U.S.
Return of Partnership Income or Form
1120–S, U.S. Income Tax Return for an
S Corporation, on which the taxpayer
also indicated it had additional section
263A costs. The Treasury Department
and the IRS expect that many taxpayers
eligible to make the election for
purposes of section 263A(f) will instead
elect the small business exemption
under section 263A(i). Additionally,
taxpayers who chose to apply section
263A even though they qualify for the
small business exemption under section
263A(i) may not have interest expense
required to be capitalized under section
263A(f). As a result, although these data
do not include taxpayers with selfconstructed assets that are eligible for
the election, the Treasury Department

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and the IRS estimate that this data
provides an upper bound for the
number of eligible taxpayers.
B. Section 448
The Treasury Department and the IRS
expect that the changes to section 448(c)
by the TCJA will expand the number of
taxpayers permitted to use the cash
method. Section 448(a) provides that C
corporations, partnerships with C
corporations as partners, and tax
shelters are not permitted to use the
cash method of accounting; however
section 448(c), as amended by the TCJA,
provides that C corporations or
partnerships with C corporations as
partners, other than tax shelters, are not
restricted from using the cash method if
their average annual gross receipts are
$25 million (adjusted for inflation) or
less. Prior to the amendments made by
the TCJA, the applicable gross receipts
threshold was $5 million. Section 448
does not apply to S corporations,
partnerships without a C corporation
partner, or any other business entities
(including sole proprietorships reported
on an individual’s Form 1040). The
Treasury Department and the IRS
estimate that there are between 587,000
and 605,000 respondents with gross
receipts of not more than $5 million
presently using an accrual method, and
between 70,000 and 76,500 respondents
with gross receipts of more than $5
million but not more than $25 million
that are permitted to use to the cash
method. These estimates come from
information collected on Form 1120,
U.S. Corporation Income Tax Return,
Form 1065, U.S. Return of Partnership
Income and Form 1120–S, U.S. Income
Tax Return for an S Corporation.
Under the regulations, taxpayers that
would meet the gross receipts test of
section 448(c) and seem to be eligible to
use the cash method but for the
definition of ‘‘syndicate’’ under section
448(d)(3), may elect to use the allocated
taxable income or loss of the
immediately preceding taxable year to
determine whether the taxpayer is a
‘‘syndicate’’ for purposes of section
448(d)(3) for the current taxable year.
The Treasury Department and IRS
estimate that 224,165 respondents may
potentially make this election. This
estimate comes from information
collected on the Form 1065, U.S. Return
of Partnership Income and Form 1120–
S, U.S. Income Tax Return for an S
Corporation., and the Form 1125–A,
Cost of Goods Sold, attached to the
Forms 1065 and 1120–S. The Treasury
Department and the IRS estimate that
these data provide an upper bound for
the number of eligible taxpayers because

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not all taxpayers eligible to make the
election will choose to do so.

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C. Section 460
The Treasury Department and the IRS
expect that the modification of section
460(e)(1)(B) by the TCJA will expand
the number of taxpayers exempted from
the requirement to apply the percentageof-completion method to long-term
construction contracts. Under section
460(e)(1)(B), as modified by the TCJA,
taxpayers (other than tax shelters) that
meet the $25 million (adjusted for
inflation) gross receipts test in section
448(c) are not required to use PCM to
account for income from a long-term
construction contract expected to be
completed in two years. Prior to the
modification of section 460(e)(1)(B) by
the TCJA, a separate $10 million dollar
gross receipts test applied. The Treasury
Department and the IRS estimate that
there are between 15,400 and 19,500
respondents with gross receipts of
between $10 million and $25 million
who are eligible to change their method
of accounting to apply the modified
exemption. This estimate comes from
information collected on the Form 1120,
U.S. Corporation Income Tax Return,
Form 1065, U.S. Return of Partnership
Income and Form 1120–S, U.S. Income
Tax Return for an S Corporation in
which the taxpayer indicated its
principal business activity was
construction (NAICS codes beginning
with 23). These data available do not
distinguish between long-term contracts
and other contracts, and also do not
include other business entities that do
not file Form 1120, U.S. Corporation
Income Tax Return, Form 1065, U.S.
Return of Partnership Income, and Form
1120–S, U.S. Income Tax Return for an
S Corporation, such as a business
reported on Schedule C, Profit or Loss
from Business, of an individual’s Form
1040, U.S. Individual Income Tax
Return.
D. Section 471
The Treasury Department and the IRS
expect that the addition of section
471(c) will expand the number of
taxpayers exempted from the
requirement to take inventories under
section 471(a). Under section 471(c),
taxpayers (other than tax shelters) that
meet the $25 million (adjusted for
inflation) gross receipts test in section
448(c) can choose to apply certain
simplified inventory methods rather
than those otherwise required by section
471(a). The Treasury Department and
the IRS estimate that there are between
3,200,000 and 3,575,000 respondents
with gross receipts of not more than $25
million that are exempted from the

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requirement to take inventories, and
will treat their inventory either as nonincidental materials and supplies, or
conform their inventory method to the
method reflected in their AFS, or if they
do not have an AFS, in their books and
records. This estimate comes from data
collected on the Form 1125–A, Cost of
Goods Sold. Within that set of
taxpayers, the Treasury Department and
the IRS estimate that there are between
10,500 and 11,500 respondents that may
choose to conform their method of
accounting for inventories to their
method for inventory reflected in their
AFS. This estimate comes from IRScollected data on taxpayers that filed the
Form 1125–A, Cost of Goods Sold, in
addition to a Schedule M3, Net Income
(Loss) Reconciliation for Corporations
With Total Assets of $10 Million or
More, that indicated they had an AFS.
These data provide a lower bound
because they do not include other
business entities, such as a business
reported on Schedule C, Profit or Loss
from Business, of an individual’s Form
1040, U.S. Individual Income Tax
Return, that are not required to file the
Form 1125–A, Cost of Goods Sold.
4. Projected Reporting, Recordkeeping,
Other Compliance Requirements, and
Costs
The Treasury Department and the IRS
have not performed an analysis with
respect to the projected reporting,
recordkeeping, and other compliance
requirements associated with the
statutory exemptions under sections
263A, 448, 460, and 471 and the final
regulations implementing these
exemptions. The taxpayer may expend
time to read and understand the final
regulations. The cost to comply with
these regulations are reflected in modest
reporting activities. Taxpayers needing
to make method changes pursuant to
these regulations will be required to file
a Form 3115. The Treasury Department
and the IRS are minimizing the cost to
comply with the regulations by
providing administrative procedures
that allow taxpayers to make multiple
changes in method of accounting related
to the statutory exemptions under
sections 263A, 448, 460, and 471 for the
same tax year on a single Form 3115,
instead of filing a separate Form 3115
for each exemption. Although there is a
nominal implementation cost, the
Treasury Department and the IRS
anticipate that the statutory exemptions
and the final regulations implementing
these exemptions will reduce overall the
reporting, recordkeeping, and other
compliance requirements of affected
taxpayers relative to the requirements
that exist under the general rules in

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263

sections 263A, 448, 460, and 471. For
example, a taxpayer that applies section
471(c)(1)(B)(i) to treat inventory as nonincidental materials and supplies will
only need to capitalize the direct
material cost of producing inventory
instead of also having to capitalize the
direct labor and indirect costs of
producing inventory under the general
rules of section 471(a). Additionally, a
taxpayer that applies section
471(c)(1)(B)(ii) can follow the inventory
method used in its applicable financial
statement, or its books and records if it
does not have an applicable financial
statement, in lieu of keeping a separate
inventory method under the general
rules of section 471(a).
5. Steps Taken To Minimize the
Economic Impact on Small Entities
As discussed earlier in the preamble,
section 448 provides a general
restriction for C corporations,
partnerships with C corporation
partners, and tax shelters from using the
cash method of accounting, and sections
263A, 460 and 471 impose specific rules
on uniform capitalization of direct and
indirect production costs, the
percentage of completion method for
long-term contracts, and accounting for
inventory costs, respectively. Section
13102 of TCJA provided new statutory
exemptions and expanded the scope of
existing statutory exemptions from these
rules to reduce compliance burdens for
small taxpayers (for example, reducing
the burdens associated with applying
complex accrual rules under section 451
and 461, maintaining inventories,
identifying and tracking costs that are
allocable to property produced or
acquired for resale, identifying and
tracking costs that are allocable to longterm contracts, applying the look-back
method under section 460, etc.). For
example, a small business taxpayer with
average gross receipts of $20 million
may pay an accountant an annual fee of
approximately $2,375 to perform a 25
hour analysis to determine the section
263A costs that are capitalized to
inventory produced during the year. If
this taxpayer chooses to apply the
exemption under section 263A and
these regulations, it will no longer need
to pay an accountant for the annual
section 263A analysis.
The regulations implementing these
exemptions are completely voluntary
because small business taxpayers may
continue using an accrual method of
accounting, and applying the general
rules under sections 263A, 460 and 471
if they so choose. Thus, the exemptions
increase the flexibility small business
taxpayers have regarding their
accounting methods relative to other

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businesses. The regulations provide
clarity and certainty for small business
taxpayers implementing the
exemptions.
As described in more detail earlier in
the preamble, the Treasury Department
and the IRS considered a number of
alternatives under the final regulations.
For example, in providing rules related
to inventory exemption in section
471(c)(1)(B)(i), which permits the
taxpayer to treat its inventory as nonincidental materials and supplies, the
Treasury Department and the IRS
considered whether inventoriable costs
should be recovered by (i) using an
approach similar to the approach set
forth under Revenue Procedure 2001–10
(2001–2 IRB 272) and Revenue
Procedure 2002–28 (2002–28 IRB 815),
which provided that inventory treated
as non-incidental materials and supplies
was ‘‘used and consumed,’’ and thus
recovered through costs of goods sold by
a cash basis taxpayer, when the
inventory items were provided to a
customer, or when the taxpayer paid for
the items, whichever was later, or (ii)
using an alternative approach that
treated inventory as ‘‘used and
consumed’’ and thus recovered through
costs of goods sold by the taxpayer, in
a taxable year prior to the year in which
the inventory item is provided to the
customer (for example, in the taxable
year in which an inventory item is
acquired or produced). The alternative
approach described in (ii) would
produce a savings equal the amount of
the cost recovery multiplied by an
applicable discount rate (determined
based on the number of years the cost
of goods sold recovery would be
accelerated under this alternative). The
Treasury Department and the IRS
interpret section 471(c)(1)(B)(i) and its
legislative history generally as codifying
the rules provided in the administrative
guidance existing at the time TCJA was
enacted. Based on this interpretation,
the Treasury Department and the IRS
have determined that section 471(c)
materials and supplies are ‘‘used and
consumed’’ in the taxable year the
taxpayer provides the goods to a
customer, and are recovered through
costs of goods sold in that year or the
taxable year in which the cost of the
goods is paid or incurred (in accordance
with the taxpayer’s method of
accounting), whichever is later. The
Treasury Department and the IRS do not
believe this approach creates or imposes
undue burdens on taxpayers.
III. Section 7805(f)
Pursuant to section 7805(f) of the
Code, the notice of proposed rulemaking
preceding this Treasury Decision was

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submitted to the Chief Counsel of the
Office of Advocacy of the Small
Business Administration for comment
on its impact on small business.
IV. Executive Order 13132: Federalism
Executive Order 13132 (entitled
‘‘Federalism’’) prohibits an agency from
publishing any rule that has federalism
implications if the rule either imposes
substantial, direct compliance costs on
state and local governments, and is not
required by statute, or preempts state
law, unless the agency meets the
consultation and funding requirements
of section 6 of the Executive Order. This
final rule does not have federalism
implications and does not impose
substantial, direct compliance costs on
state and local governments or preempt
state law within the meaning of the
Executive Order.
Drafting Information
The principal author of these
regulations is Anna Gleysteen, IRS
Office of the Associate Chief Counsel
(Income Tax and Accounting). However,
other personnel from the Treasury
Department and the IRS participated in
their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and
recordkeeping requirements.
Amendments to the Regulations
Accordingly, 26 CFR part 1 is
amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation
for part 1 continues to read in part as
follows:

■

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.263A–0 is amended
by:
■ 1. Revising the entry in the table of
contents for § 1.263A–1(b)(1).
■ 2. Redesignating the entries in the
table of contents for § 1.263A–1(j), (k),
and (l) as the entries for § 1.263A–1(k),
(l), and (m).
■ 3. Adding a new entry in the table of
contents for § 1.263A–1(j).
■ 4. Revising the newly designated
entries for § 1.263A–1(k), (l), and adding
an entry for (m)(6).
■ 5. Revising the entries in the table of
contents for § 1.263A–3(a)(2)(ii).
■ 6. Adding entries for § 1.263A–3(a)(5)
and revising the entry for § 1.263A–3(b).
■ 7. Redesignating the entries in the
table of contents for § 1.263A–4(a)(3)
and (4) as the entries for § 1.263A–
4(a)(4) and (5).
■ 8. Adding in the table of contents a
new entry for § 1.263A–4(a)(3).
■

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9. Revising the entry in the table of
contents for § 1.263A–4(d) introductory
text.
■ 10. Redesignating the entry in the
table of contents for § 1.263A–4(d)(5) as
the entry for § 1.263A–4(d)(7).
■ 11. Adding in the table of contents a
new entry for § 1.263A–4(d)(5).
■ 12. Adding an entry in the table of
contents for § 1.263A–4(d)(6).
■ 13. Adding an entry in the table of
contents for § 1.263A–4(e)(5).
■ 14. Revising the entry in the table of
contents for § 1.263A–4(f) introductory
text.
■ 15. Adding an entry in the table of
contents for § 1.263A–4(g).
■ 16. Revising the entry in the table of
contents for § 1.263A–7(a)(4).
The revisions and additions read as
follows:
■

§ 1.263A–0 Outline of regulations under
section 263A.

