Changing from cash to accrual accounting after revoking an S election under TCJA

Editor: Michael D. Koppel, CPA (Retired)/PFS/CITP

As a result of the income tax rate changes incorporated into the tax law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, many practitioners have considered whether to convert passthrough entities to C corporations for tax purposes, including the option of revoking existing S corporation elections. One significant consideration for large cash-basis S corporations is the requirement under Sec. 448 that C corporations use the accrual basis of accounting unless gross receipts are less than the threshold provided in Sec. 448(c)(1). The TCJA includes a new provision related to the timing of when these large taxpayers include the positive or negative adjustments required by Sec. 481(a)(2). The IRS recently issued Rev. Proc. 2018-44, which provided necessary modifications to Rev. Proc. 2018-31 to incorporate these statutory amendments.

Sec. 448 stipulates that unless otherwise provided, a C corporation (other than a farming business or qualified personal service corporation) is required to use the accrual basis of accounting for income tax purposes unless the C corporation meets the gross receipts test in Sec. 448(c)(1). The gross receipts test (as revised by the TCJA) states that a “corporation or partnership meets the gross receipts test of this subsection for any taxable year if the average annual gross receipts of such entity for the 3-taxable-year period ending with the taxable year which precedes such taxable year does not exceed $25,000,000.” The gross receipts test requires an existing S corporation with annual gross receipts in excess of $25,000,000 that revokes an existing S election to convert to the accrual basis of accounting unless a separate exclusion applies.

Sec. 481 provides that when a taxpayer changes from one method of accounting to another, the taxpayer is required to include in taxable income for the year of the accounting method change “those adjustments which are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted.” Rev. Proc. 2018-31 states that when changing from the overall cash basis to the overall accrual basis of accounting, the adjustment provided under Sec. 481 “must reflect the account[s] receivable[], account[s] payable[], inventory, and any other item determined to be necessary in order to prevent items from being duplicated or omitted.” Generally, when a taxpayer converts from the cash basis to accrual basis, a net positive adjustment under Sec. 481 must be included in a taxpayer’s income for the year of change and the next three tax years, and a negative adjustment must be included in taxable income in the year of change (see Rev. Proc. 2015-13). However, the TCJA introduced a new Sec. 481(d), which extends the Sec. 481 income inclusion period for certain eligible terminated S corporations.

Under Sec. 481(d)(1), an “eligible terminated S corporation” with an adjustment under Sec. 481(a)(2) created as a result of its revocation of its S corporation election is required to take the adjustment “into account ratably during the 6-taxable year period beginning with the year of change.” An eligible terminated S corporation is defined in Sec. 481(d)(2) and clarified in Rev. Proc. 2018-44 as “any C corporation that: (1) was an S corporation on December 21, 2017; (2) revokes its S corporation election after December 21, 2017, but before December 22, 2019; and (3) has the same owners of stock in identical proportions on December 22, 2017, and the revocation date.”

Rev. Proc. 2018-44 further provides that the six-year inclusion period for adjustments under Sec. 481(a)(2) also applies to an electing eligible terminated S corporation that would be permitted to continue to use the cash basis of accounting after the revocation of its S corporation election but chooses to change to the overall accrual method for the C corporation’s first tax year after the revocation. Absent an election, the corporation would be required to include adjustments under Sec. 481(a)(2) over the periods provided in Section 7.03(1) of Rev. Proc. 2015-13. However, Rev. Proc. 2018-44 provides specific guidance on making the election to use the six-year spread provided in Sec. 481(d)(1). This guidance states that “an eligible terminated S corporation that wants to use this six-year spread period must indicate in the statement required by Line 26 of Form 3115[, Application for Change in Accounting Method,] . . . that it is making the change in method of accounting with the spread period permitted under this section 15.01(3)(a)(ii)(B) on its timely filed Form 3115.”

Rev. Proc. 2018-31 sets forth in Section 15.01 guidance for taxpayers making an automatic change in overall accounting method from cash basis to accrual basis, including changes required by Sec. 448. Rev. Proc. 2018-44 confirms that eligible terminated S corporations required to make a change from a cash-basis accounting method to an accrual-basis accounting method for tax reporting purposes as a result of the revocation of its S corporation election, and that makes the change in accounting method under Section 15.01 of Rev. Proc. 2018-31, must take the Sec. 481(a)(2) adjustment into account ratably during the six-year period beginning with the year of change. It is also important to note that Rev. Proc. 2018-44 states that any other accounting method changes that might result from the revocation of an S election are not within the scope of the revenue procedure.

The tax rate changes in the TCJA have created opportunities for tax practitioners to analyze business taxpayers and revisit decisions related to whether S corporation or C corporation tax status is a better fit for a client. For many large taxpayers the adjustment under Sec. 481(a)(2) dramatically impacts the decision of whether to convert to a C corporation. In addition, some current S corporations that wish to convert back to a C corporation have compelling reasons to concurrently move to the overall accrual method of accounting even when not statutorily required. The provisions provided in Sec. 481(d) and the guidance found in Rev. Proc. 2018-44 provide practitioners guidance in navigating these conversions, and the six-year spread may help taxpayers to better absorb their tax consequences.

EditorNotes

Michael D. Koppel, CPA (Retired)/PFS/CITP, is a retired partner with Gray, Gray & Gray LLP in Canton, Mass.

For additional information about these items, contact Mr. Koppel at 781-407-0300 or mkoppel@gggcpas.com.

Unless otherwise noted, contributors are members of or associated with CPAmerica International.