Press Room: Tax Release
2016 Top Year-End Tax Accounting Method Considerations for Businesses
As we approach the end of the 2016 calendar year, year-end tax planning is a subject that is undoubtedly garnering attention. Historically, planning has focused on concern over whether expired tax incentives would be retroactively reinstated. The Protecting Americans from Tax Hikes Act of 2015 (PATH Act) permanently extended many of these tax benefits. Year-end tax planning in 2016 should take into account not only your business strategy, tax position and recent tax legislative changes, but also the potential for tax reform in 2017. In anticipation of a potential overall reduction in tax rates and potential limitation of business deductions, profitable companies will likely want to identify ways to defer income and accelerate deductions prior to the effective date of any tax reform legislation.
Consider the impact of recent legislative changes and traditional planning to accelerate deductions:
- Consider the extension and expansion of bonus depreciation. The PATH Act extended the bonus depreciation deduction through 2019. In addition, the Act added a new class of property eligible for bonus depreciation. The new class of nonresidential real property, qualified improvement property, replaces the former qualified leasehold improvement property. This expanded application of bonus depreciation allows taxpayers, beginning in 2016, to claim bonus depreciation for qualifying nonresidential real property expenditures. Bonus depreciation on nonresidential real property improvements was previously limited to improvements where the building was at least three years old and subject to a lease.
- Evaluate current year fixed asset additions and consider annual elections under the final tangible property regulations. Most businesses have adopted the final regulations, which were effective January 1, 2014. Each year a taxpayer must evaluate its current year fixed asset expenditures to determine whether the expenditure may be deducted as a repair or is capitalizable as an improvement. An annual de minimis safe harbor election allows a taxpayer with an applicable financial statement and a written capitalization policy as of the first day of the tax year to expense amounts paid for tangible property up to $5,000 that are expensed for book purposes. For 2016, the de minimis safe harbor for taxpayers without an applicable financial statement has been increased from $500 to $2,500. The final regulations also allow taxpayers to make an election to capitalize expenditures in accordance with book accounting. This annual election is one lever that taxpayers can consider to manage taxable income for 2016. Did you forget to file a Form 3115? A change in method of accounting can generally be filed for 2016 to implement the final tangible property regulations with back year audit protection.
- Perform a cost segregation study. Cost segregation studies have long been known as a tax planning strategy to increase current cash flow and generate net-present-value savings. With the impending sunset of bonus depreciation and a good possibility of tax reform, a current year cost segregation study can provide a company with significant benefit by minimizing the costs allocated to the building and its structure and instead allocating them to personal property, land improvements or qualified improvement property that may be eligible for bonus depreciation. A change in method of accounting to correct erroneous depreciation methods can generally be filed under the automatic provisions with back year audit protection.
- Deduct prepaids, intangibles, and software development. Many prepaid expenditures and intangibles are currently deductible under the 12-month rule. Analysis is necessary to determine the nature of the items and to sort through the various economic performance rules that may apply. This analysis is complicated by confusion over when the payment liability, 3-1/2 month and 8-1/2 month, rules apply. Software development costs that are capitalized and amortized for financial accounting purposes are often currently deductible for tax purposes.
Consider alternative methods of accounting to defer income:
- Consider the timing of income recognition for advance payments. As a general rule, an accrual basis taxpayer is required to recognize income upon receipt as it relates to advance payments for goods or services to be provided in the future. For financial reporting purposes, revenue is generally recognized in the period the costs to generate the revenue are incurred. As a result, this is an area that may result in a significant divergence between book and tax treatment. There are several optional methods of accounting for advance payments that a company may adopt to obtain a deferral of income for tax purposes. Many are familiar with the rule in Rev. Proc. 2004-34, which provides a one-year deferral for tax purposes for certain advance payments. This simple rule also presents many separate issues for taxpayers. Is the payment received a refundable deposit or a true advance payment? Does the advance payment meet the strict terms of Rev. Proc. 2004-34? Are there applicable financial statements that report the advance payment? What difference does it make if there is an accrued reserve rather than an advance payment reported in the balance sheet section of the financial statements? All of these issues require careful analysis and each is pertinent to determining whether the taxpayer’s method of tax accounting for advance payments is proper. A taxpayer may be eligible for a longer deferral for advance payments for goods. To the extent your company is not utilizing a deferral method, this year is a good time to consider these alternative methods in anticipation of possible reduced federal income tax rates as part of tax reform.
- Evaluate use of the cash method of accounting. Companies operating in partnership, S corporation, or LLC form are generally able to use the cash method of accounting unless they hold inventoriable goods or have a C corporation as a partner. The cash method of accounting may be very favorable to service providers who bill in arrears. Certain small taxpayers may change from the accrual to the cash method of accounting under the automatic consent procedure. For other taxpayers, a change to the cash method requires prior IRS permission. Alternatively, service providers who use the accrual method may change to the non-accrual experience method.
- Evaluate the impact of accounting methods in a transaction. Tax risk related to an acquired business's method of accounting is often identified by the buyer either as part of the due diligence process or subsequent to a transaction. The seller can accelerate an unfavorable adjustment resulting from a change in method of accounting into the pre-acquisition tax year by making an eligible acquisition transaction election. In addition to simplifying the transaction, the election also opens a new planning opportunity for businesses with net operating losses (NOLs) that will be limited following the transaction. Unfavorable adjustments in the pre-acquisition year can be offset by NOLs that would otherwise be limited, potentially creating additional tax basis for the buyer.
- Conform to financial accounting method changes (or not). Many assume that financial accounting methods are proper for tax and, when the financial accounting methods change, that the tax accounting method may change as well. Neither of these assumptions is necessarily true. Taxpayers must obtain permission to follow a new book method for tax purposes. Further, the new book method may not be an appropriate tax method, or may be disadvantageous, and a book/tax difference may be the end result of a book method change. In either situation, it is important to be aware of any financial accounting method changes, including those that are not disclosed in audited financial statements, and to consider what tax filings are appropriate. For companies that follow GAAP, the new revenue recognition standard, which will be adopted in 2018 for public companies and 2019 for private companies, may result in changes that require the filing of an accounting method change application. Businesses should begin to determine how this new book standard will impact them from both a book and tax perspective.
- Identify original issue discount. Often, original issue discount (OID) arises in connection with loans between family members and their closely-held businesses because interest is not paid at least annually or the ability to defer payments exists. Treasury Regulations require that the interest on OID loans be accounted for on a constant yield accrual method. Because the treatment of OID is an accounting method, erroneous treatment is corrected through a method change with a catch-up adjustment to bring current the accrued interest. Where loans have remained outstanding for an extended period, the interest accrual may be substantial and the failure to accrue interest income may present significant exposure to the lenders. This exposure can be cured by filing an accounting method change application with IRS before the taxpayer is contacted for examination.
- Consider methods of accounting for foreign subsidiaries. U.S. multinationals must use U.S. tax accounting methods to compute the income or loss of their foreign subsidiaries. Maximizing tax accounting methods for foreign subsidiaries tends to be overlooked because companies tend to use book financial statement results. Consider using accounting methods to adjust the foreign subsidiary’s earnings and profits in order to realize tax benefits such as increasing foreign tax credit utilization, minimizing an income inclusion from actual or deemed dividends.