Changing Accounting Methods for Potential Tax Deferrals
Author: Matt Haase
An overall accounting method change is an often-overlooked tax planning opportunity. A company’s accounting method often is taken for granted and could be revised to a more favorable method. While a company may have used a particular method for a long time, perhaps no one can remember why. Maybe the company started with the cash basis of accounting to defer income into the future as it grew, then switched to accrual method with percentage completion once its average receipts exceeded $10 million. Maybe it wanted to keep the books on the accrual basis and didn’t want to have a separate method for tax reporting. In reality, there are a number of accounting methods that could be chosen. Also, there isn’t just one method to calculate percentage completion—we’ll discuss a few of these potentially beneficial options in this article.
Accrual to Cash
Switching from the accrual basis to cash basis of accounting could create a substantial deferral of income and reduction of current-year tax. In general, companies with average annual gross receipts in the prior three years that are less than $10 million (less than $5 million for C corporations) can make an automatic method change to the cash method. It also should be noted that the Tax Cuts and Jobs Act, which was signed into law December 22, 2017, increased the revenue threshold to $25 million for years beginning after December 31, 2017, before the company would be required to switch over to accrual method. During the year of change, the company will include all items of income that were actually or constructively received and deduct expenses that were actually paid. For example, if the accounts receivable balance is $1 million at year-end and accounts payable is $250,000, there will be a negative Section 481(a) adjustment of $750,000, which will reduce net income by that amount in the year of the change. The one caveat to this is if you have to make the switch back to the accrual basis, the change can often be painful. However, if the company has to switch back to accrual basis, it would be allowed to spread the adjustment over a four-year period. If a company qualifies and desires to change to the cash method, it will need to file Form 3115, Application for Change in Accounting Method, with the IRS. The company can file Form 3115 as early as the first day of the year of the change and as late as the extended due date for the return. An automatic change doesn’t require a user fee to be paid to the IRS.
Another potential strategy of changing to cash basis would involve a company that’s above the $10 million in revenue threshold ($25 million under the new tax law) by making an accounting change to cash for its short-term or exempt contracts. These are the contracts that begin and end in the same year. The assumption tends to be that once a contractor goes over the $10 million revenue threshold, it automatically has to report on the accrual method. Internal Revenue Code (IRC) §460 states long-term contracts need to be reported on the accrual method with an approved form of percentage completion, but short-term contracts can stay on the cash basis. If a company wants to take advantage of this accounting method change, it would need to file a Form 3115 with the IRS. This is a nonautomatic change, so it would require IRS approval. Also, companies seeking this treatment would need to pay the user fee, which was $9,500 in 2017. It also should be noted the method would be a hybrid method where short-term contracts are accounted for on the cash basis and long-term contracts accounted for on accrual basis using a form of percentage completion. This strategy would probably work best for subcontractors whose jobs are more often short-term and don’t have many open contracts at year-end.
Percentage Completion Options
A company with average annual gross receipts of $10 million or more ($25 million or more for years beginning after December 31, 2017) is required under IRC §460 to switch to the accrual method using an approved form of percentage completion to determine revenue earned on its long-term contracts. Percentage completion uses the costs incurred to date divided by the total estimated contract costs. The percentage is multiplied against the estimated contract revenue to arrive at the revenue earned for that year. However, there are some additional adjustments that can be made to help defer income to future years.
The 10 Percent Method
The 10 percent deferral method doesn’t require filing Form 3115. Instead, the change is made by filing an election with an originally filed return. By making this election, companies are allowed to defer the recognition of income for a long-term contract until the tax year in which at least 10 percent of the estimated total contract costs have been incurred on a cumulative basis. Also, if elected, the method is used for determining alternative minimum tax as well as look-back interest on Form 8697. However, if a company uses this method, it can’t use the simplified contract cost method as well. While the 10 percent method is implemented with filing an election, once implemented it requires an accounting method change by filing Form 3115 to change back.
Percentage Completion Excluding Retainage Payable
Under this accounting method, companies can exclude subcontractor retainage payable from the numerator but include it in the denominator of the percentage completion formula as long as the all-events test has not been met. The all-events test is met when the liability is reasonably and accurately determined. It also requires economic performance has been met, i.e., services or property have been provided by the third party with which the liability was established. The subcontractor retainage usually doesn’t meet the all-events test until the year in which the final inspection and acceptance of the work have occurred. If the company excludes the retainage payable amount from the numerator, it’s deferring the recognition of profit until the year of final contract acceptance. This is a nonautomatic change and will require filing Form 3115 (and the user fee) with the IRS.
Percentage Completion Excluding Subcontractor Payables in Pay if Paid States
Let’s first discuss what “pay if paid” means. Contracts with this language allow a general contractor to not pay the subcontractors if it hasn’t been paid by the owner. Use of this method will depend on what state the contract is in. If a general contractor can write contracts in such a way, it could make an accounting method change that excludes the subcontractor payables from the numerator of the percentage completion formula. As mentioned above, reducing the contract costs from the numerator also reduces income from that contract for the year, which defers recognition of the contract profit to a future year. It should be noted that the contract has to include the pay if paid language. If the contract doesn’t include that language, the subcontractor payables on those contracts can’t be excluded. In addition, if you’re doing business in a state that doesn’t allow pay if paid, then those contracts can’t have the pay if paid language included. That means you couldn’t exclude subcontractor payables on those contracts. Using this accounting method could create a revenue deferral. A user fee would apply to this nonautomatic change and will require filing Form 3115 with the IRS.
It should be noted these are just some of the possibilities. Changing your accounting method shouldn’t be taken lightly. If you’re considering changing your accounting method, contact Matt or your trusted BKD advisor for more information.