Ten Accounting Method Changes to Consider Before Year-End 2011

Below are ten of the most popular accounting methods changes for individuals and their closely-held businesses to consider before year-end. All of these opportunities are implemented through a Form 3115 filing with IRS.

1. Conforming 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 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.

2. Determining whether accrual of bonuses is appropriate – Many expect that bonuses are currently deductible if paid within two and a half months of year-end. This is not always true. Bonus plans must also meet the “all events” test at year-end (i.e., the bonus must be an absolute liability that is payable in all events). In situations where, for example, the bonus is paid only if the employee is still employed on the date of payment or where a judgmental evaluation occurs after year-end, the bonus plan may not satisfy the all events test at year-end and it is possible that none of the bonus accrual is permitted for tax. In these cases, if the taxpayer is accruing the bonus, the method is improper and a method change may be appropriate. Further, it may be possible to reform the plan so that it qualifies for current accrual.

3. Coping with advance payments – Many are familiar with the rule in Rev. Proc. 2004-34 that only one year deferral is permitted for tax purposes for certain advance payments. This simple rule 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. This year, three different method changes are required for book purposes that may trigger a corresponding tax filing on the treatment of advance payments. Depending on the facts, the filing may be a statement attached to a return or a Form 3115. The important point is to look at this item before year-end.

4. Identifying 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. IRS requires that the interest on OID loans be accounted for on an 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. That catch-up adjustment is spread over four years to provide an incentive for the taxpayer to come forward and file the method change application. Where loans have remained outstanding for decades, the interest accrual may be substantial and the failure to accrue interest may present significant exposure to the lenders. This exposure can be easily cured by filing a Form 3115 with IRS before the taxpayer is contacted for examination. 

5. Considering 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 produce inventory or have a C corporation as a partner. The cash method of accounting may be very favorable to service providers who bill in arrears. Except in a few rare situations, a change to the cash method requires prior IRS permission.

6. Deducting prepaids and intangibles – Many prepaids and intangibles are currently deductible. 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.

7. Distinguishing bad debts from disputes – Are you treating disputes as bad debts? If so, it may be possible to accelerate the deduction for disputes that are identified before year-end. Disputes “unfix” the right to income and therefore reduce income, avoiding the need to report a bad debt at all. However, a method change is necessary to take advantage of this opportunity.

8. Taking a second look at inventory overhead allocations – Many companies use erroneous methods to capitalize overhead to inventory for tax purposes, principally because spreadsheets have been carried over from year-to-year without a good understanding of the underlying tax rules. Often, methods overcapitalize costs for tax purposes because appropriate adjustments have not been made for costs already capitalized for book purposes. A careful analysis of the uniform capitalization rules will identify exposure and opportunities. 

9. Reviewing depreciation deductions – If you find you have failed to take allowable bonus depreciation or have used incorrect asset classes, a method change allows you to “catch up” depreciation to the amount that would have been properly allowed. 

10. Deducting reserves – Taxpayers often assume that no reserves may be deducted for tax purposes. This is not always the case. Employee self-insured medical and sales incentives are two examples of reserves that may be deductible because the filing of claim forms are considered merely ministerial. It is always a good idea to look at reserves that are routinely reversed for tax purposes to see if deduction of the reserve is appropriate.

WTAS can assist with determining whether method change filings are appropriate. For more information on how WTAS can help, contact your WTAS advisor.