*

*

*

§ 1.263A–1

*

*

*

*

Uniform Capitalization of Costs.

*

*

*

(b) * * *
(1) Small business taxpayers.

*

*

*

*

*

(j) Exemption for certain small business
taxpayers.
(1) In general.
(2) Application of the section 448(c) gross
receipts test.
(i) In general.
(ii) Gross receipts of individuals, etc.
(iii) Partners and S corporation
shareholders.
(iv) Examples.
(A) Example 1
(B) Example 2
(3) Change in method of accounting.
(i) In general.
(ii) Prior section 263A method change.
(k) Special rules
(1) Costs provided by a related person.
(i) In general
(ii) Exceptions
(2) Optional capitalization of period costs.
(i) In general.
(ii) Period costs eligible for capitalization.
(3) Trade or business application
(4) Transfers with a principal purpose of
tax avoidance. [Reserved]
(l) Change in method of accounting.
(1) In general.
(2) Scope limitations.
(3) Audit protection.
(4) Section 481(a) adjustment.
(5) Time for requesting change.
(m) * * *
(6) Exemption for certain small business
taxpayers.
§ 1.263A–3 Rules Relating to Property
Acquired for Resale.
(a) * * *
(2) * * *
(ii) Exemption for small business
taxpayers.

*

*

*

*

*

(5) De minimis production activities.

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(i) In general.
(ii) Definition of gross receipts to
determine de minimis production activities.
(iii) Example.
(b) [Reserved].

*

*

*

*

*

§ 1.263A–4 Rules for Property Produced in
a Farming Business.
(a) * * *
(3) Exemption for certain small business
taxpayers.

*

*

*

*

*

(d) Election not to have section 263A apply
under section 263A(d)(3).

*

*

*

*

*

(5) Revocation of section 263A(d)(3)
election to permit exemption under section
263A(i).
(6) Change from applying exemption under
section 263A(i) to making a section
263A(d)(3) election.

*

*

*

*

*

(e) * * *
(5) Special temporary rule for citrus plants
lost by reason of casualty.
(f) Change in method of accounting.

*

*

*

*

*

(g) Effective date.
(1) In general.
(2) Changes made by Tax Cuts and Jobs Act
(Pub. L. 115–97).
§ 1.263A–7 Changing a method of
accounting under section 263A.
(a) * * *
(4) Applicability dates.
(i) In general.
(ii) Changes made by Tax Cuts and Jobs Act
(Pub. L. 115–97).

*

*
*
*
*
Par. 3. Section 1.263A–1 is amended
by:
■ 1. Revising paragraph (a)(2) subject
heading.
■ 2. In paragraph (a)(2)(i), revising the
second sentence and adding a new third
sentence.
■ 3. Revising paragraph (b)(1).
■ 4. In the second sentence of paragraph
(d)(3)(ii)(B)(1), the language ‘‘§ 1.263A–
3(b)’’ is removed and the language
‘‘§ 1.263A–1(j)’’is added in its place.
■ 5. Redesignating paragraphs (j)
through (l) as paragraphs (k) through
(m).
■ 6. Adding a new paragraph (j).
■ 7. In newly-redesignated paragraph
(m), adding paragraph (m)(6).
The revisions and addition read as
follows:
■

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§ 1.263A–1

Uniform capitalization of costs.

(a) * * *
(2) Applicability dates. (i) * * * In
the case of property that is inventory in
the hands of the taxpayer, however,
these sections are applicable for taxable
years beginning after December 31,
1993. The small business taxpayer
exception described in paragraph (b)(1)
of this section and set forth in paragraph

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(j) of this section is applicable for
taxable years beginning after December
31, 2017. * * *
*
*
*
*
*
(b) * * * (1) Small business
taxpayers. For taxable years beginning
after December 31, 2017, see section
263A(i) and paragraph (j) of this section
for an exemption for certain small
business taxpayers from the
requirements of section 263A.
*
*
*
*
*
(j) Exemption for certain small
business taxpayers—(1) In general. A
taxpayer, other than a tax shelter
prohibited from using the cash receipts
and disbursements method of
accounting under section 448(a)(3), that
meets the gross receipts test under
section 448(c) and § 1.448–2(c) (section
448(c) gross receipts test) for any taxable
year (small business taxpayer) is not
required to capitalize costs under
section 263A to any real or tangible
personal property produced, and any
real or personal property described in
section 1221(a)(1) acquired for resale,
during that taxable year. This section
448(c) gross receipts test applies even if
the taxpayer is not otherwise subject to
section 448(a).
(2) Application of the section 448(c)
gross receipts test—(i) In general. In the
case of any taxpayer that is not a
corporation or a partnership, and except
as provided in paragraphs (j)(2)(ii) and
(iii) of this section, the section 448(c)
gross receipts test is applied in the same
manner as if each trade or business of
the taxpayer were a corporation or
partnership.
(ii) Gross receipts of individuals, etc.
Except when the aggregation rules of
section 448(c)(2) apply, the gross
receipts of a taxpayer other than a
corporation or partnership are the
amount derived from all trades or
businesses of such taxpayer. Amounts
not related to a trade or business are
excluded from the gross receipts of the
taxpayer. For example, an individual
taxpayer’s gross receipts do not include
inherently personal amounts, such as
personal injury awards or settlements
with respect to an injury of the
individual taxpayer, disability benefits,
Social Security benefits received by the
taxpayer during the taxable year, and
wages received as an employee that are
reported on Form W–2.
(iii) Partners and S corporation
shareholders. Except when the
aggregation rules of section 448(c)(2)
apply, each partner in a partnership
includes a share of the partnership’s
gross receipts in proportion to such
partner’s distributive share, as
determined under section 704, of items

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265

of gross income that were taken into
account by the partnership under
section 703. Similarly, a shareholder of
an S corporation includes such
shareholder’s pro rata share of S
corporation gross receipts taken into
account by the S corporation under
section 1363(b).
(iv) Examples. The operation of this
paragraph (j) is illustrated by the
following examples:
(A) Example 1. Taxpayer A is an
individual who operates two separate
and distinct trades or business that are
reported on Schedule C, Profit or Loss
from Business, of A’s Federal income
tax return. For 2020, one trade or
business has annual average gross
receipts of $5 million, and the other
trade or business has average annual
gross receipts of $35 million. Under
paragraph (j)(2)(ii) of this section, for
2020, neither of A’s trades or businesses
meets the gross receipts test of
paragraph (j)(2) of this section ($5
million + $35 million = $40 million,
which is greater than the inflationadjusted gross receipts test amount for
2020, which is $26 million).
(B) Example 2. Taxpayer B is an
individual who operates three separate
and distinct trades or business that are
reported on Schedule C of B’s Federal
income tax return. For 2020, Business X
is a retail store with average annual
gross receipts of $15 million, Business
Y is a dance studio with average annual
gross receipts of $6 million, and
Business Z is a car repair shop with
average annual gross receipts of $12
million. Under paragraph (j)(2)(ii) of this
section, B’s gross receipts are the
combined amount derived from all three
of B’s trades or businesses. Therefore,
for 2020, X, Y and Z do not meet the
gross receipts test of paragraph (j)(2)(i)
of this section ($15 million + $6 million
+ $12 million = $33 million, which is
greater than the inflation-adjusted gross
receipts test amount for 2020, which is
$26 million).
(3) Change in method of accounting—
(i) In general. A change from applying
the small business taxpayer exemption
under paragraph (j) of this section to not
applying the exemption under this
paragraph (j), or vice versa, is a change
in method of accounting under section
446(e) and § 1.446–1(e). A taxpayer
changing its method of accounting
under paragraph (j) of this section may
do so only with the consent of the
Commissioner as required under section
446(e) and § 1.446–1. In the case of any
taxpayer required by this section to
change its method of accounting for any
taxable year, the change shall be treated
as a change initiated by the taxpayer.
For rules relating to the clear reflection

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Federal Register / Vol. 86, No. 2 / Tuesday, January 5, 2021 / Rules and Regulations

of income and the pattern of consistent
treatment of an item, see section 446
and § 1.446–1. The amount of the net
section 481(a) adjustment and the
adjustment period necessary to
implement a change in method of
accounting required under this section
are determined under § 1.446–1(e) and
the applicable administrative
procedures to obtain the
Commissioner’s consent to change a
method of accounting as published in
the Internal Revenue Bulletin (see
Revenue Procedure 2015–13 (2015–5
IRB 419) (or successor) (see also
§ 601.601(d)(2) of this chapter).
(ii) Automatic consent for certain
method changes. Certain changes in
method of accounting made under
paragraph (j) of this section may be
made under the procedures to obtain the
automatic consent of the Commissioner
to change a method of accounting. See
Revenue Procedure 2015–13 (2015–5
IRB 419) (or successor) (see also
§ 601.601(d)(2) of this chapter)). In
certain situations, special terms and
conditions may apply.
*
*
*
*
*
(m) * * *
(6) Exemption for certain small
business taxpayers. The second and
third sentence in paragraph (a)(2)(i),
paragraphs (b)(1) and (j) of this section
apply to taxable years beginning on or
after January 5, 2021. However, for a
taxable year beginning after December
31, 2017, and before January 5, 2021, a
taxpayer may apply the paragraphs
described in the first sentence of this
paragraph (m)(6), provided that the
taxpayer follows all the applicable rules
contained in the regulations under
section 263A for such taxable year and
all subsequent taxable years.
■ Par. 4. Section 1.263A–2 is amended
by:
■ 1. Adding a sentence at the end of
paragraph (a) introductory text.
■ 2. Revising paragraph (a)(1)(ii)(C).
■ 3. Revising paragraph (g) subject
heading.
■ 4. Adding paragraph (g)(4).
The additions and revisions read as
follows:

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§ 1.263A–2 Rules relating to property
produced by the taxpayer.

(a) * * * For taxable years beginning
after December 31, 2017, see § 1.263A–
1(j) for an exception in the case of a
small business taxpayer that meets the
gross receipts test of section 448(c) and
§ 1.448–2(c).
(1) * * *
(ii) * * *
(C) Home construction contracts.
Section 263A applies to a home
construction contract unless that

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contract will be completed within two
years of the contract commencement
date, and, for contracts entered into after
December 31, 2017, in taxable years
ending after December 31, 2017, the
taxpayer meets the gross receipts test of
section 448(c) and § 1.448–2(c) for the
taxable year in which such contract is
entered into. Except as otherwise
provided in this paragraph (a)(1)(ii)(C),
section 263A applies to such a contract
even if the contractor is not considered
the owner of the property produced
under the contract under Federal
income tax principles.
*
*
*
*
*
(g) Applicability dates.* * *
(4) The rules set forth in the last
sentence of the introductory text of
paragraph (a) of this section and in
paragraph (a)(1)(ii)(C) of this section
apply for taxable years beginning on or
after January 5, 2021. However, for a
taxable year beginning after December
31, 2017, and before January 5, 2021, a
taxpayer may apply the paragraphs
described in the first sentence of this
paragraph (g)(4), provided that the
taxpayer follows all the applicable rules
contained in the regulations under
section 263A for such taxable year and
all subsequent taxable years.
■ Par. 5. Section 1.263A–3 is amended:
■ 1. In paragraph (a)(1), by revising the
second sentence.
■ 2. By revising paragraphs (a)(2)(ii) and
(iii).
■ 4. In paragraph (a)(3), by removing the
language ‘‘small reseller’’ and adding in
its place the language ‘‘small business
taxpayer’’.
■ 5. In paragraph (a)(4)(ii), removing the
language ‘‘(within the meaning of
paragraph (a)(2)(iii) of this section)’’ and
adding in its place the language
‘‘(within the meaning of paragraph (a)(5)
of this section)’’.
■ 6. By adding paragraph (a)(5).
■ 7. By removing and reserving
paragraph (b).
■ 8. By revising paragraph (f).
The revisions and additions read as
follows:
§ 1.263A–3 Rules relating to property
acquired for resale.

