The must-know accounting methods for 2022 (and after)

Editor: Kevin Anderson, CPA, J.D.

This item highlights five topics specifically related to accounting methods to help taxpayers and practitioners comply with law changes, streamline onerous compliance processes, and minimize tax liabilities.

1. Sec. 174 research or experimental expenditures

As amended by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, Sec. 174 now requires taxpayers to capitalize specified research or experimental expenditures paid or incurred for tax years starting after Dec. 31, 2021, and amortize those amounts over either five or 15 years (depending on whether the activities were performed in or outside the United States), applying the midpoint convention.

Sec. 174 costs include costs incidental to the development or improvement of a product (or process) to the point that uncertainty is eliminated, as well as all software development costs. If a taxpayer previously deducted Sec. 174 costs, complying with the legislative change is considered a change in accounting method.

In late December 2022, the IRS released guidance (Rev. Proc. 2023-11) providing simplified procedures — such as filing a statement in lieu of Form 3115, Application for Change in Accounting Method — for taxpayers changing their method of accounting under Sec. 174 for the first tax year in which the amended Sec. 174 rules apply. For more on these simplified procedures, see the immediately preceding item on p. 24, “R&E Expenses: Automatic Accounting Method Change Procedures.”

Identifying research or experimental expenditures: Determining which costs fall within amended Sec. 174 can be challenging. For taxpayers that already perform R&D tax credit studies, using the qualified research expenses identified in the analysis can be a good starting point. However, the Sec. 174 definition of costs is much broader than that in Sec. 41, in that it includes all incidental costs rather than just wages, supplies, amounts paid to third parties to use computers for qualified research, and contract research. Although substantive guidance had not been released as of this writing, a basic framework for capturing applicable costs such as the one below could be applied:

• Step 1: Identify direct Sec. 174 costs, such as wages, supplies, amounts paid to third parties to use computers for qualified research, and contract research.
• Step 2: Identify indirect Sec. 174 costs, such as personnel costs, overhead, and depreciation.
• Step 3: Identify costs, such as legal fees, to obtain patent and regulatory approval.
• Step 4: Allocate book-to-tax adjustments that relate to costs identified in Steps 1 through 3.
• Step 5: Ensure alignment with positions taken on the R&D credit study (if applicable), accounting for cost-sharing or contract research arrangements.
• Step 6: Apply correct amortization periods based on the jurisdiction where the activity is performed.

Importantly, the IRS and Treasury have indicated that they are working on substantive guidance addressing Sec. 174, which may require modifying the steps outlined above. Taxpayers and practitioners should check for any important updates related to Sec. 174.

2. Accounting method changes for controlled foreign corporations

The second must-know accounting method topic highlighted here involves controlled foreign corporations (CFCs). Under the final regulations addressing the global intangible low-taxed income (GILTI) regime, a CFC must use the same accounting methods to compute tested income that it uses to compute earnings and profits (E&P). For E&P purposes, the Sec. 964 regulations require foreign corporations to generally apply the same rules related to tax accounting methods as U.S. taxpayers. Thus, a CFC that is using an improper method of accounting and seeking to change to a proper method must file Form 3115 to do so. Filing Form 3115 generally provides a taxpayer with audit protection, which precludes the IRS from being able to adjust the taxpayer’s given method (and assess interest and penalties if the taxpayer’s historical method was improper and resulted in exposure) for any tax years leading up to the year of change.

However, under Rev. Proc. 2015-13, a CFC does not receive audit protection from filing Form 3115 if the amount of foreign taxes paid with respect to the CFC exceeds 150% of the average amount of foreign taxes paid by its owner in the owner’s three prior tax years. Rev. Proc. 2021-26 further clarifies that the 150% threshold is based on the amount of foreign taxes deemed paid, regardless of the extent to which a foreign tax credit is allowed.

The TCJA transition tax required under Sec. 965 resulted in a significant increase in foreign taxes deemed paid for numerous CFCs, thereby causing them to fail the 150% test for their 2017 tax year. Because the denial of audit protection likely discouraged many taxpayers from filing method changes in recent years, the potential closing of the 2017 statute in 2022 may have provided taxpayers with an excellent opportunity to revisit filing a method change for CFCs to address any exposure related to the use of improper methods.

