The 2017 federal tax reform legislation, P.L. 115-97, known as the Tax Cuts and Jobs Act (TCJA), creates many new and complex rules that affect taxpayers of all types and in all industries. These include the reduction in the corporate tax rate from a graduated rate up to 35% to a flat rate of 21% (with a blended rate for fiscal-year taxpayers), generally effective for tax years beginning after 2017 (Secs. 11 and 15).
This rate cut could allow corporate taxpayers to seek permanent tax benefits through accounting method changes that defer income and/or accelerate deductions. Although accounting method planning typically provides only a timing benefit, the tax rate change provides an opportunity for taxpayers to make favorable accounting method changes for the 2017 tax year to create permanent tax benefits. (This discussion focuses on the ability of calendar-year taxpayers to request automatic accounting method changes; however, fiscal-year taxpayers that have not yet reached the end of their fiscal 2018 tax year still may file nonautomatic method changes.)
This item discusses the applicable procedural rules for making accounting method changes, including special considerations for taxpayers under examination. It also covers common automatic method changes that could defer income or accelerate deductions. Finally, because exposure items may be discovered when reviewing the treatment of income and expense items, the ability to request method changes to limit exposure for favorable, but improper, methods of accounting is addressed.
Requesting a method change
An accounting method change generally is implicated when a taxpayer changes the time for recognizing income or deductions. Generally, a taxpayer must obtain IRS consent to change an accounting method. Rev. Proc. 2015-13 provides the procedures and terms and conditions for requesting both automatic and nonautomatic consent. An automatic Form 3115, Application for Change in Accounting Method, may be filed with the IRS in Covington, Ky., any time between the first day of the year of change and the date the federal income tax return for the year of change is timely filed (including extensions), and it is deemed to be approved upon filing. In addition to filing the automatic Form 3115 with the IRS, a duplicate copy of the form must be attached to the taxpayer's federal income tax return for the year of change. In contrast, a nonautomatic Form 3115 must be filed with the IRS national office in Washington by the last day of the year of change, and is subject to formal IRS review and approval.
The IRS generally provides favorable terms and conditions for a taxpayer-initiated accounting method change, including a one-year spread of a negative (favorable), and a four-year spread of a positive (unfavorable), Sec. 481(a) adjustment (i.e., the adjustment necessary to cumulatively catch up to the new method). In addition, the IRS will not require the taxpayer to change its method of accounting for the same item for a tax year prior to the requested year of change (known as "audit protection"). These conditions generally provide incentives for taxpayers to initiate accounting method changes when they find they have established impermissible methods.
However, certain limitations may affect a taxpayer's ability to file an accounting method change. For instance, under Rev. Proc. 2015-13, a taxpayer may not request an automatic method change for the same item that was the subject of an accounting method change within the past five years. A taxpayer also generally cannot request a method change for the final year of its trade or business. Taxpayers should review the applicable procedures to determine whether they are eligible for automatic consent.
Finally, taxpayers that are under exam have special considerations when determining whether and when to request a method change. Specifically, although taxpayers under exam are not precluded from filing an otherwise permissible Form 3115, those taxpayers generally will not receive audit protection. However, the IRS provides several exceptions to this rule, including the three-month and 120-day window during which a taxpayer under examination may file a Form 3115 and receive audit protection.
The three-month window generally is the period that begins on the 15th day of the seventh month of the taxpayer's tax year and ends on the 15th day of the 10th month of the taxpayer's tax year. This window applies to a taxpayer that has been under IRS examination for at least 12 consecutive months as of the first day of the window, as long as the issue is not part of the IRS exam. The 120-day window is the period following the date an IRS examination of the taxpayer ends, regardless of whether a subsequent examination has commenced, but this window also does not apply if the issue is part of the IRS exam. Additional exceptions may apply when the taxpayer is changing from a permissible method or from a method that results in a negative (favorable) Sec. 481(a) adjustment. Details on these exceptions, as well as other exceptions, are provided in Rev. Proc. 2015-13.