(a) * * * (1) * * * However, for
taxable years beginning after December
31, 2017, a small business taxpayer, as
defined in § 1.263A–1(j), is not required
to apply section 263A in that taxable
year. * * *
(2) * * *
(ii) Exemption for certain small
business taxpayers. For taxable years
beginning after December 31, 2017, see
§ 1.263A–1(j) for an exception in the
case of a small business taxpayer that

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meets the gross receipts test of section
448(c) and § 1.448–2(c).
(iii) De minimis production activities.
See paragraph (a)(5) of this section for
rules relating to an exception for
resellers with de minimis production
activities.
*
*
*
*
*
(5) De minimis production activities—
(i) In general. In determining whether a
taxpayer’s production activities are de
minimis, all facts and circumstances
must be considered. For example, the
taxpayer must consider the volume of
the production activities in its trade or
business. Production activities are
presumed de minimis if—
(A) The gross receipts from the sale of
the property produced by the reseller
are less than 10 percent of the total gross
receipts of the trade or business; and
(B) The labor costs allocable to the
trade or business’s production activities
are less than 10 percent of the reseller’s
total labor costs allocable to its trade or
business.
(ii) Definition of gross receipts to
determine de minimis production
activities. Gross receipts has the same
definition as for purposes of the gross
receipts test under § 1.448–2(c), except
that gross receipts are measured at the
trade-or-business level rather than at the
single-employer level.
(iii) Example: Reseller with de
minimis production activities. Taxpayer
N is in the retail grocery business. In
2019, N’s average annual gross receipts
for the three previous taxable years are
greater than the gross receipts test of
section 448(c). Thus, N is not exempt
from the requirement to capitalize costs
under section 263A. N’s grocery stores
typically contain bakeries where
customers may purchase baked goods
produced by N. N produces no other
goods in its retail grocery business. N’s
gross receipts from its bakeries are 5
percent of the entire grocery business.
N’s labor costs from its bakeries are 3
percent of its total labor costs allocable
to the entire grocery business. Because
both ratios are less than 10 percent, N’s
production activities are de minimis.
Further, because N’s production
activities are incident to its resale
activities, N may use the simplified
resale method, as provided in paragraph
(a)(4)(ii) of this section.
*
*
*
*
*
(f) Applicability dates. (1) Paragraphs
(d)(3)(i)(C)(3), (d)(3)(i)(D)(3), and
(d)(3)(i)(E)(3) of this section apply for
taxable years ending on or after January
13, 2014.
(2) The rules set forth in the second
sentence of paragraph (a)(1) of this
section, paragraphs (a)(2)(ii) and (iii) of

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Federal Register / Vol. 86, No. 2 / Tuesday, January 5, 2021 / Rules and Regulations
this section, the third sentence of
paragraph (a)(3) of this section, and
paragraphs (a)(4)(ii) and (a)(5) of this
section apply for taxable years
beginning on or after January 5, 2021 .
However, for a taxable year beginning
after December 31, 2017, and before
January 5, 2021, a taxpayer may apply
the paragraphs described in the first
sentence of this paragraph (f)(2),
provided the taxpayer follows all the
applicable rules contained in the
regulations under section 263A for such
taxable year and all subsequent taxable
years.
■ Par. 6. Section 1.263A–4 is amended:
■ 1. In paragraph (a)(1), by revising the
last sentence.
■ 2. In paragraph (a)(2)(ii)(A)(1), by
removing the language ‘‘section 464(c)’’
and adding in its place the language
with ‘‘section 461(k)’’.
■ 3. By redesignating paragraphs (a)(3)
and (4) as paragraphs (a)(4) and (5)
respectively.
■ 4. By adding new paragraph (a)(3).
■ 5. By revising the paragraph (d)
subject heading.
■ 6. In paragraph (d)(1), by revising the
last sentence and adding a new sentence
at the end of the paragraph.
■ 7. In paragraph (d)(3)(i), by removing
the last sentence.
■ 8. By revising paragraph (d)(3)(ii).
■ 9. By redesignating paragraph (d)(5) as
paragraph (d)(7).
■ 10. By adding new paragraphs (d)(5)
and (6)
■ 11. By adding paragraph (e)(5).
■ 12. By redesignating paragraph (f) as
paragraph (g).
■ 13. By adding new paragraph (f).
■ 14. By revising the subject headings of
newly-redesignated paragraphs (g) and
(g)(1), and by revising newly-designated
paragraph (g)(2).
The revisions and additions read as
follows:

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§ 1.263A–4 Rules for property produced in
a farming business.

(a) * * * (1) * * * Except as
provided in paragraphs (a)(2), (a)(3), and
(e) of this section, taxpayers must
capitalize the costs of producing all
plants and animals unless the election
described in paragraph (d) of this
section is made.
*
*
*
*
*
(3) Exemption for certain small
business taxpayers. For taxable years
beginning after December 31, 2017, see
§ 1.263A–1(j) for an exception in the
case of a small business taxpayer that
meets the gross receipts test of section
448(c) and § 1.448–2(c).
*
*
*
*
*
(d) Election not to have section 263A
apply under section 263A(d)(3)—(1)

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* * * Except as provided in paragraph
(d)(5) and (6) of this section, the election
is a method of accounting under section
446. An election made under section
263A(d)(3) and this paragraph (d) is
revocable only with the consent of the
Commissioner.
*
*
*
*
*
(3) * * *
(ii) Nonautomatic election. Except as
provided in paragraphs (d)(5) and (6) of
this section, a taxpayer that does not
make the election under this paragraph
(d) as provided in paragraph (d)(3)(i) of
this section must obtain the consent of
the Commissioner to make the election
by filing a Form 3115, Application for
Change in Method of Accounting, in
accordance with § 1.446–1(e)(3).
*
*
*
*
*
(5) Revocation of section 263A(d)(3)
election to permit exemption under
section 263A(i). A taxpayer that elected
under section 263A(d)(3) and paragraph
(d)(3) of this section not to have section
263A apply to any plant produced in a
farming business that wants to revoke
its section 263A(d)(3) election, and in
the same taxable year, apply the small
business taxpayer exemption under
section 263A(i) and § 1.263A–1(j) may
revoke the election in accordance with
the applicable administrative guidance
as published in the Internal Revenue
Bulletin (see § 601.601(d)(2)(ii)(b) of this
chapter). A revocation of the taxpayer’s
section 263A(d)(3) election under this
paragraph (d)(5) is not a change in
method of accounting under sections
446 and 481 and §§ 1.446–1 and 1.481–
1 through 1.481–5.
(6) Change from applying exemption
under section 263A(i) to making a
section 263A(d)(3) election. A taxpayer
whose method of accounting is to not
capitalize costs under section 263A
based on the exemption under section
263A(i), that becomes ineligible to use
the exemption under section 263A(i),
and is eligible and wants to elect under
section 263A(d)(3) for this same taxable
year to not capitalize costs under
section 263A for any plant produced in
the taxpayer’s farming business, must
make the election in accordance with
the applicable administrative guidance
as published in the Internal Revenue
Bulletin (see § 601.601(d)(2)(ii)(b) of this
chapter). An election under section
263A(d)(3) made in accordance with
this paragraph (d)(6) is not a change in
method of accounting under sections
446 and 481 and §§ 1.446–1 and 1.481–
1 through 1.481–5.
*
*
*
*
*
(e) * * *
(5) Special temporary rule for citrus
plants lost by reason of casualty.

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267

Section 263A(d)(2)(A) provides that if
plants bearing an edible crop for human
consumption were lost or damaged
while in the hands of the taxpayer by
reason of freezing temperatures, disease,
drought, pests, or casualty, section 263A
does not apply to any costs of the
taxpayer of replanting plants bearing the
same type of crop (whether on the same
parcel of land on which such lost or
damaged plants were located or any
other parcel of land of the same acreage
in the United States). The rules of this
paragraph (e)(5) apply to certain costs
that are paid or incurred after December
22, 2017, and on or before December 22,
2027, to replant citrus plants after the
loss or damage of citrus plants.
Notwithstanding paragraph (e)(2) of this
section, in the case of replanting citrus
plants after the loss or damage of citrus
plants by reason of freezing
temperatures, disease, drought, pests, or
casualty, section 263A does not apply to
replanting costs paid or incurred by a
taxpayer other than the owner described
in section 263A(d)(2)(A) if—
(i) The owner described in section
263A(d)(2)(A) has an equity interest of
not less than 50 percent in the replanted
citrus plants at all times during the
taxable year in which such amounts
were paid or incurred and the taxpayer
holds any part of the remaining equity
interest; or
(ii) The taxpayer acquired the entirety
of the equity interest in the land of that
owner described in section
263A(d)(2)(A) and on which land the
lost or damaged citrus plants were
located at the time of such loss or
damage, and the replanting is on such
land.
(f) Change in method of accounting.
Except as provided in paragraphs (d)(5)
and (6) of this section, any change in a
taxpayer’s method of accounting
necessary to comply with this section is
a change in method of accounting to
which the provisions of sections 446
and 481 and § 1.446–1 through 1.446–7
and § 1.481–1 through § 1.481–3 apply.
(g) Applicability dates—(1) In general.
* * *
(2) Changes made by Tax Cuts and
Jobs Act (Pub. L. 115–97). Paragraphs
(a)(3), (d)(5), (d)(6), and (e)(5) of this
section apply for taxable years
beginning on or after January 5, 2021.
However, for a taxable year beginning
after December 31, 2017, and before
January 5, 2021, a taxpayer may apply
the paragraphs described in the first
sentence of this paragraph (g)(2),
provided that the taxpayer follows all
the applicable rules contained in the
regulations under section 263A for such
taxable year and all subsequent taxable
years.

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Par. 7. § 1.263A–7 is amended:
1. By revising paragraph (a)(3)(i).
2. By redesignating paragraph (a)(4) as
paragraph (a)(4)(i).
■ 3. By adding a paragraph (a)(4) subject
heading.
■ 4. By revising the newly-designated
paragraph (a)(4)(i) subject heading.
■ 5. By adding paragraph (a)(4)(ii).
■ 6. In paragraph (b)(1), by removing the
language ‘‘Rev. Proc. 97–27 (1997–21
I.R.B.10)’’ and adding in its place the
language ‘‘Revenue Procedure 2015–13
(2015–5 IRB 419)’’.
■ 7. In paragraph (b)(2)(ii), by removing
the language ‘‘Rev. Proc. 2002–9 (2002–
1 C.B. 327) and Rev. Proc. 97–27 (1991–
1 C.B. 680)’’ and adding the language
‘‘Revenue Procedure 2015–13, 2015–5
IRB 419 (or successor)’’ in its place.
The revisions and additions read as
follows:
■
■
■

§ 1.263A–7 Changing a method of
accounting under section 263A.

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(a) * * *
(3) * * *
(i) For taxable years beginning after
December 31, 2017, resellers of real or
personal property or producers of real or
tangible personal property whose
average annual gross receipts for the
immediately preceding 3-taxable-year
period, or lesser period if the taxpayer
was not in existence for the three
preceding taxable years, annualized as
required, exceed the gross receipts test
of section 448(c) and the accompanying
regulations where the taxpayer was not
subject to section 263A in the prior
taxable year;
*
*
*
*
*
(4) Applicability dates—(i) In
general.* * *
(ii) Changes made by Tax Cuts and
Jobs Act (Pub. L. 115–97). Paragraph
(a)(3)(i) of this section applies to taxable
years beginning on or after January 5,
2021. However, for a taxable year
beginning after December 31, 2017, and
before January 5, 2021, a taxpayer may
apply the paragraph described in the
first sentence of this paragraph (a)(4)(ii),
provided that the taxpayer follows all
the applicable rules contained in the
regulations under section 263A for such
taxable year and all subsequent taxable
years.
*
*
*
*
*
■ Par. 8. Section 1.263A–8 is amended
by adding a sentence to the end of
paragraph (a)(1) to read as follows:
§ 1.263A–8
interest.

Requirement to capitalize

(a) * * * (1) * * * However, a
taxpayer, other than a tax shelter
prohibited from using the cash receipts
and disbursements method of

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accounting under section 448(a)(3), that
meets the gross receipts test of section
448(c) for the taxable year is not
required to capitalize costs, including
interest, under section 263A. See
§ 1.263A–1(j).
*
*
*
*
*
■ Par. 9. Section 1.263A–9 is amended
by adding a sentence to the end of
paragraph (e)(2) to read as follows:
§ 1.263A–9

The avoided cost method.

*

*
*
*
*
(e) * * *
(2) * * *A taxpayer is an eligible
taxpayer for a taxable year for purposes
of this paragraph (e) if the taxpayer is a
small business taxpayer, as defined in
§ 1.263A–1(j).
*
*
*
*
*
■ Par. 10. Section 1.263A–15 is
amended by adding paragraph (a)(4) to
read as follows:
§ 1.263A–15 Effective dates, transitional
rules, and anti-abuse rule.

(a) * * *
(4) The last sentence of each of
§ 1.263A–8(a)(1) and § 1.263A–9(e)(2)
apply to taxable years beginning on or
after January 5, 2021. However, for a
taxable year beginning after December
31, 2017, and before January 5, 2021, a
taxpayer may apply the last sentence of
each of § 1.263A–8(a)(1) and § 1.263A–
9(e)(2), provided that the taxpayer
follows all the applicable rules
contained in the regulations under
section 263A for such taxable year and
all subsequent taxable years.
*
*
*
*
*
■ Par. 11. Section 1.381(c)(5)–1 is
amended:
■ 1. In paragraph (a)(6), by designating
Examples 1 and 2 as paragraphs (a)(6)(i)
and (ii), respectively.
■ 2. In newly-designated paragraphs
(a)(6)(i) and (ii), by redesignating the
paragraphs in the first column as the
paragraphs in the second column:
Old paragraphs
(a)(6)(i)(i) and (ii) .......
(a)(6)(ii)(i) and (ii) ......

