With an improving economy, and the possibility that bonus depreciation will not return, the “easy” tax planning days are over and more complex alternatives need to be explored to reduce a company’s tax burden while profits rise.
One of the most powerful, yet often overlooked, tax planning opportunities is selecting optimal methods of accounting for income tax purposes. A taxpayer’s accounting method determines the period in which a taxpayer includes income or deducts an expense in calculating taxable income. The tax code allows a taxpayer to employ the most advantageous method of accounting insofar as it provides conformity, consistency and a clear reflection of income. Therefore, it is important for a taxpayer to understand what methods of accounting they are employing for tax purposes and verify that they are the most advantageous for their particular business.
An accounting method can refer to an overall method of accounting or the treatment of a single item. When a taxpayer determines that they would like to switch to a more advantageous method, the mechanism for doing so is through an application for an accounting method change with the IRS. Just a few common examples of accounting method changes that can be beneficial to a taxpayer include:
- Overall accounting method from accrual to cash – defers revenue and expenditures until cash is received or paid for qualifying taxpayers
- Accelerating the deduction of certain prepaid liabilities – allows certain prepaid expenses to be deducted when paid
- Capitalization vs. deduction of expenditures related to tangible property –allows remaining basis of certain items on the depreciation schedules to be currently deducted
- Deferring the recognition of income from advance payments – allows a deferral for certain advanced payment
- Determining the value of inventory – allows advantageous inventory valuation and cost flow assumptions
- Depreciation acceleration – allows accelerated depreciation deductions for assets improperly using long lives
- IBNR reserves – allows a taxpayer to deduct expenses for self insured claims incurred but not reported at year end in certain circumstances
Note that when an accounting method change results in a favorable position for the taxpayer, in most cases the effect of all of the prior years’ missed deduction are reflected at one time in the tax return for the year of the applicable change.
Common misconceptions surrounding tax accounting method changes include:
- Accelerating deductions will make my financial statements look bad – The truth is that tax accounting method changes do not affect a taxpayer’s reporting of the item for book or GAAP purposes
- These changes are only a benefit for one year and then I’ll have to reverse it and pay tax the next year – While technically true, once an advantageous tax accounting method is adopted, the accelerated deductions or deferred income is in place as long as that taxpayer remains in business and has similar items, effectively creating a semi-permanent tax savings in many cases
The tax code allows for many automatic accounting method changes, which allow you to apply the change even after the tax year has ended! In some cases, more complicated changes require advanced IRS consent, an application prior to the year end, and a $7,000 IRS user fee. In either case, employing the often overlooked tax accounting method strategies described above have resulted in millions of dollars of tax deferrals and savings for our clients.