Consider Changing Accounting Methods to Reduce Your 2017 Tax Liability
The recently-enacted tax reform bill reduces the highest federal individual income tax rate from 39.6 percent to 37 percent and provides a 20 percent deduction on income from certain pass-through businesses. The 20 percent deduction effectively reduces the top marginal tax rate applicable to most pass-through income to 29.6 percent.
In addition, the new law reduces the top corporate income tax rate from 35 percent to 21 percent. For many taxpayers, the lower rates could mean a one-time opportunity for permanent tax savings by deferring income to 2018 and accelerating deductions to 2017. One way to defer income and accelerate deductions is to change accounting methods.
Example: Abigail is the sole shareholder of AB Inc., an S corporation manufacturing business. AB Inc. is highly profitable and Abigail is consistently subject to the highest marginal tax rates. If AB Inc. is able to defer $100,000 of income from 2017 to 2018 by changing a method of accounting, the income will be subject to a 29.6 percent tax rate rather than a 39.6 percent tax rate, providing Abigail with permanent tax savings of $10,000. In addition, Abigail will be able to defer $29,600 of taxes.
Some taxpayers may find that their tax rates will actually increase as a result of tax reform, particularly those with income not eligible for the 20 percent deduction that is sourced to states with high income tax rates. Accordingly, deferring income and accelerating deductions may not be appropriate in all circumstances. Please consult your tax advisor.
An accounting method deals with the timing for taking into account an item of income or deduction for tax purposes. In some instances there are several acceptable accounting methods available (e.g., a small business can use either the cash or the accrual method of accounting).
Once an accounting method is established, it generally must be used consistently from year to year, but there is a process that allows taxpayers to change their accounting methods. Some changes require the IRS to agree to the proposed change before it can be made, while other changes are automatic and do not require IRS approval.
The process begins by completing IRS Form 3115, which details the current and proposed method of accounting and describes the legal basis for the change, among other things. The form is separate from the annual income tax return filing. In many cases, the process requires the taxpayer to compute an adjustment equal to the difference between the cumulative income reported using the old method, and the cumulative income that would have been reported using the new method had the method been consistently used.
The purpose of the adjustment is to prevent duplication or omission of an item of income or deduction. If the adjustment is favorable, then the adjustment is taken into account in the year of the change, potentially resulting in a significant reduction to taxable income. If the adjustment is unfavorable, then 25 percent of the adjustment is taken into income in each year for four years beginning with the year of change.
Common automatic accounting method changes
Accounting method changes present one final opportunity to plan for your 2017 taxes.There are hundreds of automatic accounting method changes available. Here are six common accounting methods you can adopt to defer income or accelerate deductions.
Tax depreciation methods
The cost of real estate is typically allocated between two asset categories for financial statement purposes: land and building. Land is not depreciable and buildings are generally depreciable over either 27.5 years or 39 years for tax purposes.
The tax law takes a much more granular approach than the typical financial statement approach; real estate can be classified into several different categories of assets, some with a depreciable life of just five years. If you own real estate for use in your business or for investment, you may be able to accelerate deductions by performing a cost segregation analysis to determine the appropriate tax life of real estate assets.
There are two other opportunities available with respect to tax depreciation methods. A repair study may identify costs that have been capitalized and are being depreciated but that could have been immediately written off as repair and maintenance costs under applicable IRS guidance. In addition, a detailed analysis of depreciation schedules may identify assets that are being depreciated using the wrong lives or methods. Any identified errors can be corrected using an accounting method change and may result in the acceleration of tax deductions.
For financial reporting purposes, accrual method businesses typically capitalize prepaid expenses and then deduct the expenses over the period to which the prepaid expenses relate. For tax purposes, certain prepaid expenses that have a useful life of 12 months or less can be deducted in the year paid, including prepaid insurance, licenses, and software maintenance fees, among others.
There may be an opportunity to accelerate deductions if you are not currently deducting prepaid expenses in the year of payment.
Expenses that are accrued for financial statement purposes may not be deductible for tax purposes until paid. Accrued compensation, including bonuses, vacation pay, and the employer’s share of related payroll taxes, is deductible in the year of accrual to the extent it is paid within 2.5 months of the end of the year. A calendar-year taxpayer that has adopted a method of deducting accrued compensation generally has until March 15, 2018 to pay accrued compensation to be able to deduct it in 2017.
For financial statement purposes, payments received from customers before goods or services have been provided are generally recorded as a deferred revenue liability and recognized as income as services are performed or goods are provided. For tax purposes, accrual method taxpayers generally recognize income when the income is due, earned, or received, whichever happens first.
Thus, taxpayers generally recognize income in the year a customer makes a prepayment for goods or services even though the taxpayer has a liability to provide goods or services in the future. Rather than recognize income in the year received, taxpayers may choose to defer recognition of income to the end of the tax year following the year of receipt if the income is also deferred for financial statement purposes. If your business receives advanced payments for goods or services there may be an opportunity to defer income recognition.
Cash method of accounting
Some businesses use the accrual method of accounting even though they are eligible to use the cash method for tax purposes. Where the production, purchase, or sale of inventory is an income-producing factor for a business, the business is generally eligible to use the cash method of accounting if its average annual gross receipts are $1 million or less. In other cases, an automatic change to the cash method is generally available for C corporations with $5 million or less in average annual gross receipts and other business types with $10 million or less in average annual gross receipts.
If your business is eligible to use the cash method of accounting for 2017 but was using a different method of accounting, then consider changing to the cash method as a way to defer income. Tax reform expands the cash method to businesses with $25 million in average annual gross receipts or less beginning in 2018, so there may be an opportunity to change to the cash method in 2018 even if your business is not eligible for 2017.
Uniform capitalization rules
The uniform capitalization rules of IRC Section 263A generally require certain direct and indirect costs allocable to tangible personal property or real property produced by the taxpayer to be included in inventory or capitalized into the basis of the property.
The rules are complex and many taxpayers overcapitalize costs (and thus unnecessarily defer deductions) or undercapitalize costs (and thus inappropriately accelerate deductions). If your business produces tangible personal property or real property, you should consult with your tax advisor to determine whether there is an opportunity or exposure that can be addressed by changing your method of accounting for direct and indirect costs.
How we can help
Tax season is a great time to review your established methods of accounting to determine if there are any one-time opportunities available to you to achieve permanent tax savings, or if there are any tax exposure items that can be addressed by changing your accounting methods. Consult with your tax advisor to weigh the pros and cons, and devise a customized strategy to respond to the opportunities and challenges that tax reform presents.