New paragraphs
(a)(6)(i)(A) and (B)
(a)(6)(ii)(A) and (B)

3. In newly designated paragraphs
(a)(6)(ii)(A) and (B), by removing the
language ‘‘small reseller’’ and adding in
its place the language ‘‘small business
taxpayer’’ everywhere it appears.
■ 4. By adding a sentence to the end of
paragraph (f).
The addition reads as follows:
■

§ 1.381(c)(5)–1

Inventory method.

*

*
*
*
*
(f) * * * The designations of
paragraphs (a)(6)(ii)(A) and (B) of this

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section and removal of the term ‘‘small
reseller’’ and replacement with the term
‘‘small business taxpayer’’ apply to
taxable years beginning on or after
January 5, 2021.
■ Par. 12. § 1.446–1 is amended:
■ 1. In paragraph (a)(4)(i), by revising
the first sentence.
■ 2. By revising paragraph (c)(2)(i).
■ 3. By adding paragraph (c)(3).
The revisions and additions read as
follows:
§ 1.446–1 General rule for methods of
accounting.

(a) * * *
(4) * * *
(i) Except in the case of a taxpayer
qualifying as a small business taxpayer
for the taxable year under section
471(c), in all cases in which the
production, purchase or sale of
merchandise of any kind is an incomeproducing factor, merchandise on hand
(including finished goods, work in
progress, raw materials, and supplies) at
the beginning and end of the year shall
be taken into account in computing the
taxable income of the year. * * *
*
*
*
*
*
(c) * * *
(2) * * *
(i) In any case in which it is necessary
to use an inventory, the accrual method
of accounting must be used with regard
to purchases and sales unless:
(A) The taxpayer qualifies as a small
business taxpayer for the taxable year
under section 471(c), or
(B) Otherwise authorized under
paragraph (c)(2)(ii) of this section.
*
*
*
*
*
(3) Applicability date. The first
sentence of paragraph (a)(4)(i) of this
section and paragraph (c)(2)(i) of this
section apply to taxable years beginning
on or after January 5, 2021. However, for
a taxable year beginning after December
31, 2017, and before January 5, 2021, a
taxpayer may apply the rules provided
in the first sentence of this paragraph
(c)(3), provided that the taxpayer
follows all the applicable rules
contained in the regulations under
section 446 for such taxable year and all
subsequent taxable years.
*
*
*
*
*
■ Par. 13. Section 1.448–1 is amended
by adding new first and second
sentences to paragraphs (g)(1) and (h)(1)
to read as follows:
§ 1.448–1 Limitation on the use of the cash
receipts and disbursements method of
accounting.

*

*
*
*
*
(g) * * * (1) * * * The rules
provided in paragraph (g) of this section

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apply to taxable years beginning before
January 1, 2018. See § 1.448–2 for rules
relating to taxable years beginning after
December 31, 2017. * * *
*
*
*
*
*
(h) * * * (1) * * * The rules
provided in paragraph (h) of this section
apply to taxable years beginning before
January 1, 2018. See § 1.448–2 for rules
relating to taxable years beginning after
December 31, 2017. * * *
*
*
*
*
*
§ 1.448–2

[Redesignated as § 1.448–3]

Par. 14. Section 1.448–2 is
redesignated as § 1.448–3.
■ Par. 15. A new § 1.448–2 is added to
read as follows:
■

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§ 1.448–2 Limitation on the use of the cash
receipts and disbursements method of
accounting for taxable years beginning
after December 31, 2017.

(a) Limitation on method of
accounting—(1) In general. The rules of
this section relate to the limitation on
the use of the cash receipts and
disbursements method of accounting
(cash method) by certain taxpayers
applicable for taxable years beginning
after December 31, 2017. For rules
applicable to taxable years beginning
before January 1, 2018, see §§ 1.448–1
and 1.448–1T.
(2) Limitation rule. Except as
otherwise provided in this section, the
computation of taxable income using
the cash method is prohibited in the
case of a:
(i) C corporation;
(ii) Partnership with a C corporation
as a partner, or a partnership that had
a C corporation as a partner at any time
during the partnership’s taxable year
beginning after December 31, 1986; or
(iii) Tax shelter.
(3) Treatment of combination
methods—(i) In general. For purposes of
this section, the use of a method of
accounting that records some, but not
all, items on the cash method is
considered the use of the cash method.
Thus, a C corporation that uses a
combination of accounting methods
including the use of the cash method is
subject to this section.
(ii) Example. The following example
illustrates the operation of this
paragraph (a)(3). In 2020, A is a C
corporation with average annual gross
receipts for the prior three taxable years
of greater than $30 million, is not a tax
shelter under section 448(a)(3) and does
not qualify as a qualified personal
service corporation, as defined in
paragraph (e) of this section. For the last
20 years, A used an accrual method for
items of income and expenses related to
purchases and sales of inventory, and

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the cash method for items related to its
provision of services. A is using a
combination of accounting methods that
include the cash method. Thus, A is
subject to section 448. A is prohibited
from using the cash method for any item
for 2020 and is required to change to a
permissible method.
(b) Definitions. For purposes of this
section—
(1) C corporation—(i) In general. The
term C corporation means any
corporation that is not an S corporation
(as defined in section 1361(a)(1)). For
example, a regulated investment
company (as defined in section 851) or
a real estate investment trust (as defined
in section 856) is a C corporation for
purposes of this section. In addition, a
trust subject to tax under section 511(b)
is treated, for purposes of this section,
as a C corporation, but only with respect
to the portion of its activities that
constitute an unrelated trade or
business. Similarly, for purposes of this
section, a corporation that is exempt
from Federal income taxes under
section 501(a) is treated as a C
corporation only with respect to the
portion of its activities that constitute an
unrelated trade or business. Moreover,
for purposes of determining whether a
partnership has a C corporation as a
partner, any partnership described in
paragraph (a)(2)(ii) of this section is
treated as a C corporation. Thus, if
partnership ABC has a partner that is a
partnership with a C corporation, then,
for purposes of this section, partnership
ABC is treated as a partnership with a
C corporation partner.
(ii) [Reserved]
(2) Tax shelter—(i) In general. The
term tax shelter means any—
(A) Enterprise, other than a C
corporation, if at any time, including
taxable years beginning before January
1, 1987, interests in such enterprise
have been offered for sale in any
offering required to be registered with
any Federal or state agency having the
authority to regulate the offering of
securities for sale;
(B) Syndicate, within the meaning of
paragraph (b)(2)(iii) of this section; or
(C) Tax shelter, within the meaning of
section 6662(d)(2)(C).
(ii) Requirement of registration. For
purposes of paragraph (b)(2)(i)(A) of this
section, an offering is required to be
registered with a Federal or state agency
if, under the applicable Federal or state
law, failure to register the offering
would result in a violation of the
applicable Federal or state law. This
rule applies regardless of whether the
offering is in fact registered. In addition,
an offering is required to be registered
with a Federal or state agency if, under

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269

the applicable Federal or state law,
failure to file a notice of exemption from
registration would result in a violation
of the applicable Federal or state law,
regardless of whether the notice is in
fact filed. However, an S corporation is
not treated as a tax shelter for purposes
of section 448(d)(3) or this section
merely by reason of being required to
file a notice of exemption from
registration with a state agency
described in section 461(i)(3)(A), but
only if all corporations offering
securities for sale in the state must file
such a notice in order to be exempt from
such registration.
(iii) Syndicate—(A) In general. For
purposes of paragraph (b)(2)(i)(B) of this
section, the term syndicate means a
partnership or other entity (other than a
C corporation) if more than 35 percent
of the losses of such entity during the
taxable year (for taxable years beginning
after December 31, 1986) are allocated to
limited partners or limited
entrepreneurs. For purposes of this
paragraph (b)(2)(iii), the term limited
entrepreneur has the same meaning
given such term in section 461(k)(4). In
addition, in determining whether an
interest in a partnership is held by a
limited partner, or an interest in an
entity or enterprise is held by a limited
entrepreneur, section 461(k)(2) applies
in the case of the trade or business of
farming (as defined in paragraph (d)(2)
of this section), and section
1256(e)(3)(C) applies in all other cases.
Moreover, for purposes of paragraph
(b)(2) of this section, the losses of a
partnership, entity, or enterprise
(entities) means the excess of the
deductions allowable to the entities over
the amount of income recognized by
such entities under the entities’ method
of accounting used for Federal income
tax purposes (determined without
regard to this section). For this purpose,
gains or losses from the sale of capital
assets or assets described in section
1221(a)(2) are not taken into account.
(B) Irrevocable annual election to test
the allocation of losses from prior
taxable year—(1) In general. For
purposes of paragraph (b)(2)(iii)(A) of
this section, to determine if more than
35 percent of the losses of a venture are
allocated to limited partners or limited
entrepreneurs, entities may elect to use
the allocations made in the immediately
preceding taxable year instead of using
the current taxable year’s allocation. An
election under this paragraph
(b)(2)(iii)(B) applies only to the taxable
year for which the election is made.
Except as otherwise provided in
guidance published in the Internal
Revenue Bulletin (see § 601.601(d)(2) of
this chapter), a taxpayer that makes an

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election under this paragraph
(b)(2)(iii)(B) must apply this election for
other provisions of the Code that
specifically apply the definition of tax
shelter in section 448(a)(3).
(2) Time and manner of making
election. A taxpayer makes this election
for the taxable year by attaching a
statement to its timely filed original
Federal income tax return (including
extensions) for such taxable year. The
statement must state that the taxpayer is
making the election under § 1.448–
2(b)(2)(iii)(B). In the case of an S
corporation or partnership, the election
is made by the S corporation or the
partnership and not by the shareholders
or partners. An election under this
paragraph (b)(2)(iii)(B) may not be made
by the taxpayer in any other manner.
For example, the election cannot be
made through a request under section
446(e) to change the taxpayer’s method
of accounting. A taxpayer may not
revoke an election under this paragraph
(b)(2)(iii)(B).
(3) Administrative guidance. The IRS
may publish procedural guidance in the
Internal Revenue Bulletin (see
§ 601.601(d)(2) of this chapter) that
provides alternative procedures for
complying with paragraph
(b)(2)(iii)(B)(2) of this section.
(C) Examples. The following
examples illustrate the rules of
paragraph (b)(2)(iii) of this section. For
purposes of the examples, the term
‘‘losses’’ has the meaning stated in
paragraph (b)(2)(iii)(A) of this section.
(1) Example 1. Taxpayer B is a
calendar year limited partnership, with
no active management from its limited
partner. For 2019, B is profitable and
has no losses to allocate to its limited
partner. For 2020, B is not profitable
and allocates 60 percent of its losses to
its general partner and 40 percent of its
losses to its limited partner. For 2021,
B is not profitable and allocates 50
percent of its losses to its general
partner and 50 percent of its losses to its
limited partner. For taxable year 2020,
B makes an election under paragraph
(b)(2)(iii)(B) of this section to use its
prior year allocated amounts.
Accordingly, for 2020, B is not a
syndicate because B was profitable for
2019 and did not allocate any losses to
its limited partner in 2019. For 2021, B
is a syndicate because B allocated 50
percent of its 2021 losses to its limited
partner under paragraph (b)(2)(ii)(3)(A)
of this section. Even if B made an
election under paragraph (b)(2)(iii)(B) of
this section to use prior year allocated
amounts, B is a syndicate for 2021
because B allocated 40 percent of its
2020 losses to its limited partner in
2020. Because B is a syndicate under

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paragraph (b)(2)(iii)(A) of this section
for 2021, B is a tax shelter prohibited
from using the cash method for taxable
year 2021 under paragraph (b)(2)(i)(B) of
this section.
(2) Example (2). Same facts as
Example (1) in paragraph (b)(2)(iii)(C)(1)
of this section, except for 2021, B is
profitable and has no losses to allocate
to its limited partner. For 2020, B makes
an election under paragraph (b)(2)(iii)(B)
of this section to use its prior year
allocated amounts. Accordingly, for
2020, B is not a syndicate because it did
not any allocate any losses to its limited
partner in 2019. For 2021, B chooses not
to make the election under paragraph
(b)(2)(iii)(B) of this section. For 2021, B
is not a syndicate because it does not
have any 2021 losses to allocate to a
limited partner. For taxable years 2019,
2020 and 2021, B is not a syndicate
under paragraph (b)(2)(iii)(A) of this
section and is not prohibited from using
the cash method for taxable years 2019,
2020 or 2021 under paragraph
(b)(2)(i)(B) of this section.
(iv) Presumed tax avoidance. For
purposes of (b)(2)(i)(C) of this section,
marketed arrangements in which
persons carrying on farming activities
using the services of a common
managerial or administrative service
will be presumed to have the principal
purpose of tax avoidance if such
persons use borrowed funds to prepay a
substantial portion of their farming
expenses. Payments for farm supplies
that will not be used or consumed until
a taxable year subsequent to the taxable
year of payment are an example of one
type of such prepayment.
(v) Taxable year tax shelter must
change accounting method. A tax
shelter must change from the cash
method for the taxable year that it
becomes a tax shelter, as determined
under paragraph (b)(2) of this section.
(vi) Determination of loss amount. For
purposes of section 448(d)(3), the
amount of losses to be allocated under
section 1256(e)(3)(B) is calculated
without regard to section 163(j).
(c) Exception for entities with gross
receipts not in excess of the amount
provided in section 448(c)—(1) In
general. Except in the case of a tax
shelter, this section does not apply to
any C corporation or partnership with a
C corporation as a partner for any
taxable year if such corporation or
partnership (or any predecessor thereof)
meets the gross receipts test of
paragraph (c)(2) of this section.
(2) Gross receipts test—(i) In general.
A corporation meets the gross receipts
test of this paragraph (c)(2) if the
average annual gross receipts of such
corporation for the 3 taxable years (or,

