As the US has emerged from the COVID-19 pandemic, the Federal Reserve has attempted to attack prolonged inflation through consistently increasing interest rates. With both inflation and interest rates therefore elevated, some US business leaders have a sour outlook on the future. Some economists have recently predicted a 61% chance of a recession in the US over the next 12 months. Moreover, 93% of CEOs indicated they are preparing for a US recession to occur in the next 12-18 months.
In poor timing, taxpayers may—all else being equal—face higher tax bills from new tax provisions taking effect for the 2022 and 2023 tax years. These include section 174 capitalization and amortization and unfavorable modifications to interest expense deductibility for 2022, followed by a reduction in certain enhanced depreciation deductions for 2023. With potential economic clouds on the horizon, business leaders are prudent to carefully manage cash levels. One tool available to inject additional capital into short-term operations is a review to optimize the business’s tax accounting methods.
Introduction to Tax Accounting Methods
A tax accounting method is the consistent manner by which a taxpayer includes items of income or expense in computing its taxable income. The two primary overall accounting methods are the accrual method and the cash method. A tax accounting method can also include the specific treatment of any significant item, such as inventory, accruals for certain liabilities, depreciation methods, etc. Once a taxpayer has established its accounting methods, it must consistently calculate taxable income in the same manner each year. However, taxpayers can initiate an accounting method change, including in cases where the change yields a deferral of taxable income. Generally, an accounting method change involves the filing of Form 3115, Application for Change in Accounting Method.
Many types of accounting method changes can be filed with an automatic method change. With automatic accounting method changes, a taxpayer files Form 3115 with its tax return, and consent from the IRS is automatically granted. However, the facts and circumstances underlying a particular method change should be carefully reviewed to ensure whether it involves a nonautomatic method change. Nonautomatic method changes involve additional costs and administrative considerations beyond the scope of this discussion.
An accounting method change only adjusts the year in which an item of income or expense will be reflected in taxable income. If an accounting method change accelerates deductions into the current year, then there will be a corresponding decrease in future deductions. Likewise, if an accounting method change defers revenue from the current year, then there will be a corresponding increase in future revenue. However, when considering operating cash flows and time value of money principles, taxpayers can still benefit from shifting otherwise current taxable income to future years.
Tax Accounting Method Changes to Increase Current Cash Flow
Several targeted accounting methods can be reviewed to determine if any current tax savings are available by initiating an accounting method change. Below is a non-exhaustive sample of situations to demonstrate the current cash savings possible with accounting method changes.
Note that accounting method changes generally involve a recalculation of a prior year through a “section 481(a) adjustment,” whereas the examples below present a simplified demonstration of a possible cumulative impact in each situation. In addition, analyzing a fact pattern to determine if a taxpayer is eligible to make an accounting method change is a complex process not evident in the simplified examples below.
For financial statement purposes, a taxpayer generally records an asset upon prepayment of an expense. Subsequently, an expense is recognized against the asset as the event(s) to which the payment relates occurs (or ratably over time, in the case of a prepaid expense for a contract for a set period). A common example is prepaid insurance expense. If a taxpayer is required to prepay for a one-year insurance policy, for example, it may create a prepaid asset upon payment and then amortize the asset monthly by 1/12th over the next year.
For tax purposes, certain prepaid expenses are deductible in the year of payment. Various technical criteria govern the mechanics of this tax rule. In general, prepaid expenses eligible for this advantageous tax treatment must relate to a policy of 12 months or less and involve prepayment for certain types of expenses, including insurance, taxes, and some warranty or service contracts.
Example: ABC Company uses a December 31 tax year. On December 1, 2022, ABC Company pays $240,000 for a one-year general liability insurance policy ($20,000 per month). As of December 31, 2022, ABC Company has recorded $20,000 of insurance expense and retains a $220,000 prepaid insurance asset on its balance sheet.
