Editor: Christine M. Turgeon, CPA
Accounting methods determine the timing of income and deductions and, in appropriate circumstances, may be used to reduce taxable income for a given tax year by accelerating deductions into that year or deferring income into a later tax year.
In times of difficult economic conditions, such as the ongoing COVID-19 pandemic, taxpayers may want to decrease taxable income to reduce cash taxes and improve overall cash flow currently. Reducing taxable income for 2020 also may create or increase a net operating loss (NOL) that, under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, can be carried back five years. Thus, taxpayers may generate NOLs in a 21% tax rate year that can be carried back to a 35% tax rate year, resulting in not just a timing difference but a permanent tax benefit.
Deferring income or accelerating deductions also may reduce the Sec. 951A tax on global intangible low-taxed income (GILTI) by reducing controlled foreign corporation (CFC) tested income, as methods for CFCs generally follow U.S. tax principles.
This item provides examples of accounting method changes or elections that may decrease taxable income and are available to both domestic and foreign entities. Generally, taxpayers may make these changes under the automatic procedures provided in Section 5.01 of Rev. Proc. 2015-13 or by electing treatment on a 2020 timely filed federal income tax return. Taxpayers may want to review their accounting methods and model various outcomes to evaluate whether they could benefit from these and other method planning opportunities, while considering the potential for future tax rate increases.
Accounting method changes to defer income
The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, amended Sec. 451(b) to accelerate the recognition of income for many accrual-method taxpayers by requiring these taxpayers to include an item in gross income when the item is recognized as revenue in the taxpayer's applicable financial statement (AFS). The TCJA also provided a limited deferral for certain advance payments under Sec. 451(c).
Recently published final regulations, generally applicable for tax years beginning on or after Jan. 1, 2021, implemented these provisions (T.D. 9941). However, taxpayers may apply the final regulations for tax years beginning on or after Jan. 1, 2018, and before Jan. 1, 2021, provided that, once applied to such a tax year, the rules are applied in their entirety and in a consistent manner to all subsequent tax years.
Below are some ways that accounting method changes can defer income.
Exceptions to Sec. 451(b) income recognition: The final regulations identify special methods of accounting, for which Sec. 451(b)'s rules accelerating the recognition of income do not apply. These include installment sales under Sec. 453; prepaid subscription income under Sec. 455; qualified returns under Sec. 458; long-term contracts under Sec. 460; rental payments under Sec. 467; the mark-to-market method under Sec. 475; hedging transactions under Regs. Sec. 1.446-4; integrated transactions under Regs. Sec. 1.988-5 or 1.1275-6; and notional principal contracts under Regs. Sec. 1.446-3. Taxpayers may be able to defer income by filing an accounting method change to recognize income under one of these special methods.
The final regulations provide additional exceptions to the general rule of AFS recognition. Under the regulations, a taxpayer is not required to include amounts in gross income for which the taxpayer does not have an enforceable right to payment at year end, such as a performance bonus, although the taxpayer recognizes the amount as revenue in its AFS. Taxpayers currently recognizing this type of income may want to file an accounting method change.
The final regulations do not permit taxpayers that offset AFS revenue for anticipated future liabilities, such as rebates and refunds or for cost of goods sold, to make similar adjustments to gross income for tax purposes. However, the regulations added an optional cost-offset method that allows a taxpayer to reduce the amount the taxpayer otherwise would include in gross income by inventory costs incurred in a tax year before the year the related inventory is transferred. A taxpayer must file an accounting method change to take advantage of the optional cost-offset method.
Advance payments: Sec. 451(c) provides rules for accrual-method taxpayers to elect to defer, for one tax year, recognizing certain advance payments in gross income consistent with treatment in an AFS (i.e., the Regs. Sec. 1.451-8 deferral method). Sec. 451(c) is largely modeled on the deferral method in Rev. Proc. 2004-34, which many accrual-method taxpayers used. The final regulations include new rules permitting taxpayers to treat "specified payments," which are payments received two or more tax years before a specified good must be delivered, as advance payments, and added an advance-payment cost-offset method similar to the Sec. 451(b) cost-offset method.