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if shorter, the taxable years during
which such corporation was in
existence, annualized as required)
ending with such prior taxable year
does not exceed the gross receipts test
amount provided in paragraph (c)(2)(v)
of this section (section 448(c) gross
receipts test). In the case of a C
corporation exempt from Federal
income taxes under section 501(a), or a
trust subject to tax under section 511(b)
that is treated as a C corporation under
paragraph (b)(1) of this section, only
gross receipts from the activities of such
corporation or trust that constitute
unrelated trades or businesses are taken
into account in determining whether the
gross receipts test is satisfied. A
partnership with a C corporation as a
partner meets the gross receipts test of
paragraph (c)(2) of this section if the
average annual gross receipts of such
partnership for the 3 taxable years (or,
if shorter, the taxable years during
which such partnership was in
existence annualized as required)
ending with such prior year does not
exceed the gross receipts test amount of
paragraph (c)(2)(v) of this section.
Except as provided in paragraph
(c)(2)(ii) of this section, the gross
receipts of the corporate partner are not
taken into account in determining
whether a partnership meets the gross
receipts test of paragraph (c)(2) of this
section.
(ii) Aggregation of gross receipts. The
aggregation rules in § 1.448–1T(f)(2)(ii)
apply for purposes of aggregating gross
receipts for purposes of this section.
(iii) Treatment of short taxable year.
The short taxable year rules in § 1.448–
1T(f)(2)(iii) apply for purposes of this
section.
(iv) Determination of gross receipts.
The determination of gross receipts
rules in § 1.448–1T(f)(2)(iv) apply for
purposes of this section.
(v) Gross receipts test amount—(A) In
general. For purposes of paragraph (c) of
this section, the term gross receipts test
amount means $25,000,000, adjusted
annually for inflation in the manner
provided in section 448(c)(4). The
inflation adjusted gross receipts test
amount is published annually in
guidance published in the Internal
Revenue Bulletin (see § 601.601(d)(2)(ii)
of this chapter).
(B) Example. Taxpayer A, a C
corporation, is a plumbing contractor
that installs plumbing fixtures in
customers’ homes or businesses. A’s
gross receipts for the 2017–2019 taxable
years are $20 million, $16 million, and
$30 million, respectively. A’s average
annual gross receipts for the three
taxable-year period preceding the 2020
taxable year is $22 million (($20 million

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Federal Register / Vol. 86, No. 2 / Tuesday, January 5, 2021 / Rules and Regulations
+ $16 million + $30 million)/3) = $22
million. A may use the cash method for
its trade or business for the 2020 taxable
year because its average annual gross
receipts for the preceding three taxable
years is not more than the gross receipts
test amount of paragraph (c)(2)(vi) of
this section, which is $26 million for
2020.
(d) Exception for farming
businesses—(1) In general. Except in the
case of a tax shelter, this section does
not apply to any farming business. A
taxpayer engaged in a farming business
and a separate non-farming business is
not prohibited by this section from
using the cash method with respect to
the farming business, even though the
taxpayer may be prohibited by this
section from using the cash method
with respect to the non-farming
business.
(2) Farming business—(i) In general.
For purposes of paragraph (d) of this
section, the term farming business
means—
(A) The trade or business of farming
as defined in section 263A(e)(4)
(including the operation of a nursery or
sod farm, or the raising or harvesting of
trees bearing fruit, nuts or other crops,
or ornamental trees),
(B) The raising, harvesting, or growing
of trees described in section 263A(c)(5)
(relating to trees raised, harvested, or
grown by the taxpayer other than trees
described in paragraph (d)(2)(i)(A) of
this section),
(C) The raising of timber, or
(D) Processing activities which are
normally incident to the growing,
raising, or harvesting of agricultural
products.
(ii) Example. Assume a taxpayer is in
the business of growing fruits and
vegetables. When the fruits and
vegetables are ready to be harvested, the
taxpayer picks, washes, inspects, and
packages the fruits and vegetables for
sale. Such activities are normally
incident to the raising of these crops by
farmers. The taxpayer will be
considered to be in the business of
farming with respect to the growing of
fruits and vegetables, and the processing
activities incident to the harvest.
(iii) Processing activities excluded
from farming businesses—(A) In
general. For purposes of this section, a
farming business does not include the
processing of commodities or products
beyond those activities normally
incident to the growing, raising, or
harvesting of such products.
(B) Examples. (1) Example 1. Assume
that a C corporation taxpayer is in the
business of growing and harvesting
wheat and other grains. The taxpayer
processes the harvested grains to

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produce breads, cereals, and similar
food products which it sells to
customers in the course of its business.
Although the taxpayer is in the farming
business with respect to the growing
and harvesting of grain, the taxpayer is
not in the farming business with respect
to the processing of such grains to
produce breads, cereals, and similar
food products which the taxpayer sells
to customers.
(2) Example 2. Assume that a taxpayer
is in the business of raising livestock.
The taxpayer uses the livestock in a
meat processing operation in which the
livestock are slaughtered, processed,
and packaged or canned for sale to
customers. Although the taxpayer is in
the farming business with respect to the
raising of livestock, the taxpayer is not
in the farming business with respect to
the meat processing operation.
(e) Exception for qualified personal
service corporation. The rules in
§ 1.448–1T(e) relating to the exception
for qualified personal service
corporations apply for taxable years
beginning after December 31, 2017.
(f) Effect of section 448 on other
provisions. Except as provided in
paragraph (b)(2)(iii)(B) of this section,
nothing in section 448 shall have any
effect on the application of any other
provision of law that would otherwise
limit the use of the cash method, and no
inference shall be drawn from section
448 with respect to the application of
any such provision. For example,
nothing in section 448 affects the
requirement of section 447 that certain
corporations must use an accrual
method of accounting in computing
taxable income from farming, or the
requirement of § 1.446–1(c)(2) that, in
general, an accrual method be used with
regard to purchases and sales of
inventory. Similarly, nothing in section
448 affects the authority of the
Commissioner under section 446(b) to
require the use of an accounting method
that clearly reflects income, or the
requirement under section 446(e) that a
taxpayer secure the consent of the
Commissioner before changing its
method of accounting. For example, a
taxpayer using the cash method may be
required to change to an accrual method
of accounting under section 446(b)
because such method clearly reflects the
taxpayer’s income, even though the
taxpayer is not prohibited by section
448 from using the cash method.
Similarly, a taxpayer using an accrual
method of accounting that is not
prohibited by section 448 from using the
cash method may not change to the cash
method unless the taxpayer secures the
consent of the Commissioner under
section 446(e).

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(g) Treatment of accounting method
change and rules for section 481(a)
adjustment—(1) In general. Any
taxpayer to whom section 448 applies
must change its method of accounting in
accordance with the provisions of this
paragraph (g). In the case of any
taxpayer required by this section to
change its method of accounting, the
change shall be treated as a change
initiated by the taxpayer to compute the
adjustment required under section 481.
A taxpayer must change to an overall
accrual method of accounting for the
first taxable year the taxpayer is subject
to this section or a subsequent taxable
year in which the taxpayer is newly
subject to this section after previously
making a change in method of
accounting that complies with section
448 (mandatory section 448 year). A
taxpayer may have more than one
mandatory section 448 year. For
example, a taxpayer may exceed the
gross receipts test of section 448(c) in
non-consecutive taxable years. If the
taxpayer complies with the provisions
of paragraph (g)(3) of this section for its
mandatory section 448 year, the change
shall be treated as made with the
consent of the Commissioner. The
change shall be implemented pursuant
to the applicable administrative
procedures to obtain the automatic
consent of the Commissioner to change
a method of accounting under section
446(e) as published in the Internal
Revenue Bulletin (see Revenue
Procedure 2015–13 (2015–5 IRB 419) (or
successor) (see also § 601.601(d)(2) of
this chapter)). This paragraph (g) applies
only to a taxpayer who changes from the
cash method as required by this section.
This paragraph (g) does not apply to a
change in method of accounting
required by any Code section (or
applicable regulation) other than this
section.
(2) Section 481(a) adjustment. The
amount of the net section 481(a)
adjustment and the adjustment period
necessary to implement a change in
method of accounting required under
this section are determined under
§ 1.446–1(e) and the applicable
administrative procedures to obtain the
Commissioner’s consent to change a
method of accounting as published in
the Internal Revenue Bulletin (see
Revenue Procedure 2015–13 (2015–5
IRB 419) (or successor) (see also
§ 601.601(d)(2) of this chapter).
(h) Applicability dates. The rules of
this section apply for taxable years
beginning on or after January 5, 2021.
However, for a taxable year beginning
after December 31, 2017, and before
January 5, 2021, a taxpayer may apply
the rules provided in this section

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provided that the taxpayer follows all
the applicable rules contained in the
regulations under section 448 for such
taxable year and all subsequent taxable
years.
■ Par. 16. Newly-redesignated § 1.448–3
is amended by revising paragraphs (a)(2)
and (h) to read as follows:
§ 1.448–3 Nonaccrual of certain amounts
by service providers.

(a) * * *
(2) The taxpayer meets the gross
receipts test of section 448(c) and
§ 1.448–1T(f)(2) (in the case of taxable
years beginning before January 1, 2018),
or § 1.448–2(c) (in the case of taxable
years beginning after December 31,
2017) for all prior taxable years.
*
*
*
*
*
(h) Applicability dates. (1) Except as
provided in paragraph (h)(2) of this
section, this section is applicable for
taxable years ending on or after August
31, 2006.
(2) The rules of paragraph (a)(2) of
this section apply for taxable years
beginning on or after January 5, 2021.
However, for a taxable year beginning
after December 31, 2017, and before
January 5, 2021, a taxpayer may apply
the paragraph described in the first
sentence of this paragraph (h)(2),
provided that the taxpayer follows all
the applicable rules contained in the
regulations under section 448 for such
taxable year and all subsequent taxable
years.
■ Par. 17. Section 1.460–0 is amended
by:
■ 1. Adding an entry for § 1.460–1(h)(3).
■ 2. Revising the entries for § 1.460–
3(b)(3), § 1.460–3(b)(3)(i) and (ii), and
adding entries for § 1.460–3(b)(3)(ii)(A),
(B), (C) and (D).
■ 3. Removing the entry for § 1.460–
3(b)(3)(iii).
■ 4. Adding entries for § 1.460–3(d),
§ 1.460–4(i), and § 1.460–6(k).
The additions and revisions read as
follows:
§ 1.460–0 Outline of regulations under
section 460.

*

*

§ 1.460–1

*

*

*

*

*

Long-term contracts.

*

*

*

(h) * * *
(3) Changes made by Tax Cuts and Jobs Act
(Pub. L. 115–97).

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*

*

§ 1.460–3

*

*

*

*

*

Long-term construction contracts.

*

*

*

(b) * * *
(3) Gross receipts test of section 448(c)
(i) In general
(ii) Application of gross receipts test
(A) In general

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(B) Gross receipts of individuals, etc.
(C) Partners and S corporation
shareholders
(D) Examples
(1) Example 1.
(2) Example 2.
(iii) Method of accounting.

*

*

*

*

*

(d) Applicability dates.
§ 1.460–4 Methods of Accounting for longterm contracts.

*

*

*

*

*

(i) Applicability date.

*

*

§ 1.460–6

*

*

*

*

*

Look-back method.

*

*

*

(k) Applicability date.

Par. 18. Section 1.460–1 is amended
by adding three sentences to the end of
paragraph (f)(3) and adding paragraph
(h)(3) to read as follows:

■

§ 1.460–1

Long-term contracts.

*

*
*
*
*
(f) * * *
(3) * * * A taxpayer may adopt any
permissible method of accounting for
each classification of contract. Such
adoption is not a change in method of
accounting under section 446 and the
accompanying regulations. For example,
a taxpayer that has had only contracts
classified as nonexempt long-term
contracts and has used the PCM for
these contracts may adopt an exempt
contract method in the taxable year it
first enters into an exempt long-term
contract.
*
*
*
*
*
(h) * * *
(3) Changes made by Tax Cuts and
Jobs Act (Pub. L. 115–97). Paragraph
(f)(3) of this section, and § 1.460–5(d)(1)
and (d)(3), apply for contracts entered
into in taxable years beginning on or
after January 5, 2021. However, for
contracts entered into after December
31, 2017, in a taxable year ending after
December 31, 2017, and before January
5, 2021, a taxpayer may apply paragraph
(f)(3) of this section, and § 1.460–5(d)(1)
and (d)(3), provided that the taxpayer
also applies the applicable rules
contained in the regulations under
section 460 for such taxable year and all
subsequent taxable years.
*
*
*
*
*
■ Par. 19. Section 1.460–3 is amended
by revising paragraphs (b)(1)(ii) and
(b)(3), and adding paragraph (d) to read
as follows:
§ 1.460–3 Long-term construction
contracts.