For tax purposes, ABC Company may be able to accelerate the deduction of the $220,000 of remaining policy expense into the 2022 tax year with an accounting method change. This change could defer $46,200 of federal income taxes if ABC Company is a C-corporation. If ABC Company is an S-corporation or partnership with owners paying tax at the top marginal federal income tax rates, then the federal income tax deferred could be greater.
Lower of Cost or Market for Inventories
If a taxpayer is using the cost method for recording its inventories for tax purposes, then it generally must maintain its inventories at actual invoice price (with certain adjustments, such as discounts received) until sold to customers. All financial statement write-downs due to excess/obsolescent inventories or market adjustments would be nondeductible and added back for taxable income.
One potentially favorable tax alternative is the lower of cost or market (LCM) method. With the LCM method, a taxpayer can recognize a deduction for any items of inventory with a market value lower than the original cost. The market value in the comparison must be the prevailing market price for the item that would be available to the taxpayer in its course of business. A taxpayer cannot use the market price a competitor would pay a vendor if that competitor gets a volume discount due to making purchases in excess of what the taxpayer would reasonably make.
Example: ABC Company uses a December 31 tax year. In its inventory, ABC Company has 5,000 units of Product X with an actual cost of $150 per unit. With respect to Product X, inflation is moderating, and demand is falling. ABC Company receives a vendor quote on December 31, 2022 to purchase additional units of Product X for $135 per unit.
If ABC Company adopts the LCM method with an accounting method change, it may be able to realize a deduction of $75,000 (5,000 units x $15 per unit write-down from cost to market). The $75,000 adjustment accelerates cost of goods sold of $15 per unit into 2022 that would otherwise be deducted in a future year when the inventory is sold. This change could defer $15,750 of federal income taxes if ABC Company is a C-corporation. If ABC Company is an S-corporation or partnership with owners paying tax at the top marginal federal income tax rates, then the federal income tax deferred could be greater.
Cost Segregation Studies with Depreciation Method Changes
Many taxpayers may place into service commercial buildings or residential rentals and overlook the optimal depreciation treatment for tax purposes. Taxpayers can employ a cost segregation study to analyze the components of real property and determine if portions of the cost basis are more appropriately reclassified as property with a shorter life, thereby accelerating tax depreciation. Asset reclassifications from cost segregation studies are a change in accounting method.
Example: ABC Company uses a December 31 tax year. ABC Company began operations in a new commercial building in 2021 that was constructed for ABC Company. ABC Company treated the entire $780,000 cost basis in the property as 39-year property (the default treatment of nonresidential real property). Through December 31, 2022, ABC Company has recorded approximately $30,000 of tax depreciation on the building.
Through a cost segregation study, ABC Company has determined that approximately $200,000 of the $780,000 that has been classified as 39-year property should be properly classified as 5-year property eligible for 100% bonus depreciation in 2021. The cumulative depreciation through December 31, 2022 would be approximately $220,000 had ABC Company treated the cost basis correctly from the start.
The $190,000 difference between the $30,000 of total tax depreciation before the cost segregation study and the $220,000 of total tax depreciation after the cost segregation study is recognized in 2022 through a change in accounting method. This acceleration of depreciation could defer $39,900 of federal income taxes if ABC Company is a C-corporation. If ABC Company is an S-corporation or partnership with owners paying tax at the top marginal federal income tax rates, then the federal income tax deferred could be greater.
Capturing Value from Tax Accounting Methods
The three cases above highlight just a fraction of the types of accounting method changes available to taxpayers. As illustrated in the examples, prudent planning around accounting method changes can shift taxable income to future years either through the acceleration of deductions or deferral of revenue for tax purposes.
While these opportunities only serve to defer taxable income rather than permanently reduce federal income taxes, many US businesses facing an unclear economic outlook could welcome the opportunity to shore up current cash flow by delaying federal income tax payments. To achieve this, our tax professionals at Elliott Davis can help your business review and optimize your current tax accounting methods.
The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.