Taxpayers currently recognizing advance payments upon receipt may be able to reduce taxable income by changing to the Regs. Sec. 1.451-8 deferral method. Taxpayers including advance payments for inventory in income may be able to reduce taxable income by changing to the cost-offset method.
Accounting method changes to accelerate deductions
Accounting methods may provide opportunities for accrual-method taxpayers to decrease taxable income by accelerating deductions. Some of these methods are outlined here.
Recurring item exception: The recurring item exception may accelerate deductions for liabilities for which economic performance is the performance of services or payment. The liability must be fixed and determinable at year end, and economic performance must occur within 8½ months after year end. Liabilities that taxpayers may accrue under the recurring item exception include legal and other professional fees, insurance, warranties, environmental remediation costs, rebates and allowances, and payroll taxes.
Calendar-year taxpayers that deferred payment of the 2020 employer's share of the Social Security portion of Federal Insurance Contributions Act and Railroad Retirement Act taxes under the CARES Act and that pay all or a portion of the deferred 2020 payroll taxes by Sept. 15, 2021, may deduct those taxes in 2020 if the taxpayer uses or files a method change to use the recurring item exception for this item.
Bad debts: Generally, taxpayers may deduct bad debts only when the receivable and related allowance account are removed from the books. However, taxpayers may change their method of accounting to deduct wholly worthless debt and partially worthless debts to the extent there is a specific reserve for the customer's debt.
Compensation liabilities: Taxpayers generally may deduct accrued compensation items (e.g., bonuses, commissions, vacation, or severance pay) in the current tax year to the extent that the liability is fixed and reasonably determinable at year end, the employee has provided the services, and the payment is made within 2½ months after the end of the tax year. Taxpayers should consider action to fix bonus liabilities at year end, such as through a board resolution that establishes a fixed bonus pool for eligible employees.
Prepaid expenses: Prepaid expenses for which economic performance is payment (e.g., insurance, software maintenance, taxes) generally are deductible to the extent they are fixed and determinable at year end and the benefit period is 12 months or less.
Defined benefit pension plans: Pension rules generally allow taxpayers to contribute to qualified defined benefit plans up to 8½ months after the end of the plan year and choose to deduct the contributions in either the current tax year or the prior tax year. The taxpayer must deduct the contributions on the federal income tax return for the chosen tax year.
Inventory: Taxpayers subject to the uniform capitalization rules under Sec. 263A might overcapitalize costs due to the complexity of the rules. Costs often capitalized that may be eligible to be expensed include sales-based royalties, selling expenses, and certain warehousing expenses (e.g., pick-and-pack labor).
Taxpayers may benefit from a change in their inventory identification and valuation methods to reduce ending inventory. For example, a taxpayer may deduct estimated inventory shrinkage, or a taxpayer with an obsolescence reserve for financial accounting purposes that is reversing that account for tax purposes may want to value subnormal goods below cost, generally at an actual offering price or scrap value.
Elections to expense costs: Taxpayers may elect Sec. 168(k) bonus depreciation on an asset class basis on their annual federal income tax return. This election enables taxpayers to either increase deductions in the current year or defer deductions to a later tax year. Under Rev. Proc. 2020-25, taxpayers may make a late election or revoke or withdraw a bonus depreciation election made under Sec. 168(g)(7), (k)(5), (k)(7), or (k)(10) for the 2018, 2019, or 2020 tax year.
Caution: Additional method planning implications
In some cases, decreasing taxable income may not be advantageous, depending on a taxpayer's particular circumstances. Taxpayers should evaluate the corollary impact of accounting methods on, for example, the Sec. 163(j) interest deduction limitation, the Sec. 59A base-erosion and anti-abuse tax, the Sec. 951A GILTI tax, and the Sec. 250 foreign-derived intangible income deduction.
Accounting method planning may provide opportunities to decrease taxable income by deferring income or accelerating deductions to generate immediate cash tax savings, improve cash flow, or provide permanent tax benefits. Taxpayers should review their financial and tax accounting records to determine whether they may be able to benefit from these or other approaches.
Christine M. Turgeon, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in New York City.
For additional information about these items, contact Ms. Turgeon at 973-202-6615 or email@example.com.
Contributors are members of or associated with PricewaterhouseCoopers LLP.