*

*
*
*
*
(b) * * *
(1) * * *
(ii) Other construction contract,
entered into after December 31, 2017, in

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a taxable year ending after December 31,
2017, by a taxpayer, other than a tax
shelter prohibited from using the cash
receipts and disbursements method of
accounting (cash method) under section
448(a)(3), who estimates at the time
such contract is entered into that such
contract will be completed within the 2year period beginning on the contract
commencement date, and who meets
the gross receipts test described in
paragraph (b)(3) of this section for the
taxable year in which such contract is
entered into.
*
*
*
*
*
(3) Gross receipts test—(i) In general.
A taxpayer, other than a tax shelter
prohibited from using the cash method
under section 448(a)(3), meets the gross
receipts test of this paragraph (b)(3) if it
meets the gross receipts test of section
448(c) and § 1.448–2(c)(2). This gross
receipts test applies even if the taxpayer
is not otherwise subject to section
448(a).
(ii) Application of gross receipts test—
(A) In general. In the case of any
taxpayer that is not a corporation or a
partnership, and except as provided in
paragraphs (b)(3)(ii)(B) and (C) of this
section, the gross receipts test of section
448(c) and the accompanying
regulations are applied in the same
manner as if each trade or business of
such taxpayer were a corporation or
partnership.
(B) Gross receipts of individuals, etc.
Except when the aggregation rules of
section 448(c)(2) apply, the gross
receipts of a taxpayer other than a
corporation or partnership are the
amount derived from all trades or
businesses of such taxpayer. Amounts
not related to a trade or business are
excluded from the gross receipts of the
taxpayer. For example, an individual
taxpayer’s gross receipts do not include
inherently personal amounts, such as
personal injury awards or settlements
with respect to an injury of the
individual taxpayer, disability benefits,
Social Security benefits received by the
taxpayer during the taxable year, and
wages received as an employee that are
reported on Form W–2.
(C) Partners and S corporation
shareholders. Except when the
aggregation rules of section 448(c)(2)
apply, each partner in a partnership
includes a share of partnership gross
receipts in proportion to such partner’s
distributive share (as determined under
section 704) of items of gross income
that were taken into account by the
partnership under section 703.
Similarly, a shareholder includes the
pro rata share of S corporation gross

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Federal Register / Vol. 86, No. 2 / Tuesday, January 5, 2021 / Rules and Regulations
receipts taken into account by the S
corporation under section 1363(b).
(D) Example. The operation of this
paragraph (b)(3) is illustrated by the
following examples:
(1) Example 1. Taxpayer A is an
individual who operates two separate
and distinct trades or business that are
reported on Schedule C, Profit or Loss
from Business, of A’s Federal income
tax return. For 2020, one trade or
business has annual average gross
receipts of $5 million, and the other
trade or business has average annual
gross receipts of $35 million. Under
paragraph (b)(3)(ii)(B) of this section, for
2020, neither of A’s trades or businesses
meets the gross receipts test of
paragraph (b)(3) of this section ($5
million + $35 million = $40 million,
which is greater than the inflationadjusted gross receipts test amount for
2020, which is $26 million).
(2) Example 2. Taxpayer B is an
individual who operates three separate
and distinct trades or business that are
reported on Schedule C of B’s Federal
income tax return. For 2020, Business X
is a retail store with average annual
gross receipts of $15 million, Business
Y is a dance studio with average annual
gross receipts of $6 million, and
Business Z is a car repair shop with
average annual gross receipts of $12
million. Under paragraph (b)(3)(ii)(B) of
this section, B’s gross receipts are the
combined amount derived from all three
of B’s trades or businesses. Therefore,
for 2020, X, Y and Z do not meet the
gross receipts test of paragraph (b)(3)(i)
of this section ($15 million + $6 million
+ $12 million = $33 million, which is
greater than the inflation-adjusted gross
receipts test amount for 2020, which is
$26 million).
(iii) Method of accounting. A change
in the method of accounting used for
exempt construction contracts described
in paragraph (b)(1)(ii) of this section is
a change in method of accounting under
section 446 and the accompanying
regulations. For rules distinguishing a
change in method from adoption of a
method, see § 1.460–1(f)(3). A taxpayer
changing its method of accounting must
obtain the consent of the Commissioner
in accordance with § 1.446–1(e)(3). For
rules relating to the clear reflection of
income and the pattern of consistent
treatment of an item, see section 446
and § 1.446–1. A change in method of
accounting shall be implemented
pursuant to the applicable
administrative procedures to obtain the
consent of the Commissioner to change
a method of accounting under section
446(e) as published in the Internal
Revenue Bulletin (IRB) (see Revenue
Procedure 2015–13 (2015–5 IRB 419) (or

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successor) (see § 601.601(d)(2) of this
chapter)). A taxpayer that uses the
percentage of completion method for
exempt contracts described in paragraph
(b)(1)(ii) of this section that wants to
change to another exempt contract
method is to use the applicable
administrative procedures to obtain the
automatic consent of the Commissioner
to change such method under section
446(e) as published in the IRB. A
taxpayer-initiated change in method of
accounting will be permitted only on a
cut-off basis, and thus, a section 481(a)
adjustment will not be permitted or
required. See § 1.460–4(g).
*
*
*
*
*
(d) Applicability Dates. Paragraphs
(b)(1)(ii) and (b)(3) of this section apply,
for contracts entered into in taxable
years beginning on or after January 5,
2021. However, for contracts entered
into after December 31, 2017, in a
taxable year ending after December 31,
2017, and before January 5, 2021, a
taxpayer may apply the paragraphs
described in the first sentence of this
paragraph (d), provided that the
taxpayer follows all the applicable rules
contained in the regulations under
section 460 for such taxable year and all
subsequent taxable years.
■ Par. 20. Section 1.460–4 is amended
by revising the first sentence of
paragraph (f)(1) and adding paragraph
(i) to read as follows:
§ 1.460–4 Methods of Accounting for longterm contracts.

*

*
*
*
*
(f) * * * (1) * * * Under section
56(a)(3), a taxpayer subject to the AMT
must use the PCM to determine its
AMTI from any long-term contract
entered into on or after March 1, 1986,
that is not a home construction contract,
as defined in § 1.460–3(b)(2). * * *
*
*
*
*
*
(i) Applicability date. Paragraph (f)(1)
of this section applies to taxable years
beginning on or after January 5, 2021.
However, for a taxable year beginning
after December 31, 2017, and before
January 5, 2021, a taxpayer may apply
the paragraph described in the first
sentence of this paragraph (i), provided
that the taxpayer follows all the
applicable rules contained in the
regulations under section 460 for such
taxable year and all subsequent taxable
years.
*
*
*
*
*
■ Par. 21. Section 1.460–5 is amended:
■ 1. In paragraph (d)(1), by removing the
language ‘‘(concerning contracts of
homebuilders that do not satisfy the
$10,000,000 gross receipts test described
in § 1.460–3(b)(3) or will not be

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273

completed within two years of the
contract commencement date)’’.
■ 2. By revising paragraph (d)(3).
The revision reads as follows:
§ 1.460–5

Cost allocation rules.

*

*
*
*
*
(d) * * *
(3) Large homebuilders. A taxpayer
must capitalize the costs of home
construction contracts under section
263A, unless the taxpayer estimates,
when entering into the contract, that it
will be completed within two years of
the contract commencement date, and
the taxpayer satisfies the gross receipts
test of section 448(c) described in
§ 1.460–3(b)(3) for the taxable year in
which the contract is entered into.
*
*
*
*
*
■ Par. 22. Section 1.460–6 is amended:
■ 1. In paragraph (b)(2) introductory
text, by removing the language ‘‘section
460(e)(4)’’ and adding in its place the
language ‘‘section 460(e)(3)’’.
■ 2. By revising the first and last
sentences of paragraph (b)(2)(ii).
■ 3. By designating the undesignated
text after paragraph (b)(3)(ii) as
paragraph (b)(3)(iii).
■ 4. In newly designated paragraph
(b)(3)(iii), by adding a sentence to the
end of the paragraph.
■ 5. In paragraph (c)(1)(i), by revising
the fifth sentence.
■ 6. In paragraph (c)(2)(i), by revising
the third sentence.
■ 7. In paragraph (c)(2)(iv), by revising
the first sentence.
■ 8. In paragraph (c)(3)(ii), by revising
the first sentence.
■ 9. In paragraph (c)(3)(vi), by revising
the first sentence.
■ 10. In paragraph (d)(2)(i), by removing
the language ‘‘whether or not the
taxpayer would have been subject to the
alternative minimum tax’’ and adding in
its place the language ‘‘for taxpayers
subject to the alternative minimum tax
without regard to whether tentative
minimum tax exceeds regular tax for the
redetermination year’’.
■ 11. By revising paragraph (d)(4)(i)(A).
■ 12. By designating paragraph (h)(8)(ii)
Example 7 as paragraph (h)(8)(iii).
■ 13. By revising newly designated
paragraph (h)(8)(iii).
■ 14. By adding paragraph (k).
The revisions and additions read as
follows:
§ 1.460–6

Look-back method.

*

*
*
*
*
(b) * * *
(2) * * *
(ii) is not a home construction
contract but is estimated to be
completed within a 2-year period by a
taxpayer, other than a tax shelter

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prohibited from using the cash receipts
and disbursements method of
accounting under section 448(a)(3), who
meets the gross receipts test of section
448(c) and § 1.460–3(b)(3) for the
taxable year in which such contract is
entered into. * * * The look-back
method, however, applies to the
alternative minimum taxable income
from a contract of this type, for those
taxpayers subject to the AMT in taxable
years prior to the filing taxable year in
which the look-back method is required,
unless the contract is exempt from
required use of the percentage of
completion method under section
56(a)(3).
(3) * * *
(iii) * * * For contracts entered into
after December 31, 2017, in a taxable
year ending after December 31, 2017, a
taxpayer’s gross receipts are determined
in the manner required by regulations
under section 448(c).
*
*
*
*
*
(c) * * *
(1) * * *
(i) * * * Based on this reapplication,
the taxpayer determines the amount of
taxable income (and, when applicable,
alternative minimum taxable income
and modified taxable income under
section 59A(c)) that would have been
reported for each year prior to the filing
year that is affected by contracts
completed or adjusted in the filing year
if the actual, rather than estimated, total
contract price and costs had been used
in applying the percentage of
completion method to these contracts,
and to any other contracts completed or
adjusted in a year preceding the filing
year. * * *
*
*
*
*
*
(2) * * * (i) * * * The taxpayer then
must determine the amount of taxable
income (and, when applicable,
alternative minimum taxable income
and modified taxable income under
section 59A(c)) that would have been
reported for each affected tax year
preceding the filing year if the
percentage of completion method had
been applied on the basis of actual
contract price and contract costs in
reporting income from all contracts
completed or adjusted in the filing year
and in any preceding year. * * *
*
*
*
*
*
(iv) * * * In general, because income
under the percentage of completion
method is generally reported as costs are
incurred, the taxable income and, when
applicable, alternative minimum taxable
income and modified taxable income
under section 59A(c), are recomputed

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only for each year in which allocable
contract costs were incurred. * * *
*
*
*
*
*
(3) * * *
(ii) * * * Under the method
described in this paragraph (c)(3) (actual
method), a taxpayer first must
determine what its regular and, when
applicable, its alternative minimum tax
and base erosion minimum tax liability
would have been for each
redetermination year if the amounts of
contract income allocated in Step One
for all contracts completed or adjusted
in the filing year and in any prior year
were substituted for the amounts of
contract income reported under the
percentage of completion method on the
taxpayer’s original return (or as
subsequently adjusted on examination,
or by amended return). * * *
*
*
*
*
*
(vi) * * * For purposes of Step Two,
the income tax liability must be
redetermined by taking into account all
applicable additions to tax, credits, and
net operating loss carrybacks and
carryovers. Thus, the taxes, if any,
imposed under sections 55 and 59A
(relating to alternative and base erosion
minimum tax, respectively) must be
taken into account. * * *
*
*
*
*
*
(d) * * *
(4) * * * (i) * * *(A) General rule.
The simplified marginal impact method
is required to be used with respect to
income reported from domestic
contracts by a pass-through entity that is
either a partnership, an S corporation,
or a trust, and that is not closely held.
With respect to contracts described in
the preceding sentence, the simplified
marginal impact method is applied by
the pass-through entity at the entity
level. The pass-through entity
determines the amount of any
hypothetical underpayment or
overpayment for a redetermination year
using the highest rate of tax in effect for
corporations under section 11. However,
for redetermination years beginning
before January 1, 2018, the pass-through
entity uses the highest rates of tax in
effect for corporations under section 11
and section 55(b)(1). Further, the passthrough entity uses the highest rates of
tax imposed on individuals under
section 1 and section 55(b)(1) if, at all
times during the redetermination year
involved (that is, the year in which the
hypothetical increase or decrease in
income arises), more than 50 percent of
the interests in the entity were held by
individuals directly or through 1 or
more pass-through entities.
*
*
*
*
*
(h) * * *

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(8) * * *
(iii) Example 7. X, a calendar year C
corporation, is engaged in the
construction of real property under
contracts that are completed within a
24-month period. Its average annual
gross receipts for the prior 3-taxableyear period does not exceed
$25,000,000. As permitted by section
460(e)(1)(B), X uses the completed
contract method (CCM) for regular tax
purposes. However, X is engaged in the
construction of commercial real
property and, for years beginning before
January 1, 2018, is required to use the
percentage of completion method (PCM)
for alternative minimum tax (AMT)
purposes. Assume that for 2017, 2018,
and 2019, X has only one long-term
contract, which is entered into in 2017
and completed in 2019 and that in 2017
X’s average annual gross receipts for the
prior 3-taxable-years do not exceed
$10,000,000. Assume further that X
estimates gross income from the
contract to be $2,000, total contract
costs to be $1,000, and that the contract
is 25 percent complete in 2017 and 70
percent complete in 2018, and 5 percent
complete in 2019. In 2019, the year of
completion, gross income from the
contract is actually $3,000, instead of
$2,000, and costs are actually $1,000.
Because X was required to use the PCM
for 2017 for AMT purposes, X must
apply the look-back method to its AMT
reporting for that year. X has elected to
use the simplified marginal impact
method. For 2017, X’s income using
estimated contract price and costs is as
follows:

TABLE 1 TO PARAGRAPH (h)(8)(iii)
Estimates
Gross Income ............
Deductions ................
Contract Income—
PCM.

