As Congress grapples with tax proposals and the pandemic continues to create uncertainty for businesses, corporations and pass-through entities can leverage tax accounting methods to effectively improve their federal income tax posture and, in turn, enhance cash tax savings.
When assessing their tax situations for 2021 and subsequent years, taxpayers should consider whether they can benefit from traditional tax accounting methods planning, which aims to defer income recognition and accelerate deductions, or “reverse” tax accounting methods planning, which does the opposite.
Whether it makes sense to change a method of accounting depends on the taxpayer’s tax posture, future company performance and goals. Taxpayers should keep in mind that current tax proposals seek to raise tax rates and make other changes to the federal income tax system for corporations and individuals. These proposals should be monitored and their potential effects considered when evaluating the short- and long-term benefits of a tax accounting method change.
Traditional Accounting Methods Planning
Companies that want to reduce their 2021 tax liability should consider traditional accounting method changes that accelerate deductions and defer income recognition. As an added benefit, these method changes often result in favorable “catch-up” adjustments that are recognized entirely in the initial year of change.
Traditional accounting method changes also may be used to generate or increase a net operating loss (NOL). Losses generated in 2021 may be carried forward. In addition, certain method changes may still be made with the 2020 extended federal tax return filing to potentially generate losses that can be carried back to a higher rate tax year. Businesses that are emerging out of losses and expect to be taxable in the near term also should consider traditional accounting methods planning.Possible traditional accounting method changes include:
- Deferring income recognition of advance payments for goods or services, sale or license of computer software, use of intellectual property or eligible gift card sales;
- Deferring taxable income by changing from the overall accrual to the overall cash method of accounting;
- Deducting certain prepaid expenses (e.g., insurance premiums, property taxes, governmental permits and licenses, software maintenance) qualifying under the “12-month rule”;
- Deducting eligible accrued compensation liabilities that are paid within 2.5 months of year end;
- Accelerating deductions of liabilities such as warranty costs, rebates, allowances and product returns under the “recurring item exception”;
- Deducting “catch-up” depreciation (including bonus depreciation) by implementing permissible method changes, such as changing to shorter recovery periods identified through a cost segregation study; and
- Optimizing uniform capitalization methods for direct and indirect costs of inventory, including changing to simplified methods.
Reverse Accounting Methods Planning
Businesses planning for a potential future tax rate increase (as under current proposals supported by the Biden Administration) may choose to undertake reverse tax accounting methods planning to accelerate revenue into a tax year with a lower tax rate or defer deductions to a tax year with a higher tax rate.
Regardless of tax rates, a company that is in an NOL position may wish to engage in reverse accounting methods planning to optimize the utilization of their NOLs.Some of the more common method changes used in reverse accounting methods planning include:
- Accelerating income recognition of advance payments;
- Accelerating taxable income by changing from the overall cash to the overall accrual method of accounting;
- Capitalization and amortization of software development costs and/or research and experimental expenditures. Note that capitalization and amortization of R&E expenditures is required beginning in 2022;
- Electing the direct allocation method of capitalizing mixed service costs for Section 263A uniform capitalization purposes; and
- Deducting state, property or payroll taxes when paid rather than when incurred under the recurring item exception.
In addition, reverse accounting method planning opportunities that do not require a Form 3115 to be filed (see Form 3115 filing requirements below) include:
- Electing out of mandatory bonus depreciation for bonus-eligible property;
- Electing the alternative depreciation system (ADS) for depreciable property;
- Using the book safe harbor method for capitalizing repairs;
- Electing to capitalize certain prepaid expenses that otherwise would be deductible when paid;
- Delaying the payment date for accrued compensation liabilities normally deductible under the 2.5-month rule; and
- Delaying the payment date for accrued payment liabilities so that the deduction falls in a later year.
Requirement to File Form 3115
Generally, tax accounting method change requests require filing a Form 3115 Application for Change in Accounting Method with the IRS under one of two procedures:
- The “automatic” change procedure, which requires the taxpayer to file the Form 3115 with the IRS as well as attach the form to the federal tax return for the year of change; or
- The “nonautomatic” change procedure, which requires advance IRS consent. The Form 3115 for nonautomatic changes must be filed as early as possible in the year of change to give the IRS time to review and approve the change request.
Certain planning opportunities may be implemented without a Form 3115. Note that tax accounting method changes falling under automatic change procedure can still be made for the 2020 tax year with the 2020 federal return.