When conducting year-end planning, business taxpayers should consider their accounting methods. The Tax Cuts and Jobs Act (TCJA) provided many taxpayers with new opportunities to use more advantageous methods, and several previously existing accounting methods are still relevant tax planning strategies.
Overall Accounting Method – Cash vs. Accrual
Prior to 2018, C corporations generally didn’t qualify to use the cash method of accounting unless their prior three years’ average annual gross receipts were less than $5 million. The TCJA increased this threshold to $25 million, allowing many previously ineligible corporations to qualify. Partnerships and S corporations in service businesses may be able to use the cash method even if gross receipts exceed $25 million.
Under the cash method, income is generally taxed when cash is received and expenses are deducted when cash is paid. Therefore, taxpayers with receivables exceeding payables may benefit from a net deferral of income under the cash method, along with a potentially significant tax deduction in the year of change. Taxpayers qualifying under the $25 million gross receipts test can convert to the cash method by filing an automatic accounting method change (Form 3115) with the IRS.
Accounting Methods Related to Inventory
Under the TCJA, taxpayers with average gross receipts of less than $25 million aren’t required to account for inventories; under prior law, this threshold was $1 million ($10 million for taxpayers in certain industries). In addition, all taxpayers with less than $25 million in gross receipts are no longer subject to the Section 263A uniform capitalization rules, which require certain additional costs to be capitalized into the basis of inventories (the previous threshold was $10 million in gross receipts for resellers, with no threshold for manufacturers).
These method changes can simplify the treatment of inventory for small business taxpayers and may result in a tax deduction in the year of change. The inventory and §263A accounting method changes are automatic and may be filed on a single Form 3115 along with the cash method change for taxpayers not exceeding the $25 million receipts threshold.
Taxpayers such as construction companies that earn revenues from contracts extending over multiple tax years are generally required to determine taxable income using the percentage-of-completion method (PCM). Under this method, income is recognized each year based on the percentage of the total estimated contract costs that have been incurred.
Taxpayers with less than $25 million in gross receipts ($10 million prior to 2018) are exempt from the requirement to use PCM and may instead use the completed contract method (CCM) for contracts lasting less than two years. Under the CCM, revenue is not recognized until the year the contract is completed. The change to the CCM is an automatic change and is implemented on a cutoff basis, meaning the new method will apply to contracts starting during or after the year of change.
Other Accounting Methods
In addition to the new opportunities for small business taxpayers under the TCJA, several other common accounting method changes may present planning opportunities:
- Prepaid Expenses: Taxpayers may elect to deduct rather than capitalize qualifying prepaid expenses, such as certain insurance and maintenance contracts that don’t extend beyond 12 months. The cumulative balance of qualifying prepaids may be deducted in the year of change.
- Cost Segregation Studies: A cost segregation study is an engineering-based study that breaks out the components of a building in order to take advantage of shorter depreciable lives and first-year bonus depreciation, if applicable. Taxpayers may undertake a study on existing buildings and file an accounting method change to implement the new asset treatments, with the cumulative difference in accumulated depreciation taken as a deduction in the year of change.
- Software Development: Taxpayers incurring software development costs may choose to either deduct these costs as incurred or capitalize and amortize them. A method change must be filed to switch from one method to the other. Beginning in 2022, software development costs will be required to be amortized over a five-year period.
- Accrued Bonuses: Taxpayers should review their bonus plan to determine whether it meets the requirements to deduct bonuses in the year accrued and consider filing a method change to deduct qualifying bonuses. In general, accrued bonuses aren’t deductible until paid if the bonus plan contains a “clawback” provision, i.e., if an employee resigns prior to the bonus payout, his or her bonus reverts back to the company. A method change also can be filed to correct the treatment of nonqualifying accrued bonuses being improperly deducted, providing audit protection for prior years and allowing the taxpayer to spread the unfavorable adjustment over four years.
Taxpayers should consult their trusted advisors to discuss their specific situations and tax planning goals and assess whether any accounting method changes may contribute to those goals for the 2019 tax year.
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