Tax reform: Accounting method opportunities

Editor: Annette B. Smith, CPA

Under the tax reform proposals of both President Donald Trump and the House Republicans (the House Blueprint), the top corporate and individual tax rates would be lowered significantly. Trump proposed lowering the top corporate tax rate from 35% to 15%; the Blueprint would reduce the rate to 20%. The House Blueprint would lower the top individual tax rate from 39.6% to 33%, while Trump’s proposal would lower it to 35%. Both proposals would lower the tax rate on the business income of passthrough entities and repeal the corporate and individual alternative minimum taxes.

Trump has said previously that he would propose a one-time, 10% repatriation tax on overseas corporate profits—although the tax reform outline the administration released on April 26 did not include a specific rate. The House Blueprint also calls for a mandatory tax on previously untaxed foreign earnings—an 8.75% tax on untaxed foreign cash and cash equivalents and a 3.5% tax rate on untaxed foreign noncash assets (i.e., earnings reinvested in the business). The House Blueprint would require payment of the tax over eight years.

In general, planning to take advantage of optimal accounting methods—i.e., accounting methods that either accelerate deductions or defer revenue—can provide taxpayers with the benefit of deferring the payment of income tax to a future tax period. By comparison, rate reductions (if enacted) could provide taxpayers with additional opportunities to generate a permanent benefit for items that typically would result only in a temporary benefit via the time value of money.

Accounting method planning that accelerates deductions (e.g., for prepaid expenses or bad debts) or defers revenue (e.g., for advance payments or unbilled receivables) provides corporations with the potential to take deductions at the current 35% rate and recognize revenue at a proposed lower rate of 15% or 20% under Trump’s plan or the House Blueprint, respectively. Implementing these planning techniques could provide significant permanent tax rate benefits and cash tax savings to corporations.

Owners of passthrough entities also should consider potential tax rate reduction opportunities. As noted above, both Trump’s proposed plan and the House Blueprint include a flat tax on passthrough entities. Assuming enactment of such a proposal, passthrough entities may wish to similarly defer income and accelerate deductions.

Taxpayers also should analyze and optimize the accounting methods of their foreign corporations in light of the deemed repatriation provisions included in both the Trump and House Blueprint tax reform proposals. Through optimal accounting method planning, taxpayers may be able to manage earnings and profits (E&P) or correct impermissible methods to obtain audit protection.

Under current law, methods of accounting generally are adopted by a foreign corporation in the year in which its E&P becomes significant for U.S. federal income tax purposes under Regs. Sec. 1.964-1(c)(6). Once an accounting method has been adopted, the foreign corporation must follow rules similar to those of domestic taxpayers to change the accounting method for E&P purposes.

Under the Sec. 964 regulations, a U.S. multinational company may be able to “protect” the foreign corporation’s historic E&P by voluntarily changing from an impermissible method to a permissible method or using the opportunity to change to a more favorable proper U.S. tax accounting method to either increase or decrease the foreign corporation’s E&P, depending on its tax position. Any such method changes generally will require IRS consent. This consent may either be automatic or nonautomatic, based on the nature of the requested change.

In light of the proposal to tax accumulated and unremitted E&P of foreign corporations, taxpayers should consider the accuracy of their current E&P calculations and the potential to file method changes or implement other accounting method strategies to reduce their foreign corporations’ accumulated E&P. Reducing accumulated E&P prior to the deemed repatriation tax may result in the ability to reduce taxes on offshore earnings. If repatriation is based on accumulated E&P at a point in time in the past (e.g., if the deemed repatriation occurs in 2018 based on accumulated E&P as of Dec. 31, 2016), taxpayers still can obtain audit protection on impermissible E&P methods and spread recognition of cumulative unfavorable adjustments over a four-year period.

If tax reform legislation along the lines proposed is enacted in 2017 and becomes effective for tax years beginning in 2018, then companies will want to implement the appropriate accounting method strategies in 2017 to maximize the opportunities from the reduction in tax rates. Accordingly, companies should begin immediately to evaluate their current accounting methods to determine what changes can be made to optimize the impact of potential tax reform and whether such changes can be made automatically. Companies also should consider whether each change can be filed up until the time the federal income tax return for the year of change is filed, or whether it must be filed on a nonautomatic basis that requires Form 3115, Application for Change in Accounting Method, to be filed no later than the last day of the tax year of change.

Similarly, companies should analyze what other accounting method planning opportunities should be taken that do not require Form 3115 to be filed but rather require other action. For example, companies should analyze their bonus plans to determine whether revisions to the plan would lead to accelerated deductions by creating a fixed liability at year end. Further, companies that can accelerate deductions by prepaying certain contracts before year end should consider whether doing so will allow the company to recognize a deduction at the 35% tax rate (rather than the proposed lower tax rate in future periods). Both opportunities highlight the importance of tax professionals’ discussing the impact of potential tax reform with executives outside the tax department.

Regardless of the approach, through the use of an accounting method change or other corporate action, companies should analyze their current accounting methods and establish a list of opportunities to optimize their federal income tax position in the event that tax reform is enacted.

An earlier version of this item appeared in PWC’s Tax Insights.

EditorNotes

Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.

For additional information about these items, contact Ms. Smith at 202-414-1048 or annette.smith@pwc.com.

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.