Tax accounting methods: Income and expense planning in uncertain times

November 19, 2020 Article 6 min read
Authors:
Emily Murphy Kurt Piwko

Accounting methods determine when income and expenses are recognized for tax purposes. With year-end approaching, now is the time to review your tax accounting methods and make sure they’re helping you achieve your business’s goals.

Businessman smiling while using a tablet handheld device.With the end of the year quickly approaching, taxpayers are reviewing their current year tax position and future years’ projections. Whether you’re planning for unexpected losses or potential tax rate increases, now is the time to review your tax accounting methods and make sure all methods and elections are helping you achieve your business’s goals.

Accounting methods determine when income and expenses are recognized for tax purposes. A taxpayer’s choice in which accounting methods are used in determining taxable income can be a very powerful tax planning tool. Any strategy should consider the many competing factors, including current cash flow, longer-term tax implications, international tax implications, and the potential for future changes in tax policy. Accounting methods provide businesses the opportunity to strategically recognize revenue and expenses by:

  • Providing overall cash-tax planning. A fresh look at tax accounting methods may provide opportunities to accelerate tax deductions, reducing the current tax burden and freeing up cash for business needs. While some tax method opportunities will provide a benefit that will reverse over several years, like accelerated tax depreciation, some methods like the cash method and inventory methods will result in perpetual tax deferral that would generally not reverse while the business continues operation.
  • Maximizing NOL carrybacks to higher tax rate years. While tax reform eliminated net operating loss (NOL) carrybacks of losses to an earlier year with taxable income, the CARES Act provided new flexibility to carryback losses. A taxpayer carrying back losses incurred in 2018 through 2020 can carryback five years, which could include pre-2018 years when tax rates were higher than the present rates. Therefore, in addition to providing cash flow now when companies may need it most, maximizing NOLs in 2020 could create permanent tax rates savings by allowing a deduction at 35–40% rates rather than the current rates that may be 21–30%, depending on entity type.
  • Planning for potential tax rate increases. Changes in the federal administration could result in tax rate changes going forward. If tax rates do increase, taxpayers generating taxable income could see significant permanent tax rate savings by accelerating income into low tax rate years and deferring deductions to higher tax rate years. Taxpayers identifying unfavorable changes are generally required to spread the unfavorable adjustment over four tax years, but there may be opportunities to accelerate these adjustments to take advantage of the present historically low tax rates.
  • Reducing GILTI and BEAT liabilities. Taxpayers with foreign subsidiaries and related parties may be subject to the global intangible low-taxed income (GILTI) and base erosion anti-avoidance tax (BEAT) tax regimes. Taxpayers with foreign subsidiaries can look for opportunities to reduce their GILTI inclusion by deferring income and accelerating deductions at their foreign subsidiary. BEAT is assessed on certain taxpayers with payments made to a foreign-related party. However, BEAT doesn’t include expenses that are recovered as cost of goods sold (COGS) on the sale of inventory. Therefore, taxpayers can review their inventory costing methods to include all allowable costs in COGS, exempting the payments from BEAT.

Planning opportunities and considerations

Below is a list of accounting method opportunities, both for increasing and decreasing taxable income, depending on the tax strategy of the taxpayer. It’s important to note that accounting methods must be applied consistently, and, once adopted, generally can’t be changed again for five years. Most accounting methods are changed by filing Form 3115 with a timely filed tax return. Other planning opportunities provide for an election made with the tax return. However, some method changes may require IRS review and approval, which must be filed by tax year-end. Consequently, taxpayers should review their accounting methods before the year closes to ensure all necessary requirements for using the methods are made on time.

Planning opportunity

Accelerate deductions (decrease income)

 Defer deductions (increase income) 

Depreciation

  • Take full advantage of bonus depreciation and immediate expensing under Section 179.
  • Review asset class lives and perform cost segregation studies.
  • Elect partial disposition deductions when making improvements to property.
  • Review previous depreciation methods and elections for opportunities to accelerate deductions.
  • Elect out of bonus depreciation.
  • Elect ADS to slow down depreciation.

Materials & supplies

  • Elect to expense de minimis amounts of materials and supplies.
  • Elect out of the de minimis safe harbor.

