Year-end tax accounting methods planning

Throughout 2022 and 2023, significant increases in interest rates put a strain on operating cash flows and increased the cost of funds borrowed to pay tax liabilities. Many taxpayers also are facing higher taxes as a result of tax law changes that recently took effect, such as changes that expanded the limitation on interest deductibility under IRC Section 163(j), capitalization and amortization of IRC Section 174 research and experimental costs, and the phaseout of bonus depreciation. Accounting method planning can be a powerful tool to more favorably manage tax-related cash flow and mitigate related issues.

Background

Accounting methods generally relate to the timing of the recognition of income or expenses. Reviewing current accounting methods could reveal opportunities for more favorable tax treatment, such as in the following situations:

• Revenues are being recognized earlier than under alternative methods that the taxpayer is eligible to use.
• Expenses are being deferred longer than under alternative methods that the taxpayer is eligible to use.
• Available elections that could result in more favorable tax treatment depending on the taxpayer’s facts and circumstances, such as a last-in, first-out (LIFO) election under IRC Section 472, are not being made.
• Internal policies, such as those related to accrued bonuses, prevent more favorable tax treatment.

In most cases, a taxpayer is required to request IRS consent to change its existing accounting method by filing Form 3115, “Application for Change in Accounting Method.” Certain method changes are eligible for automatic consent, meaning that the request is automatically granted if the Form 3115 requesting the change is filed with the IRS in Ogden, Utah, and is attached to the taxpayer’s income tax return for the year of change filed by the due date (including extensions). Other method changes require advance consent. If a nonautomatic method change is requested, the taxpayer may not apply the method change unless and until the IRS approves the request. A taxpayer requests a nonautomatic method change by filing a Form 3115 with the IRS national office before the last day of the tax year for the year of the change. Nonautomatic method changes require payment of a user fee. A user fee is not required to request an automatic method change.

Reviewing current accounting methods does not come without some cost. Internal staff will need to provide information relevant to current accounting methods, including internal policies and other documentation. Additionally, user fees to request a nonautomatic change and professional fees might apply. In many cases, however, an acceleration of deductions or a deferral of revenue can result in more favorable tax treatment for the current year that would persist into the future.

Crowe observation

Accounting method planning can provide significant and meaningful time value of money savings, particularly with increased costs of capital, that outweigh costs incurred.

Accounting method change example: Accrued employee bonuses

Consider an example relating to the timing of the deduction for employee bonuses:

• A taxpayer currently is deducting bonus expenses upon payment. However, a review conducted in 2023 of the taxpayer’s facts and circumstances, including internal policies and documentation, indicates that its accrued bonus liabilities (approximately $1 million each year) are fixed at year-end and paid within 2½ months of year-end. Further analysis indicates that the taxpayer is eligible to deduct employee bonuses under IRC Section 404(a) in the year the liability is fixed, rather than in the year paid.
• Accelerating the deduction for employee bonuses will require the taxpayer to request an automatic method change. The taxpayer requests the automatic method change by filing a Form 3115 with its timely filed 2023 income tax return to deduct bonuses accrued at year-end rather than when they are paid the following year.
• For purposes of this example, assume that the taxpayer is a calendar year C corporation and for all relevant tax years it has a 25% blended tax rate, a 7% discount rate, and a 10-year horizon (that is, a final year return will be filed for 2032). Also, assume present value refers to amounts determined in 2023 dollars based on a 7% discount rate.

The following table illustrates that, in nominal value (referring to the undiscounted monetary value respective to each year shown), the method change does not change the total amount eligible to be deducted by the taxpayer. However, the additional $1 million deduction in 2023 in present value dollars when tax effected is worth approximately $114,000 more than the $1 million reduction in the deduction in 2032, the taxpayer’s final year of business.

As the example illustrates, it is likely worth the additional cost to implement this method change. A taxpayer might recognize an even better result because several of the following assumptions used might understate the present value benefit:

• A 7% discount rate might be significantly lower than the actual borrowing rates or internal rates of return for many taxpayers, with higher rates further increasing the present value of the additional deduction.
• A 10-year horizon might be understated for the lifetime of many taxpayers, with a longer time frame increasing the present value of the additional deduction.
• For an item like accrued bonuses, generally the accrual will grow over time, resulting in additional deductions accelerated each year.

Looking ahead

The benefit of deferring income or accelerating a deduction on a present value basis can persist even through potential increases in tax rates in the future. It can be a worthwhile exercise for taxpayers to model the impact of various method changes and evaluate the extent of any sensitivity to changes in assumptions, such as changes in discount rate or tax rate, to understand the true economic benefit of a change.

Accounting method opportunities are not always readily apparent, so taxpayers should work with their tax advisers to review their existing accounting methods to consider any opportunities for tax planning, as the benefits can be significant.