Tax accounting methods (or “methods of accounting”) affect when an item of income or expense is recognized. A company’s tax accounting methods could include tax depreciation, inventory capitalization, treatment of prepaid amounts, and countless other items. Proper tax accounting methods planning can help a company avoid IRS risk or help to defer tax payments.
Taxpayers may at various points determine that a change in a particular method of accounting is warranted. Specifically, when new legislation is enacted, companies are often well served by reviewing their tax accounting methods to determine what methods can and should be changed. This should start with a thorough review of pertinent documents – such as the most recent financial statements, trial balance, book-to-tax workpapers, and federal tax returns – to gain an understanding of your company’s current tax accounting methods, and result in a set of opportunities and risk areas. A tax advisor can assist in this process and advise you on the optimal time to change methods and how the ideas impact the bottom line, based on your particular facts and circumstances.
Companies are permitted to change their tax accounting methods to either 1) take advantage of a more beneficial permissible method, or 2) change to a proper/permissible method (if the company is on an improper method).
A change to an already established method would require the company to file a Form 3115, Application for Change in Accounting Method.
There are well over 200 automatic accounting method changes, with most falling into four areas: 1) fixed asset/depreciation changes, 2) revenue recognition changes, 3) expense recognition changes (including capitalization of intangibles and prepaid amounts), and 4) tax inventory accounting method changes.
Read on for brief descriptions of each of these four areas. Eligible companies can also change their overall method (cash to accrual or vice versa). This is not an exhaustive listing, so please contact your trusted advisors for further information.
Fixed asset studies (including cost segregation studies)
Fixed assets are often one of the largest expenditures for a company. Two studies – fixed asset studies and cost segregation studies – can help a company accelerate fixed asset deductions/depreciation for tax purposes.
The goal of a fixed asset (repair) study is to identify assets that were capitalized for tax purposes that could have been expensed for tax purposes under the “tangible property regulations.” Oftentimes, companies capitalize a wide range of items that might be deductible for tax purposes. One example might be a roof repair: A company might spend $500,000 to repair or replace a roof. Depending on the company’s specific facts, that roof repair could be deductible for tax purposes.
The goal of a cost segregation study is to assign some or all the cost of a capitalizable fixed asset to a shorter tax life. Some short-lived assets are eligible for additional first-year depreciation (“bonus depreciation”), which allows a taxpayer to write off the entire cost of eligible assets. The classic example involves the cost segregation of a building. For example, if a company paid $20 million to acquire or construct a building, a cost segregation study would allow a company to identify and allocate various components that make up that $20 million, such as electrical service to data handling equipment; information systems; personal property like floor coverings, decorative lighting, and telephone communications systems; and land improvements. To the extent those components belong to a short tax life, the company would enjoy accelerated depreciation on eligible assets. Because cost segregation identifies and assigns costs to building components, these studies require not only in-depth knowledge of the tax rules, but also knowledge of construction processes and techniques.
All taxpayers are now required to adopt, and be in compliance with, Accounting Standards Codification (ASC) 606 – Revenue from Contracts with Customers. ASC 606 provides that taxpayers must recognize revenue when goods and services are transferred to a customer. For tax purposes, IRC Section 451 and related Regulations provide for exceptions if taxpayers meet certain conditions.
When examining methods of accounting currently being used by a taxpayer, it is imperative to understand the changes in methods used for financial statement purposes to determine if changes may also be necessary for tax purposes. If a taxpayer has used a tax method that follows the method used for financial statement purposes, and the taxpayer’s financial statement method changes, a Form 3115 will be required to change the tax method of accounting. If a Form 3115 is determined to be necessary, it would be an automatic method change if it is filed in the year of implementation. If the Form 3115 is filed in a year other than the one in which the change was implemented, it will be deemed a non-automatic method change and the taxpayer will incur filing fees with the IRS.
A review of tax accounting methods should also consider whether the company is permitted to accelerate certain deductions for tax purposes, specifically whether certain prepaid expenses with a life of 12 months or less (capitalized for financial statement purposes) are deductible for tax purposes.
In addition to prepaid amounts, other expenses should also be reviewed for any tax risks or – on the other hand – opportunities to accelerate deductions.
For companies with inventory, cost of goods sold is typically the largest “expense.” An accounting method review should consider whether the company’s tax inventory accounting methods are correct and/or optimal (i.e., that they help to defer taxable income). The two main areas to focus on are 1) whether the company would benefit from using the Last In, First Out (LIFO) method, and 2) whether the company’s Uniform Capitalization (UNICAP or 263A) method is correct.
Taxpayers that manufacture, produce, or sell goods can realize large tax deferrals by making the election to use the Last In, First Out (LIFO) inventory method. In times of inflation, it allows a company to recognize more recent (higher) costs as cost of goods sold – and leaves older, lower costs in ending inventory. It is a timing difference, but in industries with consistent inflation, it could result in a long-term tax deferral.
LIFO methods can be simplified by adopting the Inventory Price Index Computations (IPIC) form of LIFO. Instead of computing inflation based on internal data, the IPIC method relies on inflation indices published by the Bureau of Labor Statistics.
The LIFO method may be adopted for tax purposes by filing a simple form with the IRS. Taxpayers currently on LIFO can change to the IPIC LIFO method via the filing of an automatic accounting method change. Amid persistent, above-average inflation, taxpayers not already on either the LIFO or IPIC LIFO inventory method should give consideration to adopting one or the other, as doing so could result in the deferral of significant amounts of current tax expense, potentially several years' worth.
Uniform Capitalization (UNICAP)
Taxpayers are generally required to capitalize additional costs (beyond GAAP capitalization) to inventory under Section 263A if their average annual gross receipts exceed $27 million and they produce or acquire for resale tangible property (e.g., inventory, self-constructed property and real property).
In addition, in late 2018, Treasury and IRS released final regulations (T.D. 9843) that will require many taxpayers to change their UNICAP (tax inventory capitalization) methods of accounting.
Taxpayers will need to analyze their current method of capitalizing direct, indirect, and mixed service costs in accordance with Section 263A to determine if another method would be more beneficial or required based on the new regulations.
Overall methods of accounting
Some companies could benefit from a change in overall tax method of accounting (cash versus accrual). A company’s overall tax method may be different from its financial statement method of accounting. The accounting method review process should consider which method is permissible and/or optimal.
As previously noted, the accounting methods noted above are merely a sampling of the over 200 automatic accounting method changes that may be relevant to you as a taxpayer. Your tax advisors can assist you in determining which may benefit you, and provide you with the necessary information to make an informed decision.
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