2017
$500 = ($2,000 ×
25%)
$(250) = ($1,000 ×
25%)
$250

(A) When X files its federal income
tax return for 2019, the contract
completion year, X applies the lookback method. For 2017, X’s income
using actual contract price and costs is
as follows:

TABLE 2 TO PARAGRAPH (h)(8)(iii)(A)
Actual
Gross Income ............
Deductions ................
Contract Income—
PCM.

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$750 = ($3,000 ×
25%)
$(250) = ($1,000 ×
25%)
$500

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(B) Accordingly, the reallocation of
contract income under the look-back
method results in an increase of income
for AMT purposes for 2017 of $250
($500–$250). Under the simplified
marginal impact method, X applies the
highest rate of tax under section 55(b)(1)
to this increase, which produces a
hypothetical underpayment for 2017 of
$50 (.20 × $250). Interest is charged to
X on this $50 underpayment from the
due date of X’s 2017 return until the due
date of X’s 2019 return. X, a C
corporation, is not subject to the AMT
in 2018. X does not compute alternative
minimum taxable income or use the
PCM in that year. Accordingly, lookback does not apply to 2018.
*
*
*
*
*
(k) Applicability date. Paragraphs
(b)(2), (b)(2)(ii), (b)(3)(iii), (c)(1)(i),
(c)(2)(i), (c)(2)(iv), (c)(3)(ii), (c)(3)(vi),
(d)(2)(i), (d)(4)(i)(A), and (h)(8)(iii) of
this section apply to taxable years
beginning on or after January 5, 2021.
However, for a taxable year beginning
after December 31, 2017, and before
January 5, 2021, a taxpayer may apply
the paragraphs described in the first
sentence of this paragraph (k), provided
that the taxpayer follows all the
applicable rules contained in the
regulations under section 460 for such
taxable year and all subsequent taxable
years. Further, a taxpayer may apply
those portions of paragraphs (b)(2)(ii)
and (b)(3)(iii) of this section that relate
to section 460(e)(1)(B) for contracts
entered into after December 31, 2017, in
a taxable year ending after December 31,
2017, provided that the taxpayer follows
all the applicable rules contained in the
regulations under section 460 for such
taxable year and all subsequent taxable
years.
■ Par. 23. § 1.471–1 is amended by:
■ 1. Designating the undesignated
paragraph as paragraph (a).
■ 2. Adding a heading to newly
designated paragraph (a) and revising
the first sentence.
■ 3. Adding paragraphs (b) and (c).
The revision and addition read as
follows:

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§ 1.471–1

Need for inventories.

(a) In general. Except as provided in
paragraph (b) of this section, in order to
reflect taxable income correctly,
inventories at the beginning and end of
each taxable year are necessary in every
case in which the production, purchase,
or sale of merchandise is an incomeproducing factor. * * *
(b) Exemption for certain small
business taxpayers—(1) In general.
Paragraph (a) of this section shall not
apply to a taxpayer, other than a tax

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shelter prohibited from using the cash
receipts and disbursements method of
accounting (cash method) under section
448(a)(3), in any taxable year if the
taxpayer meets the gross receipts test
described in paragraph (b)(2) of this
section, and uses as a method of
accounting for its inventory a method
that is described in paragraph (b)(3) of
this section.
(2) Gross receipts test—(i) In general.
A taxpayer, other than a tax shelter
prohibited from using the cash method
under section 448(a)(3), meets the gross
receipts test of this paragraph (b)(2) if it
meets the gross receipts test of section
448(c) and § 1.448–2(c). This gross
receipts test applies even if the taxpayer
is not otherwise subject to section
448(a).
(ii) Application of the gross receipts
test—(A) In general. In the case of any
taxpayer that is not a corporation or
partnership, and except as otherwise
provided in paragraphs (b)(2)(ii)(B) and
(C) of this section, the gross receipts test
of section 448(c) and the accompanying
regulations are applied in the same
manner as each trade or business of the
taxpayer were a corporation or
partnership.
(B) Gross receipts of individuals, etc.
Except when the aggregation rules of
section 448(c)(2) apply, the gross
receipts of a taxpayer other than a
corporation or partnership are the
amount derived from all trades or
businesses of such taxpayer. Amounts
not related to a trade or businesses are
excluded from the gross receipts of the
taxpayer. For example, an individual
taxpayer’s gross receipts do not include
inherently personal amounts, such as:
personal injury awards or settlements
with respect to an injury of the
individual taxpayer, disability benefits,
Social Security benefits received by the
taxpayer during the taxable year, and
wages received as an employee that are
reported on Form W–2.
(C) Partners and S corporation
shareholders—(1) In general. Except
when the aggregation rules of section
448(c)(2) apply, each partner in a
partnership includes a share of the
partnership’s gross receipts in
proportion to such partner’s distributive
share (as determined under section 704)
of items of gross income that were taken
into account by the partnership under
section 703. Similarly, a shareholder
includes the pro rata share of S
corporation gross receipts taken into
account by the S corporation under
section 1363(b).
(2) [Reserved]
(D) Examples. The operation of this
paragraph (b)(2) is illustrated by the
following examples:

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(1) Example 1. Taxpayer A, a calendar
year S corporation, is a reseller and
maintains inventories. In 2017, 2018,
and 2019, A’s gross receipts were $10
million, $11 million, and $13 million
respectively. A is not prohibited from
using the cash method under section
448(a)(3). For 2020, A meets the gross
receipts test of paragraph (b)(2) of this
section.
(2) Example 2. Taxpayer B operates
two separate and distinct trades or
businesses that are reported on
Schedule C, Profit or Loss from
Business, of B’s Federal income tax
return. For 2020, one trade or business
has annual average gross receipts of $5
million, and the other trade or business
has average annual gross receipts of $35
million. Under paragraph (b)(2)(ii)(B) of
this section, for 2020, neither of B’s
trades or businesses meets the gross
receipts test of paragraph (b)(2) of this
section ($5 million + $35 million = $40
million, which is greater than the
inflation-adjusted gross receipts test
amount for 2020, which is $26 million).
(3) Example 3. Taxpayer C is an
individual who operates three separate
and distinct trades or business that are
reported on Schedule C of C’s Federal
income tax return. For 2020, Business X
is a retail store with average annual
gross receipts of $15 million, Business
Y is a dance studio with average annual
gross receipts of $6 million, and
Business Z is a car repair shop with
average annual gross receipts of $12
million. Under paragraph (b)(2)(ii)(B) of
this section, C’s gross receipts are the
combined amount derived from all three
of C’s trades or businesses. Therefore,
for 2020, X, Y and Z do not meet the
gross receipts test of paragraph (b)(2)(i)
of this section ($15 million + $6 million
+ $12 million = $33 million, which is
greater than the inflation-adjusted gross
receipts test amount for 2020, which is
$26 million).
(3) Methods of accounting under the
small business taxpayer exemption. A
taxpayer eligible to use, and that
chooses to use, the exemption described
in paragraph (b) of this section may
account for its inventory by either:
(i) Using a method that treats its
inventory as non-incidental materials
and supplies (section 471(c) NIMS
inventory method), as described in
paragraph (b)(4) of this section; or
(ii) Using the method for each item
that is reflected in the taxpayer’s
applicable financial statement (AFS)
(AFS section 471(c) inventory method);
or, if the taxpayer does not have an AFS
for the taxable year, the books and
records of the taxpayer prepared in
accordance with the taxpayer’s
accounting procedures, as defined in

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paragraph (b)(6)(ii) of this section (nonAFS section 471(c) inventory method).
(4) Inventory treated as nonincidental materials and supplies—(i) In
general. The costs of inventory treated
as non-incidental materials and supplies
are recovered through cost of goods sold
only in the taxable year in which the
inventory is used or consumed in the
taxpayer’s business, or in the taxable
year in which the taxpayer pays for or
incurs the cost of the inventory,
whichever is later. Inventory treated as
non-incidental materials and supplies is
used or consumed in the taxpayer’s
business in the taxable year in which
the taxpayer provides the inventory to
its customer. The costs of inventory are
treated as non-incidental materials and
supplies under this paragraph (b)(4) are
not eligible for the de minimis safe
harbor election under § 1.263(a)–1(f)(2).
(ii) Identification and valuation of
inventory treated as non-incidental
materials and supplies. A taxpayer may
determine the amount of the costs of its
inventory treated as non-incidental
materials and supplies that are
recoverable through costs of goods sold
by using either a specific identification
method, a first-in, first-out (FIFO)
method, or an average cost method,
provided that method is used
consistently. See § 1.471–2(d). A
taxpayer that uses the section 471(c)
NIMS inventory method may not use
any other method described in the
regulations under section 471, or the
last-in, first-out (LIFO) method
described in section 472 and the
accompanying regulations, to either
identify inventory treated as nonincidental materials and supplies, or to
value that inventory treated as nonincidental materials and supplies. The
inventory costs includible in the section
471(c) NIMS inventory method are the
direct material costs of the property
produced or the costs of property
acquired for resale. However, an
inventory cost does not include a cost
for which a deduction would be
disallowed, or that is not otherwise
recoverable but for paragraph (b)(4) of
this section, in whole or in part, under
a provision of the Internal Revenue
Code.
(iii) Allocation methods. A taxpayer
treating its inventory as non-incidental
materials and supplies under this
paragraph (b)(4) may allocate the costs
of such inventory by using specific
identification or any other reasonable
method.
(iv) Example. Taxpayer D is a baker
that reports its baking trade or business
on Schedule C, Profit or Loss From
Business, of the Form 1040, Individual
Tax Return, and D’s baking business has

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average annual gross receipts for the 3taxable years prior to 2019 of less than
$100,000. D meets the gross receipts test
of section 448(c) and is not prohibited
from using the cash method under
section 448(a)(3) in 2019. Therefore, D
qualifies as a small business taxpayer
under paragraph (b)(2) of this section. D
uses the overall cash method, and the
section 471(c) NIMS inventory method.
D purchases $50 of peanut butter in
November 2019. In December 2019, D
uses all of the peanut butter to bake
cookies available for immediate sale. D
sells those peanut butter cookies to
customers in January 2020. The peanut
butter cookies are used or consumed
under paragraph (b)(4)(i) of this section
in January 2020 when the cookies are
sold to customers, and D may recover
the cost of the peanut butter in 2020.
(5) AFS section 471(c) inventory
method—(i) In general. A taxpayer that
meets the gross receipts test described
in paragraph (b)(2) of this section and
that has an AFS for such taxable year
may use the AFS section 471(c)
inventory method described in this
paragraph to account for its inventory
costs for the taxable year. For purposes
of the AFS section 471(c) inventory
method, an inventory cost is a cost of
production or resale that a taxpayer
capitalizes to inventory property
produced or property acquired for resale
in its AFS. For purposes of the AFS
section 471(c) inventory method, costs
that are generally required to be
capitalized to inventory under section
471(a) but that the taxpayer does not
capitalize to inventory on its AFS are
not required to be capitalized to
inventory. However, an inventory cost
does not include a cost that is neither
deductible nor otherwise recoverable
but for paragraph (b)(5) of this section,
in whole or in part, under a provision
of the Internal Revenue Code (for
example, section 162(c), (e), (f), (g), or
274). In lieu of the inventory method
described in section 471(a), a taxpayer
using the AFS section 471(c) inventory
method recovers its inventory costs in
accordance with the inventory method
used in its AFS.
(ii) Definition of Applicable Financial
Statement (AFS). The term applicable
financial statement (AFS) is defined in
section 451(b)(3) and the accompanying
regulations. See § 1.451–3(a)(5). The
rules relating to additional AFS issues
provided in § 1.451–3(h) apply to the
AFS section 471(c) inventory method. In
the case of a taxpayer with a financial
accounting year that differs from the
taxpayer’s taxable year, the taxpayer
must consistently use the same method
of accounting described in § 1.451–
3(h)(4)(i)(A) through (C) that is used for