Common favorable, automatic changes
Although calendar-year taxpayers no longer may request nonautomatic changes in accounting method for their 2017 tax year, taxpayers still may be able to implement a number of favorable, automatic accounting method changes listed in Rev. Proc. 2018-31 (or successor guidance) to obtain the permanent tax benefit associated with the lower tax rate. While not an exhaustive list of automatic method changes, the following are examples of common, favorable automatic changes that may apply depending on a taxpayer's facts and circumstances:
- Depreciation (to claim missed depreciation or amortization) (see Sec. 168; Rev. Proc. 2018-31, §6.01);
- Internally developed computer software (to deduct costs to develop computer software) (see Rev. Proc. 2000-50; Rev. Proc. 2018-31, §9.01; under the TCJA, software development expenditures must be capitalized in tax years beginning on or after Jan. 1, 2021 (Sec. 174(c)(3));
- Prepaid payment liabilities (to deduct certain prepaid expenses such as insurance with terms of 12 months or less) (see Regs. Sec. 1.263(a)-4(f); Rev. Proc. 2018-31, §11.05);
- Deferred costs (to deduct costs to provide services or of certain goods that are deferred for financial reporting purposes) (see Regs. Sec. 1.263(a)-4; Rev. Proc. 2018-31, §11.05);
- Uniform capitalization methodologies (to correct methodologies that result in overcapitalization) (see Sec. 263A; Rev. Proc. 2018-31, §12);
- Advance payments(to defer advance payments for up to one year, in accordance with book deferral) (see Rev. Proc. 2004-34; Rev. Proc. 2018-31, §16.07 (Sec. 451(c), as amended by the TCJA, provides modified rules for deferring advance payments for tax years beginning after Dec. 31, 2017));
- Accrued compensation (to deduct amounts that are fixed and determinable at year end and are paid within 2½ months after year end) (see Regs. Sec. 1.461-4; Sec. 404; Rev. Proc. 2018-31, §§14.01 and 20.01);
- Self-insured medical liabilities (to deduct certain incurred but not reported liabilities in the year the medical services are provided) (see Sec. 461 and related Treasury regulations; General Dynamics Corp., 481 U.S. 239 (1987); Rev. Proc. 2018-31, §20.01);
- Inventory valuation methods (to value subnormal goods below cost, accrue inventory shrinkage, or apply a lower-of-cost-or-market valuation method) (see Sec. 471 and related Treasury regulations; Rev. Proc. 2018-31, §§22.02, 22.05, and 22.11);
- Rebates (to deduct amounts that are fixed and determinable at year end and are paid within 8½ months after year end) (see Sec. 461 and the related Treasury regulations; Rev. Proc. 2018-31, §20.07).
Correcting impermissible methods
Although this discussion focuses on favorable accounting method changes, taxpayers may discover exposure items in the form of improper methods of accounting that will result in a positive (unfavorable) Sec. 481(a) adjustment when corrected. In this case, taxpayers should consider requesting a method change to adopt a proper, taxpayer-unfavorable method in their 2018 tax year. This approach not only could result in recognizing any unfavorable catch-up Sec. 481(a) adjustments in the lower-rate tax year, but also could provide the taxpayer with audit protection for the improper prior-year treatment.
Examples of impermissible methods include improper revenue recognition methodologies, such as an erroneous method of deferring revenue attributable to advance payments beyond the limited one-year or two-year deferral allowed under pre-TCJA law (see Rev. Proc. 2004-34 and Regs. Sec. 1.451-5, respectively), or erroneous methods of deferring unbilled receivables past the point at which the receivables have been "earned" for income tax purposes (see Sec. 451 and related guidance). These improper methods may be discovered during a taxpayer's transition to the new revenue recognition standards under FASB Accounting Standard Codification Topic 606, Revenue From Contracts With Customers, for financial statement purposes.
Time to take advantage of changes going forward
The rate change under the TCJA presents an opportunity for taxpayers to seek permanent tax benefits through accounting method changes that defer income or accelerate deductions. Although calendar-year taxpayers can no longer request nonautomatic method changes for 2017, several automatic, favorable method changes may apply and still can be implemented. Careful analysis of each taxpayer's specific facts and the applicable rules is required to determine if the taxpayer is eligible for the automatic accounting method changes noted in this discussion. Also, because taxpayers generally receive audit protection upon the filing of Form 3115, taxpayers may have an opportunity to correct improper methods in 2018 to protect prior-year treatment and recognize any related, unfavorable Sec. 481(a) adjustments in a lower-tax-rate year.
Annette B. 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 email@example.com.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.