Compensation accruals (bonus, vacation, payroll tax)

  • Accrued bonuses and similar plans: Ensure accruals are “fixed,” providing a tax deduction by making changes to bonus plans or approving bonus pools by year-end, and pay bonuses within 2.5 months of year-end.
  • Accrued payroll tax: Elect the recurring item exception for payroll taxes paid within 8.5 months after year-end. 
  • Accrued bonuses: Pay bonuses more than 2.5 months after year-end or don’t fix the bonus plan amounts by year-end.
  • Accrued payroll tax: For payroll taxes deferred as part of the CARES Act, don’t pay those for 2021/2022 when they’re required to be repaid. Consider electing off the recurring item exception.

Other accruals (property taxes, self-insured health, rebates)

  • Property tax: Use the recurring item exception and deduct payments made within 8.5 months after year-end. Adopt the ratable accrual method.
  • Self-insured health accrual: Many self-insured health accruals are deductible in the year in which the services are provided.
  • Rebates: Use the recurring item exception for rebates earned by year-end, and deduct payments made within 8.5 months after year-end.
  • Property tax: Deduct taxes only when paid.
  • Rebates: Deduct rebates only when paid.

Inventory

  • Review UNICAP methods: Final regulations effective for 2019 tax years can be favorable to many taxpayers.
  • Review inventory reserves for subnormal goods that may be deductible.
  • Review inventory related discounts, such as volume rebates.
  • LIFO taxpayers should consider electing off of LIFO now while tax rates are low.
  • Review UNICAP methods, specifically sub methods that may allow for semipermanent capitalization of service costs.

Prepaid expenses

  • Elect the 12-month rule to accelerate deductions for certain prepaid expenses, such as prepaid insurance. Adopt the 3.5-month rule for prepaid services.
  • Elect off of 12-month rule to defer prepaid expenses.

Research & development (R&D) expenses

  • Elect to capitalize and amortize R&D costs over five years or more.

Deferred revenue

  • Use the one-year deferral method for advance payments.
  • Adopt the full-inclusion method for advanced payments. 

Pension contributions

  • Qualified pension contributions can be deducted if paid by the tax return due date and contributed to the prior tax year.
  • Calendar-year taxpayers should consider making pension contributions after the tax return due date or for the benefit of the subsequent plan year to the extent possible. This contribution would then be deducted in the tax year in which the contribution is made, thus deferring the deduction.

Overall income & expense recognition

  • Review the options to change to the overall cash method or overall accrual method to defer deductions and generate income currently.

Bad debt

  • Review opportunities to use the specific charge-off method.
  • Certain service providers may adopt the nonaccrual experience method to exclude noncollectible receivables from income.

Small business taxpayer inventory methods

  • Certain small business taxpayers can elect off of Section 263A, which requires capitalization of tax costs to inventory.
  • Consider adopting other favorable inventory methods such as the materials and supplies approach for accounting for inventory or the book conformity method for inventory, which may allow for accelerated deductions compared to historical tax methods.
  • Adopt traditional tax inventory accounting and Section 263A to capitalize additional tax costs to inventory.

Percentage-of-completion: Small business taxpayer

  • Small business taxpayers in construction can elect to apply cash or completed contract method instead of percentage-of-completion for long term contracts. 
  • Elect to apply Section 460 to long-term contracts. 

Percentage-of-completion: Larger taxpayers

  • Contractors should evaluate whether their percentage-of-completion methods for taxpayers takes advantage of favorable tax deferrals including pay-if-paid and 10% method.
  • Taxpayers can also evaluate different submethods to accelerate taxable income. 

How we can help with tax accounting methods

Our team will work with you to identify and implement accounting method opportunities to meet your business needs. We’ll also help you:

  • Evaluate the accounting methods and their indirect impacts on other tax strategies
  • Navigate the complex procedural rules in implementing a tax accounting method change
  • File accounting method changes with the IRS and represent your business in the approval process

Related Services:

Tax

Related Industries:

Construction Dealerships Food and Beverage Franchise Manufacturing Professional Services Real Estate Retail Technology Companies

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