In past years, the temptation to disregard certain tax planning strategies or file them under the “maybe later” category primarily stemmed from the fact that many of these strategies would result in a temporary tax decrease. These timing differences would eventually reverse and the tax benefit received would have a finite life other than the time value of money savings. Due to the passage of the Tax Cuts and Jobs Act (TCJA) in late 2017, this argument may be temporarily invalid for many of these strategies. By reducing the top corporate tax rate from 35 percent to a flat 21 percent, and the top marginal rate paid by individual owners of pass-through entities from 39.6 percent to 37 percent, accounting method changes implemented for the 2017 tax year could yield permanent tax savings. This is especially true for changes that accelerate deductions into 2017 or defer income to 2018 or beyond. Before filing your 2017 tax return, you may want to revisit that list of “maybe later” planning opportunities. Even if you’ve already filed your return, opportunities still exist to implement the change for 2017 provided action is taken within six months after the original 2017 due date.
How to Implement
The accounting method a taxpayer uses for a particular item dictates when the item is properly includible in taxable income. In most cases, IRS consent is required before taxpayers can change their method of accounting for a particular item. The change is requested by filing Form 3115, Application for Change in Accounting Method, with the IRS. For changes the IRS designates as automatic accounting method changes, Form 3115 can be filed as early as the first day of the year of the change and as late as the extended due date for the return. However, for changes not available under the automatic change procedures, i.e., advance consent changes, Form 3115 must be filed by the end of the year of change.
In the year of change, taxpayers must calculate and report on Form 3115 a cumulative adjustment to recognize the impact of the change on all previous tax periods. Required under Internal Revenue Code Section 481(a), this adjustment prevents affected items from being “double counted” in the years following the change. If the adjustment is negative, the taxpayer includes the entire amount in the year of change. If positive and less than $50,000, the taxpayer may elect to recognize the entire amount in the year of change; otherwise, the adjustment is spread over four years, including the year of change.
Common Automatic Accounting Method Changes
Taxpayers should review their list of cumulative deferred tax items for potential accounting method change opportunities. Here’s a list of common automatic accounting method changes to consider:
Warranty expenses are generally deductible in the year repair services are rendered. An accounting method change can be filed to deduct accrued warranty repair work performed in the current year, which may accelerate deductions and create a current-year tax benefit.
Self-Insured Health Claims
Self-insured health claims are deductible in the year medical services are performed if service providers are required to submit claims for payment directly to the employer’s plan. Self-insured taxpayers should analyze their accrued self-insurance account to identify any eligible claims. Similar to self-insured health claims, self-insured workers’ compensation claims for medical expenses are deductible in the year medical services are performed if medical service providers are required to submit claims for payment directly to the employer’s plan. Analyzing accrued workers’ compensation claims for medical expenses may result in additional current-year deductions.
Accrued Vacation Pay
Accrued vacation paid to employees is generally deductible in the year accrued to the extent it’s paid within two and a half months after year-end. Taxpayers may file an accounting method change to deduct eligible amounts accrued and paid within this time frame.
Favorable regulations exist concerning the capitalization of payments related to the creation or acquisition of intangible assets. This includes the expensing rules for disbursements with a benefit of 12 months or less. Many types of prepaid expenses fall under this provision. Opportunities especially exist for prepaid insurance, warranty or service contracts, taxes, licenses and permits.
Accrual-basis taxpayers are allowed an exception to the general rules of economic performance for recurring items. This exception may apply if certain criteria are met. For example, the liability must be recurring in nature and economic performance with respect to the liability must occur on or before the earlier of:
- The 15th day of the ninth month after the tax year-end OR
- The date of the timely filed return (including extensions)
Opportunities exist to allow taxpayers to accelerate depreciation deductions into 2017. These opportunities may be identified and implemented by undergoing a real estate cost segregation study. During the study, engineers specifically trained in tax depreciation methods identify assets embedded in a building’s construction or acquisition costs that can be depreciated for tax purposes over a shorter time frame than the standard 39 years typically assigned to these assets (27.5 years for residential rental property). As discussed in this BKD Thoughtware® article, taxpayers can reap these benefits by filing an accounting method change with the IRS. Any new construction, existing building purchase or renovation costing more than $1 million that occurred in the last 15 years may qualify for cost segregation. Contact your trusted BKD advisor if you think your business would be a good candidate for a cost segregation study.
Under certain circumstances, taxpayers may defer income recognition for payments received before goods or services are provided to a customer. Accrual-basis taxpayers should analyze income from services and consider filing an accounting method change to take advantage of this treatment for advance payments. In general, qualifying taxpayers may defer this income to the next succeeding taxable year if that income also is deferred for financial statement purposes.
For more information on how the TCJA affects accounting methods as well as accounting periods, check out Simply Tax Episode 21 – TRPs After Tax Reform. Guest Ogo Eke-Okoro, American Institute of CPAs (AICPA) lead manager and staff liaison to the AICPA’s technical resource panels (TRP), discusses these topics and other projects the Tax Methods & Periods TRP is working on.
Contact Julia or your trusted BKD advisor for more information on how an accounting method change may benefit your company and for help implementing a change on your 2017 tax return.