The tax returns of many businesses in the specialty fabrics industry have been—and will most likely continue to be—extra thick. Thanks to newly issued “repair regulations,” tax return filings for last year included more work on “Form 3115, Application for Change in Accounting Method” than usual. Fortunately, the IRS recently made it easier for small businesses, including sole proprietors, with assets totaling $10 million or less to comply with the final regulations for repair write-offs and other moves requiring a change in accounting methods.
The tax laws require a business to get consent from the IRS to change a “method of accounting” whenever there is a change to the way something is reported on the operation’s tax return. It can be as simple as the timing of income or expenses, not the total amount over time. In other words, it is temporary versus permanent differences.
IRS permission is required even if the accounting method change is demanded by an IRS auditor or is necessary to comply with new tax laws. And a request to change accounting methods requires certain adjustments to avoid distorting an operation’s income and/or deductions.
Changing Accounting Methods
Because the IRS doesn’t want anyone to change accounting methods willy-nilly, changing the “method of accounting”—the way something is accounted for on the tax return that affects the timing of income or expenses—is everything for tax purposes. According to our tax laws, a change in the method of accounting occurs when the method to be used by a taxpayer for an item when computing taxable income is different from the operation’s “established” method of accounting. This type of change does not include correcting mathematical or posting errors, or errors in the computation of tax liability.
The IRS’s latest guidelines identify the steps for obtaining the advance (nonautomatic) consent of the IRS Commissioner to change an operation’s method of accounting as well as for obtaining an “automatic” consent.
The term “method of accounting” includes (a) an overall plan of accounting, such as for gross income and deductions, and (b) the treatment of any “material item” that involves the proper timing for inclusion in income or claiming the item as a deduction, or both.
Once a business uses a particular method for treating income, expenses, deductions or transactions in a manner that properly reflects income, it is considered to have “adopted” that method of accounting. It is not necessary to treat the item consistently in two or more consecutive returns in order to have adopted a method of accounting.
To obtain the IRS’s consent to change a method of accounting, a business must usually file a Form 3115, Application for Change in Accounting Method, during the taxable year for which the change is proposed. With many Forms 3115 filed for nonautomatic changes requiring additional information, the IRS recommends filing a Form 3115 as early as possible during the year of change.
Unfortunately, there is no such thing as a “retroactive” change in a method of accounting. Unless specifically authorized by the commissioner or by law, no one may request, or otherwise make, a retroactive change in method of accounting.
Ripe for Change
The IRS uses the deduction for so-called energy-efficient commercial buildings to illustrate a situation in which a business may want to change its method of accounting for the expense of installing energy-efficient property, equipment or systems. This deduction is subject to limits and must be claimed in the tax year in which the energy equipment or improvements are placed in service.
The basis or book value of the energy-efficient commercial building property is reduced by the amount of the deduction taken, and the remaining basis of the energy-efficient commercial building property is depreciated over its recovery period. Business owners making this change must attach a statement of adjustments to their Form 3115.
Adjustments for Change
The “adjustment” required whenever accounting methods are changed involves computing the amount necessary to prevent amounts from being duplicated or omitted when the operation computes its taxable income for the year of change, and thereafter using a different method of accounting. Of course, the IRS may decide that certain changes in methods of accounting can be made without an adjustment.
When there is a change in the method of accounting, taxable income for the tax year before the year of change must be determined under the method of accounting that was then employed. Taxable income for the year of change and the following taxable years must also be determined using the method of accounting for which consent is granted, as if that method of accounting had always been used.
When a change in method of accounting is made without an adjustment (for example, on a cutoff basis), generally only those items arising on or after the beginning of the year of change, or other operative date, are accounted for under the method of accounting for which consent has been granted. Any items arising before the year of change, or other operative date, must continue to be accounted for using the operation’s previous method of accounting.
The tax rules clearly state that if taxpayers do not regularly employ a method of accounting that clearly reflects their income, the IRS may change the method of accounting to one that, in its opinion, does clearly reflect income. However, this accounting method change is often the result of an IRS audit or examination.
In situations where the business is compelled to change its method of accounting, especially a change that results in a positive adjustment, the change will ordinarily be made in the earliest taxable year under examination, with a one-year adjustment period.
Advantages of Change
Under a recent IRS revenue procedure, taxpayers will be given automatic approval from the IRS to change their method of accounting for a number of listed changes. Instead of amending an earlier-filed tax return, a taxpayer simply attaches Form 3115 to a timely filed federal income tax return for the year in which the change applies, and also sends a copy to the IRS national office.
As mentioned, the cumulative negative effect (taxpayer favorable) of the change in the taxpayer’s method of accounting is reported as an adjustment, which can be deducted immediately in the taxable year of change. A positive adjustment (unfavorable to the taxpayer) can be amortized over four consecutive years (beginning with the first year in which the change was applicable).
Included within these automatic method changes is a change from an impermissible method of depreciation, under which the taxpayer did not claim the depreciation allowable, to a permissible method for depreciation, under which the taxpayer will claim the depreciation allowable and expensing versus capitalization.
The IRS’s newly issued revenue procedure outlines the steps business owners should take when changing their method of accounting—whether to obtain nonautomatic consent or automatic consent. Nonautomatic changes in methods of accounting require IRS consent. Automatic changes in accounting methods do not require IRS consent.
The IRS doesn’t want changes made that might distort the operation’s tax bill. But the good news is that because the IRS doesn’t have the time to consider every accounting method change, it publishes a long list of “automatic” method changes each year.
The bad news is that even an automatic change isn’t free, especially if it is necessary to go through old records to determine the catch-up deduction. However, if a business has significant depreciable property, it is probably worth the effort to investigate both the advantages and potential pitfalls in changing accounting methods. In this case, the assistance of a qualified professional could make things go more smoothly, and could possibly unearth other areas that might benefit the business should an accounting method be changed.
Mark E. Battersby writes extensively on business, financial and tax-related topics.
The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board released the revenue recognition standard in May 2014 after a decade of work harmonizing U.S. Generally Accepted Accounting Principles (GAAP) with International Financial Reporting Standards. It is considered to be the most comprehensive change to accounting principles ever amassed. Almost every company applying U.S. GAAP will be affected in some way by the required changes of this standard. The new standard takes effect for publicly-traded companies starting with annual reporting periods beginning after Dec. 15, 2017, and for most other businesses, for annual reporting periods beginning after Dec. 15, 2018.