Tax planning: Accounting methods to help preserve cash in unsure times
Recent reporting in various news outlets consistently reflects what economists have been warning about for much of 2022: The United States economy is staring down a recession within the next twelve months. Amid fears of a contracting economy, rising interest rates, and some experts estimating a reduction of 175,000 jobs per month during the first quarter of 2023, companies are looking for any available opportunities to preserve cash.
Companies can adopt or change existing accounting methods to optimize the timing of when certain items of income or expense are recognized for tax purposes, and this can help them preserve cash. These methods may result in a company paying tax liabilities at a later date. Generally, tax accounting methods do not alter the total amount of tax liability that will be owed by a company over the life of the business. However, in the event tax rates are revised through new legislation, the taxes paid on any deferred items of income or expense could be different in future years than what would have been paid in the year of deferral. In the absence of changes in applicable tax rates, the various accounting methods merely accelerate or defer items of income or expense, resulting in a deferral of any federal income tax that may be due.
Some of the more common accounting methods include:
- Advance payments: Taxpayers may have an opportunity to defer income for one year beyond the year in which the payments are received. For example, a taxpayer may be able to recognize revenue in the year received only to the extent that income is reported in the taxpayer’s financial statements. The remainder of the payment will be reported in the next taxable year for tax purposes, thus resulting in a possible one-year deferral.
- Prepaid and accrued expenses: For financial statement purposes, many prepaid expenses must be capitalized and amortized (expensed) over the life of the asset. For tax purposes, taxpayers may be able to deduct all or a portion of those prepaid expenses in the year paid. Similarly, some accrued expenses are eligible to be deducted in the year accrued for tax purposes provided they are paid within a certain period of time following the taxpayer’s year-end.
- Tangible property regulations: Many taxpayers filed automatic method changes following the introduction of the tangible property regulations in 2013. When filing an automatic method change for an item of income or expense, taxpayers are generally precluded from filing a subsequent automatic method for the same item of income or expense within a five-year period. Given the requisite passage of time between the method changes filed to comply with the tangible property regulations of 2013, it may be beneficial for taxpayers to revisit their fixed asset registers/listings to determine if some items that have been capitalized on their financial statements would qualify for immediate expensing for tax purposes.
- Section 263A (UNICAP)/Inventory valuation: The IRS promulgated regulations in 2018 that revised the methodologies taxpayers may use to calculate annual UNICAP adjustments. Taxpayers should evaluate the methods they are currently using to help ensure they are compliant with the updated regulations. In periods of high inflation – such as what is currently being experienced in the United States in many industries – taxpayers should evaluate whether it makes sense to convert from the First In First Out (FIFO) method of inventory valuation to Last In First Out (LIFO) methodology for tax purposes. In the current economic environment, converting to the LIFO method would result in a higher cost of goods sold amount for taxpayers, thus reducing taxable income in the current year.
Taxpayers wishing to change a tax accounting method must file Form 3115, Application for Change in Accounting Method, with the Internal Revenue Service under one of two procedures:
- Automatic changes require taxpayers to file Form 3115 with the IRS and attach the form to the federal tax return filed for the year of change.
- Non-automatic changes require taxpayers to file Form 3115 with the IRS and wait for IRS consent before filing a federal tax return employing the desired method. The non-automatic method change must be filed during the year of change and come with additional requirements, such as a filing fee due at the time of filing the request.
- Bonus depreciation: Taxpayers have grown accustomed to the bonus depreciation provisions of Section 168(k) in recent years. Through Dec. 31, 2022, bonus depreciation remains at 100% for qualifying property. Beginning Jan. 1, 2023, bonus depreciation decreases by 20% each year until it completely phases out in 2027. Taxpayers should be mindful of these impending phase-outs when making capital expenditure decisions in 2022 and beyond.
- Section 179D: The Energy Efficient Commercial Building Deduction is generated by energy-efficient building construction related to lighting, HVAC, and the building envelope (the separation of the interior and exterior of a building). The deduction is available for both commercial property and residential rental properties that are three stories or less above grade. It is important to note that Section 179D is a deduction, not a credit, and was made permanent via the passage of the Inflation Reduction Act of 2022.
- SECTION 45L: The new energy-efficient home credit was extended via the Inflation Reduction Act of 2022 and now applies to dwelling units leased and sold from 2023 through 2032. The credit is $2,500 for single-family and manufactured homes if constructed in accordance with Energy Star Residential New Construction Program or the Manufactured Homes Program, and $5,000 for single-family and manufactured homes if certified as Department of Energy Zero Energy Ready Homes. For multifamily homes, the credit is $500 if constructed based on the Energy Star Single Family New Homes Program, or $1,000 if constructed based on the DOE Zero Energy Ready Home Requirements. Pursuant to the new Section 45L guidelines found in the Inflation Reduction Act of 2022, the credit no longer reduces the Low-Income Housing Tax Credit eligible basis.
- R&D credit: The R&D credit is an activities-based credit that is driven by qualified research expenses paid or incurred during the tax year. Many taxpayers with domestic Section 174 expenses qualify for the R&D credit. In light of the new Section 174 capitalization requirements – which may or may not be postponed – the R&D credit helps taxpayers mitigate increased tax liability. As the new year approaches, it is also important to be aware of state credit deadlines. Some states, including Florida and Hawaii, have spring deadlines for certifying credits. Taxpayers should consult with their providers in the winter to determine if they have a spring deadline.
The CohnReznick Tax Accounting Methods and Credits team can assist you with performing any necessary analysis to help determine the most optimal tax accounting methods/credits for your business.
Richard Shevak, JD, Principal, National Tax
Travis Butler, Director, National Tax – Cost Segregation
Scott Hamilton, CPA, Partner, National Tax – R&D
Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice specific to, among other things, your individual facts, circumstances and jurisdiction. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.
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