COVID-19 Pandemic - Accounting Method Planning to Defer 2019 Income to 2020

This tax release was updated on April 17, 2020 to include a discussion of the CARES Act technical correction for qualified improvement property.  

Taxpayers should consider ways to increase cash flow in light of the challenging environment presented by the COVID-19 pandemic. One alternative is to decrease cash taxes paid through accounting method planning. Taxpayers should identify accounting method changes that can be filed for 2019 under the automatic procedure by filing Form 3115, Application for Change in Accounting Method. Any automatic Form 3115 must be filed by the time the 2019 tax return is due. A non-automatic change is available for 2020 and must be filed by the end of the tax year. Below is a discussion of some of the ways accounting methods can help to decrease 2019 cash taxes. Please note, the analysis below will be updated for legislative and/or administrative changes.

Consider Planning to Accelerate Deductions or Defer Income

• Defer advance payments. Generally, 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 create a significant divergence between book and tax treatment. New Sec. 451(c) codified a one-year deferral rule. To the extent a taxpayer is not optimizing the deferral method, this is a good time to consider this alternative method.
• Evaluate revenue recognition under ASC 606 and Sec. 451(b). Private companies with audited financial statements must adopt ASC 606 in 2019 and must recognize revenue no later than for book purposes under new Sec. 451(b). An accounting method change is normally required to be filed for tax purposes. Some businesses will have an acceleration of income, while others will have an income deferral, or a mixture of both. Most unfavorable changes can be made with a four-year spread period, while favorable changes can be taken into account all in one year.
• Evaluate accounting methods related to inventory. Adoption of the lower of cost or market or analysis around subnormal goods can accelerate the cost of goods sold exclusion for certain items in ending inventory. Final regulations under Sec. 263A are effective in 2019. For taxpayers in compliance with Sec. 263A, these new rules will often result in an acceleration of deductions in the year of adoption.
• Deduct prepaid expenses. Taxpayers should consider accelerating the deduction for certain prepaid expenses in 2019 such as insurance, ratable service contracts performed within 3 ½ months of payment, rebates, refunds, and dues and subscriptions. Many prepaid expenditures and intangibles are currently deductible under the 12-month rule for cash and accrual basis taxpayers.
• Accelerate deductions for property taxes. Adoption of the lien-date method with the recurring item exception for property taxes may allow taxpayers to accelerate deductions for property taxes paid after year end but before the tax return is filed.
• Deduct software development expenditures. Software development costs that are capitalized and amortized for financial accounting purposes are often currently deductible for tax purposes and can be deducted by requesting a change in method of accounting.

Small Businesses

• Maximize Sec. 179 deduction. A qualifying taxpayer can deduct the cost of certain property as an expense when the property is placed in service. For 2019, a taxpayer can deduct up to $1,020,000 on certain property. The definition of Sec. 179 property was  expanded under the 2017 Tax Cuts and Jobs Act (TCJA) to include improvements to non-residential real property (e.g., roofs, heating, ventilation, air conditioning, and fire and alarm protection systems).There is no separate real property dollar limitation for expensing qualified real property under Sec. 179. As a result, taxpayers may elect to use their entire Sec. 179 dollar limitation to expense qualified real property expenditures, including qualified leasehold improvement, restaurant and retail property.
• Evaluate use of the cash or accrual method of accounting for small business taxpayers. Prior to 2018, C corporations or partnerships with a C corporation partner could only use the cash method of accounting if their average annual gross receipts for the prior three tax years did not exceed $5 million for all prior tax years. The TCJA increased the threshold to $25 million, indexed for inflation, and the requirement that such businesses satisfy the gross receipts requirement for all prior tax years is repealed. For 2019, the indexed threshold is $26 million. The cash method of accounting may be very favorable to service providers who bill in arrears. Alternatively, businesses that receive advance payments may find the accrual method to be beneficial and could make a change from the cash method to the accrual method.
• Evaluate accounting methods related to inventory for small business taxpayers. As part of TCJA, small business taxpayers meeting the $25 million gross receipted threshold are also eligible for certain simplifying measures around accounting for inventories. These taxpayers are not required to account for inventories under Sec. 471. Inventories may instead be accounted for as non-incidental materials and supplies or treated consistent with the method of accounting used in the taxpayer’s financial statements or books and records. This rule is particularly advantageous for manufacturers as labor and overhead related to production could be expensed as incurred and raw materials expensed when they are used or consumed in the production of finished goods. Further, eligible taxpayers are exempt from the provisions under Sec. 263A, which require certain additional costs to be capitalized into the tax basis of inventory. These small business rules generally result in a tax deduction in the year of change.