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section 451(b) purposes to also
determine its inventory for the taxable
year under this paragraph (b)(5)(ii). A
taxpayer has an AFS for the taxable year
if all of the taxpayer’s taxable year is
covered by an AFS.
(iii) Timing of inventory costs.
Notwithstanding the timing rules used
in the taxpayer’s AFS, the amount of
any inventoriable cost may not be
capitalized or otherwise taken into
account for Federal income tax purposes
any earlier than the taxable year during
which the amount is paid or incurred
under the taxpayer’s overall method of
accounting, as described in § 1.446–
1(c)(1). For example, in the case of an
accrual method taxpayer, inventoriable
costs must satisfy the all events test,
including economic performance, of
section 461. See § 1.446–1(c)(1)(ii) and
section 461 and the accompanying
regulations.
(iv) Example. H is a calendar year C
corporation that is engaged in the trade
or business of selling office supplies and
providing copier repair services. H
meets the gross receipts test of section
448(c) and is not prohibited from using
the cash method under section 448(a)(3)
for 2019 or 2020. For Federal income tax
purposes, H chooses to account for
purchases and sales of inventory using
an accrual method of accounting and for
all other items using the cash method.
For AFS purposes, H uses an overall
accrual method of accounting. H uses
the AFS section 471(c) inventory
method of accounting. In H’s 2019 AFS,
H incurred $2 million in purchases of
office supplies held for resale and
recovered the $2 million as cost of
goods sold. On January 5, 2020, H
makes payment on $1.5 million of these
office supplies. For purposes of the AFS
section 471(c) inventory method of
accounting, H can recover the $2
million of office supplies in 2019
because the amount has been included
in cost of goods sold in its AFS
inventory method and section 461 has
been satisfied.
(6) Non-AFS section 471(c) inventory
method—(i) In general. A taxpayer that
meets the gross receipts test described
in paragraph (b)(2) of this section for a
taxable year and that does not have an
AFS, as defined in paragraph (b)(5)(ii) of
this section, for such taxable year may
use the non-AFS section 471(c)
inventory method to account for its
inventories for the taxable year in
accordance with this paragraph (b)(6).
The non-AFS section 471(c) inventory
method is the method of accounting
used for inventory in the taxpayer’s
books and records that properly reflect
its business activities for non-tax
purposes and are prepared in

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accordance with the taxpayer’s
accounting procedures. For purposes of
the non-AFS section 471(c) inventory
method, an inventory cost is a cost of
production or resale that the taxpayer
capitalizes to inventory property
produced or property acquired for resale
in its books and records, except as
provided in paragraph (b)(6)(ii) of this
section. Costs that are generally required
to be capitalized to inventory under
section 471(a), but that the taxpayer
does not capitalize in its books and
records are not required to be
capitalized to inventory. However, an
inventory cost does not include a cost
that is neither deductible nor otherwise
recoverable but for paragraph (b)(5) of
this section, in whole or in part, under
a provision of the Internal Revenue
Code (for example, section 162(c), (e),
(f), (g), or 274). In lieu of the inventory
method described in section 471(a), a
taxpayer using the non-AFS section
471(c) inventory method recovers its
applicable costs through its book
inventory method of accounting. A
taxpayer that has an AFS for such
taxable year may not use the non-AFS
section 471(c) inventory method.
(ii) Timing and amounts of costs.
Notwithstanding the timing of costs
reflected in the taxpayer’s books and
records, a taxpayer may not recover any
costs that have not been paid or
incurred under the taxpayer’s overall
method of accounting, as described in
§ 1.446–1(c)(1). For example, in the case
of an accrual method taxpayer or a
taxpayer using an accrual method for
purchases and sales, inventory costs
must satisfy the all events test,
including economic performance, under
section 461(h). See § 1.446–1(c)(1)(ii),
and section 461 and the accompanying
regulations.
(iii) Examples. The following
examples illustrate the rules of
paragraph (b)(6) of this section.
(A) Example 1. Taxpayer E is a C
corporation that is engaged in the retail
trade or business of selling beer, wine,
and liquor. In 2019, E has average
annual gross receipts for the prior 3taxable-years of $15 million and is not
otherwise prohibited from using the
cash method under section 448(a)(3). E
does not have an AFS for the 2019
taxable year. E is eligible to use the nonAFS section 471(c) inventory method of
accounting. E uses the overall cash
method, and the non-AFS section 471(c)
inventory method of accounting for
Federal income tax purposes. In E’s
electronic bookkeeping software, E
treats all costs paid during the taxable
year as presently deductible. As part of
its regular business practice, E’s
employees take a physical count of

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inventory on E’s selling floor and its
warehouse on December 31, 2019, and
E uses this physical count as part of its
books and records for purposes of
capitalizing and allocating costs to
inventory. E also makes representations
to its creditor of the cost of inventory on
hand for specific categories of product
it sells. E may not expense all of its costs
paid during the 2019 taxable year
because its books and records do not
accurately reflect the inventory records
used for non-tax purposes in its regular
business activity. Instead, E must use
the physical inventory count taken at
the end of 2019 to determine how its
capitalized costs are allocated and
recovered.
(B) Example 2. Same facts as Example
(1) in paragraph (b)(6)(iii)(A) of this
section but E does not use the physical
count to capitalize and allocate costs to
inventory and does not make any
representations about inventory on hand
to any creditors. Although E pays or
incurs costs that are generally required
to be capitalized to inventory under
section 471(a), because such costs are
not capitalized to inventory in E’s books
and records, they are not required to be
capitalized to inventory under
paragraph (b)(6)(i) of this section.
(C) Example 3. Same facts as Example
(1) in paragraph (b)(6)(iii)(A) of this
section but E does not use the physical
count to capitalize and allocate costs to
inventory in its electronic bookkeeping
software and does not make any
representations about inventory on hand
to any external parties. E does use the
physical count to value inventory on
hand for internal reports to its
shareholders. The internal reports to its
shareholders are part of E’s books and
records and must be taken into account
for E’s non-AFS section 471(c) inventory
method. E recovers its inventory costs
consistent with its non-AFS section
471(c) inventory method.
(D) Example 4. Taxpayer F is a C
corporation that is engaged in the
manufacture of baseball bats. In 2019, F
has average annual gross receipts for the
prior 3-taxable-years of less than $25
million and is not otherwise prohibited
from using the cash method under
section 448(a)(3). F does not have an
AFS for the 2019 taxable year. For
Federal income tax purposes, F uses the
overall cash method of accounting, and
the non-AFS section 471(c) inventory
method of accounting. For its books and
records, F uses an overall accrual
method and maintains inventories. In
December 2019, F’s financial statements
show $500,000 of direct and indirect
material costs. F pays its supplier in
January 2020. Under paragraph (b)(6)(ii)

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277

of this section, F recovers its direct and
indirect material costs in 2020.
(E) Example 5. Taxpayer G is a baker
that reports its baking trade or business
on Schedule C, Profit or Loss From
Business, of the Form 1040, Individual
Tax Return. In 2020, G’s baking business
has average annual gross receipts for the
prior 3-taxable years of less than
$100,000 and is not otherwise
prohibited from using the cash method
under section 448(a)(3). G does not have
an AFS for the 2020 taxable year. For
Federal income tax purposes, G uses the
overall cash method of accounting and
the non-AFS section 471(c) inventory
method. In G’s books and records for
2020 that properly reflects its business
activities for non-tax purposes, G
capitalizes the cost of its cookie
ingredients to inventory but
immediately expenses the cost of labor
for G’s employee who bakes the cookies.
Under paragraphs (b)(6)(i) and (ii) of
this section, G treats as an inventory
cost the cost of its cookie ingredients
and recovers such costs in accordance
with the accounting procedures used to
prepare its books and records, or, if
later, when paid. Additionally, although
the cost of direct labor is generally
required to be capitalized to inventory
under section 471(a), because such cost
is not capitalized to inventory in G’s
books and records, it is not required to
be capitalized to inventory under
paragraph (b)(6)(i) of this section.
Further, because such direct labor cost
is generally deductible under section
162, and not otherwise required to be
capitalized under section 263(a), G may
deduct the cost of labor in the year G
pays that expense.
(F) Example 6. Taxpayer H is a
partnership engaged in the resale of
beer, wine, and liquor. In 2020, H has
average annual gross receipts for the
prior 3-taxable-years of less than $25
million and is not otherwise prohibited
from using the cash method under
section 448(a)(3). H does not have an
AFS for the 2020 taxable year. For
Federal income tax purposes, H uses the
overall cash method of accounting, and
the non-AFS section 471(c) inventory
method of accounting. For its books and
records, H uses the overall cash method.
As part of its regular business practice,
H’s employees take regular physical
counts of the inventory on the shop
floor and in the storeroom, however H’s
method of accounting for inventory for
its books and records does not allocate
costs between ending inventory and cost
of goods sold, and instead expenses the
cost of the inventory in the year it was
paid for. Prior to December 2020, H
acquires and pays for $500,000 of beer,
wine, and liquor. In addition, on

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December 1, 2020, H acquires $50,000
in beer and wine, and pays for this beer
and wine on December 20, 2020. H may
recover as deductions in 2020 the
$550,000 of inventory costs.
(G) Example 7. Taxpayer J is a
partnership engaged in the resale of
beer, wine, and liquor. In 2020, J has
average annual gross receipts for the
prior 3-taxable-years of less than $25
million and is not otherwise prohibited
from using the cash method under
section 448(a)(3). J does not have an
AFS for the 2020 taxable year. For
Federal income tax purposes, J uses the
overall cash method of accounting, and
the non-AFS section 471(c) inventory
method of accounting. For its books and
records, J uses the overall cash method.
J maintains a point-of-sale computer
system that tracks acquisition costs and
inventory levels of the beer, wine, and
liquor. The ledger is periodically
reconciled with physical counts
performed by J’s employees. J must use
the physical inventory count and ledger
to determine its ending inventory. J
includes in cost of goods sold for 2020
those inventory costs that are not
properly allocated to ending inventory.
(7) Effect of section 471(c) on other
provisions. Nothing in section 471(c)
shall have any effect on the application
of any other provision of law that would
otherwise apply, and no inference shall
be drawn from section 471(c) with
respect to the application of any such
provision. For example, an accrual
method taxpayer that includes
inventory costs in its AFS is required to
satisfy section 461 before such cost can
be included in cost of goods sold for the
taxable year. Similarly, nothing in
section 471(c) affects the requirement
under section 446(e) that a taxpayer
secure the consent of the Commissioner

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before changing its method of
accounting. If an item of income or
expense is not treated consistently from
year to year, that treatment may not
clearly reflect income, notwithstanding
the application of this section. Finally,
nothing in section 471(c) permits the
deduction or recovery of any cost that
a taxpayer is otherwise precluded from
deducting or recovering under any other
provision in the Code or Regulations.
(8) Method of accounting—(i) In
general. A change in the method of
treating inventory under this paragraph
(b) is a change in method of accounting
under sections 446 and 481 and the
accompanying regulations. A taxpayer
changing its method of accounting
under paragraph (b) of this section may
do so only with the consent of the
Commissioner as required under section
446(e) and § 1.446–1. For example, a
taxpayer using the AFS section 471(c)
inventory method or non-AFS section
471(c) inventory method that wants to
change its method of accounting for
inventory in its AFS, or its books and
records, respectively, is required to
secure the consent of the Commissioner
before using this new method for
Federal income tax purposes. However,
a change from having an AFS to not
having an AFS, or vice versa, without a
change in the underlying method for
inventory for financial reporting
purposes that affects Federal income tax
is not a change in method of accounting
for such inventory under section 446(e).
In the case of any taxpayer required by
this section to change its method of
accounting for any taxable year, the
change shall be treated as a change
initiated by the taxpayer. For rules
relating to the clear reflection of income
and the pattern of consistent treatment
of an item, see section 446 and § 1.446–

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1. The amount of the net section 481(a)
adjustment and the adjustment period
necessary to implement a change in
method of accounting required under
this section are determined under
§ 1.446–1(e) and the applicable
administrative procedures to obtain the
Commissioner’s consent to change a
method of accounting as published in
the Internal Revenue Bulletin (see
Revenue Procedure 2015–13 (2015–5
IRB 419) (or successor) (see also
§ 601.601(d)(2) of this chapter).
(ii) Automatic consent for certain
method changes. Certain changes in
method of accounting made under
paragraph (b) of this section may be
made under the procedures to obtain the
automatic consent of the Commissioner
to change a method of accounting. See
Revenue Procedure 2015–13 (2015–5
IRB 419) (or successor) (see
§ 601.601(d)(2) of this chapter)). In
certain situations, special terms and
conditions may apply.
(c) Applicability dates. This section
applies for taxable years beginning on or
after January 5, 2021. However, for a
taxable year beginning after December
31, 2017, and before January 5, 2021, a
taxpayer may apply this section
provided that the taxpayer follows all
the applicable rules contained in this
section for such taxable year and all
subsequent taxable years.
Douglas W. O’Donnell,
Acting Deputy Commissioner for Services and
Enforcement.
Approved: December 18, 2020.
David J. Kautter,
Assistant Secretary of the Treasury (Tax
Policy).
[FR Doc. 2020–28888 Filed 12–31–20; 8:45 am]
BILLING CODE P

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