Editor: Christine M. Turgeon, CPA
Taxpayers typically want to reduce their taxable income to generate cash tax savings. However, in certain circumstances, taxpayers may benefit from increasing taxable income. In appropriate circumstances, accounting method planning can help taxpayers achieve that objective.
Benefits of increasing taxable income
Taxpayers may seek to increase taxable income to offset expiring net operating losses or other expiring attributes (e.g., foreign tax credits) or to mitigate an expected Sec. 382 limitation.
After the passage of the law known as the Tax Cuts and Jobs Act, P.L. 115-97, increasing taxable income may increase a foreign-derived intangible income (FDII) deduction, reduce the base-erosion and anti-abuse tax (BEAT), or increase the Sec. 163(j) business interest deduction limitation. By increasing taxable income, a taxpayer subject to these provisions may be able to reduce its overall tax liability and possibly realize permanent tax benefits — for example, if the taxpayer avoids BEAT liability.
Increasing taxable income can be especially significant when tax rates are expected to rise in a later year. For example, if the corporate tax rate increases from 21% to 25%, a taxpayer that accelerates income into the 21% rate year can achieve a 4% permanent tax benefit. If the taxpayer defers deductions to the later, higher tax rate year, the taxpayer pays tax on the increased taxable income at 21% and takes the deductions at a 25% tax rate. A tax rate increase also may impact global intangible low-taxed income (GILTI) rates and calculations; thus, accelerating income into a lower tax rate year could reduce a taxpayer's overall GILTI liability.
Accounting method planning can accelerate income or defer deductions to help taxpayers achieve these objectives. However, because of the complexity and interaction of tax provisions, taxpayers should carry out modeling to analyze all tax impacts based on their particular facts before pursuing these strategies.
Accounting methods that increase taxable income
A number of opportunities exist for taxpayers to use accounting methods to increase taxable income by accelerating income into the current tax year or deferring deductions to a later tax year. This item points out some of these potential opportunities.
Some accounting method changes to accelerate income or defer deductions may be made under the automatic procedures and filed with the tax return for the year of change. The resulting positive Sec. 481(a) adjustment is spread over four tax years. Taxpayers may change to some methods through an election or by changes in facts and do not have to make a Sec. 481(a) adjustment.
Accelerating income: Accounting method changes to accelerate income include (1) recognizing amounts for which there is no enforceable right to payment under Sec. 451(b); (2) not using the cost-offset method under Sec. 451(b); (3) using the full-inclusion method instead of the deferral method to recognize advance payments under Sec. 451(c); (4) using the percentage-of-completion method and not using the 10% method under Sec. 460; and (5) electing out of the installment method under Sec. 453. (For an in-depth discussion of this issue, see "When Does It Make Sense to Elect Out of the Installment Method?" also in this issue.)
Taxpayers also may be able to accelerate income by structuring transactions or changing the underlying facts of a transaction by the end of the tax year in a way that results in an acceleration of income — for example, by:
- Contractually providing for advance payments that would be recognized under a full-inclusion method;
- Engaging in a sale/leaseback transaction to sell appreciated property at a gain and then leasing it back; or
- Deferring payments to foreign related parties that are subject to Sec. 267.
Deferring deductions: Taxpayers may increase taxable income by changing from methods that accelerate deductions, changing the facts of transactions to defer deductions, electing accounting methods that defer deductions, or increasing costs capitalized to inventory or self-constructed property.
Taxpayers may defer deductions for accrued liabilities into a later tax year by changing from the recurring item exception to economic performance for payment liabilities, such as rebates, allowances, refunds, taxes, insurance, and warranty and service contracts, and deducting these liabilities only when paid.
Deductions may be deferred into the next tax year by changing the terms of compensation plans, such as for bonuses or severance pay, so that the compensation is not fixed at year end or payment is made more than 2½ months after the end of the year.
Taxpayers may be able to electcertain accounting methods that defer deductions, sometimes on an annual basis, thus obtaining the flexibility to meet current-tax-year objectives without the longer-term binding effect of an accounting method change. For example, taxpayers may be able to elect to capitalize, instead of deduct, costs such as prepaid expenses. An election under Sec. 59(e) or Sec. 174(b) allows taxpayers to capitalize research-and-development costs and amortize them over 10 years or 60 months, respectively. Sec. 266 allows an election to capitalize carrying charges such as interest and taxes to carry certain property prior to the time it is used in a business; the carrying charges are capitalized into the basis of the related property. Taxpayers may choose to capitalize certain internal costs relating to tangible or intangible property under Sec. 263(a) that they otherwise may expense.
The depreciation rules provide options for electing out of bonus depreciation to extend depreciation over the life of the asset or electing the alternative depreciation system, which generally results in less depreciation over a longer recovery period.
Taxpayers may increase taxable income by using inventory methods of accounting under Sec. 471 or Sec. 263A that include additional costs in inventory costs or increase costs allocated to ending inventory — for example, by using a first-in, first-out cost flow assumption as opposed to last-in, first-out; valuing inventory at cost; or using the direct-reallocation method (DRM) for mixed service costs. Taxpayers also may apply a Sec. 263A method, such as the DRM, that increases the costs capitalized to self-constructed assets and recovered through depreciation.
Taxpayers may benefit from increasing taxable income in a tax year. Accounting method planning may provide opportunities to achieve this result by accelerating income or deferring deductions through accounting method changes, elections, or changes in facts. Taxpayers may wish to engage in accounting method planning to evaluate the options available under each of these 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.