Other Considerations

• Charitable donations of food inventory. In recognition of the importance of food donation, the U.S. federal government has incentivized food contributions through the provision of an enhanced deduction for certain qualifying contributions of food inventory for all taxpayers. Under the enhanced deduction, a taxpayer can deduct its basis in the donated “wholesome food” inventory plus one-half of the gain that would have been recognized in income if the food inventory had been sold for its fair market value. The charitable deduction is limited to twice the taxpayer’s basis in the contributed food inventory.
• Charitable donations of inventory by C corporations. C corporations that hold inventory may take an enhanced deduction for the donation of an inventory item to a charitable organization if the donee uses the property for the care of the ill, the needy, or infants and certain other criteria are met. The enhanced deduction for contributions of inventory is the cost of the inventory plus one-half the gain if the property were sold for its fair market value. The charitable deduction is limited to twice the taxpayer’s basis in the contributed food inventory.
• Analysis of bad debt. Many taxpayers reverse the financial statement bad debt expense for tax purposes without analyzing the underlying debts for worthlessness. Taxpayers may analyze these debts to claim a deduction for wholly worthless debts in the tax year they become wholly worthless and a deduction for partially worthless debts in the tax year they are properly charged off. Companies may also encounter disputes with customers regarding the amounts billed for various reasons such as clerical errors, incorrect quantity, or dissatisfaction with the quality of goods, and short the payment of the invoiced amounts in these circumstances. To the extent the dispute is made prior to the end of the taxable year in which the sale was made, taxpayers have the opportunity to exclude the disputed amounts from taxable income. Taxable income would be recognized in the year the dispute is settled.
• Planning for interest expense limitations. Accounting methods planning can be used to lessen or avoid a Sec. 163(j) limitation. Capitalizing and depreciating costs, as opposed to expensing the costs at the time incurred will impact adjusted taxable income while capitalizing interest may also reduce the amount of interest subject to limitation. Impending legislation surrounding the Sec. 163(j) limitation would require additional modeling. Reverse accounting method planning for certain 163(j) limited businesses may be necessary. 
• Interactions with GILTI, BEAT and other provisions. Evaluating your business’s tax provision can be significant more complex after the TCJA. Consider using accounting methods planning to manage overall taxable income, and also take the impact of methods planning on other calculations into account.

Cost Recovery Provisions

• Consider the extension and expansion of bonus depreciation. The TCJA allows taxpayers to expense the entire cost of certain depreciable assets acquired or placed in service after September 27, 2017, and before January 1, 2023 (with an additional year for aircraft and longer production period property). The requirement of original use is repealed, and the property qualifies for bonus depreciation if it is purchased from an unrelated party and it is the first use of the property by the taxpayer. Final regulations provide rules for determining when there is a written binding contract and new proposed regulations exclude certain self-constructed property from the written binding contract constraint, thus it must be determined whether property is eligible under these new rules.
• Analyzing current year fixed asset additions to identify repairs. When incurring expenditures related to existing buildings, land improvements, or other tangible property, a taxpayer should consider whether the expenditure must be capitalized for tax purposes or whether it could be currently deducted as repair and maintenance expense. Expenditures that taxpayers routinely capitalize and depreciate for book purposes can be expensed for tax purposes under these rules. For example, a cosmetic refresh or remodel of a portion of a building where there is no impact to the building’s structure or systems is generally not required to be capitalized. Costs that are deducted under the de minimis rule or as a repair and maintenance expense are not subject to depreciation recapture rules upon a future transaction. A retroactive adjustment for prior year asset additions may be available by filing Form 3115.
• 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. The TCJA increased the benefit by allowing bonus depreciation for eligible acquired used property. A current year cost segregation study can significantly benefit a company by enabling them to minimize the costs allocated to the longer-lived building and its structure and instead allocating them to personal property, land improvements or other bonus-eligible property. Has the building already been placed in service? A retroactive change from a cost segregation study with a cumulative catch-up adjustment can be made by filing Form 3115.
• Make partial disposition elections. When there is a capitalizable improvement made to a building or other property, taxpayers can write off the remaining tax basis of the replaced property by making a partial disposition election. A partial disposition election is made by disposing of the remaining tax basis of the retired property on the originally filed tax return for the year of disposition.

The Takeaway

Taxpayers should consider accounting method changes to optimize their tax position in light of the COVID-19 pandemic. The current environment presents taxpayers with a variety of challenges, including the potential for decreases in cash flow. Taxpayers have a variety of accounting methods planning options available to them to increase cash flow. Andersen Tax’s accounting methods specialists are prepared to assist with analysis and have discussions to identify appropriate strategies. Andersen is monitoring and will continue to report developments regarding tax relief in response to COVID-19.