3. Historic absorption ratio election

The final Sec. 263A uniform capitalization (UNICAP) regulations were effective for tax years beginning on or after Nov. 20, 2018. Taxpayers that adopted a simplified method in 2019, including large producers that were required to switch to the modified simplified production method, may be able to reduce UNICAP-related compliance efforts by making the historic absorption ratio (HAR) election starting in 2022.

Taxpayers that used the simplified production method, the modified simplified production method, or the simplified resale method for three consecutive tax years can elect the HAR in the fourth year. Making the HAR election is not considered a change in accounting method and, therefore, can be implemented by attaching an election statement to the tax return. Under the election, taxpayers compute an average absorption ratio based on the prior three years and apply that ratio to ending inventory to compute their UNICAP adjustments for a qualifying period of five years. After that qualifying period, the taxpayer recomputes the UNICAP ratio, using the underlying method. If the ratio computed is within 0.5% of the HAR, the taxpayer can continue to use its HAR for another qualifying period of five years; however, if the taxpayer fails the retest, it will need to start a new three-year testing period.

While the benefits of the HAR election can range from lowering compliance burdens to locking in lower absorption ratios, taxpayers should note that once they make the election, they are generally required to remain on this method and would need to seek consent from the IRS to revoke the election.

4. Inflation amounts for the small business taxpayer threshold

Under the TCJA, taxpayers that meet the Sec. 448(c) gross-receipts test could be eligible for several measures to provide relief to small business taxpayers, such as:

• The ability to apply the overall cash method;
• The exception from capitalizing costs under Sec. 263A;
• The exception from accounting for inventories under Sec. 471; and
• The exception from the Sec. 163(j) limitation.

To be eligible for the above provisions, taxpayers must meet (or be under) a gross-receipts threshold, which is computed by averaging the gross receipts from the prior three tax years. For example, to determine eligibility for the small business taxpayer exemption in the 2022 tax year, a taxpayer must average its gross receipts from its 2019, 2020, and 2021 tax years. The dollar threshold when the TCJA was first enacted was $25 million, adjusted for inflation annually. Under Rev. Proc. 2021-45, the gross-receipts threshold for small business taxpayers in 2022 is $27 million, and under Rev. Proc. 2022-38, the 2023 threshold is $29 million. Given those increases, taxpayers that may not have qualified for the simplifying provisions a few years ago by a small margin may find themselves eligible in 2022 or 2023. As such, taxpayers should consider the inflation adjustments to determine if they are eligible for any tax-favorable methods as they compute their 2022 tax liabilities and 2023 estimated tax payments.

5. Tangible property regulations

The tangible property regulations will regain popularity with taxpayers as the phaseout of the 100% bonus depreciation begins in 2023. In particular, taxpayers should focus on accurately identifying costs deductible under Sec. 162 to allow for the immediate recovery of those amounts (versus having to capitalize and depreciate amounts over a future period).

For costs to acquire tangible property, taxpayers should revisit the de minimis safe-harbor election under Regs. Sec. 1.263(a)-1(f) and determine whether any refinements can be made to maximize tax deductions. Under the election, taxpayers can set their tax de minimis policy by adjusting their book de minimis policy (which must be done by the beginning of the tax year to take effect). For tax purposes, the de minimis safe-harbor amount is capped at $5,000; however, if a taxpayer’s book de minimis policy exceeds that threshold, purchases over $5,000 may still be deductible outside the safe harbor if the taxpayer can demonstrate that the deduction clearly reflects income. The de minimis amount can be adjusted annually without obtaining IRS consent and without any impact on how taxpayers treated prioryear amounts.

Taxpayers should also refamiliarize themselves with the definition of materials and supplies to accurately capture and deduct all eligible purchases. Once they have identified materials and supplies, taxpayers will need to determine whether to deduct the costs as incidental (deducted in the year purchased) or nonincidental (deducted in the year used). Taxpayers also should assess whether any of their materials and supplies are considered rotable or emergency spare parts, because those subcategories of materials and supplies are eligible for an optional method of accounting that may accelerate the deduction of the amounts (as compared to the general treatment of expensing the amounts in the year in which the taxpayer disposes of the parts).

For repair and maintenance costs, taxpayers should revisit the rules for treating costs incurred as deductible repairs versus capital improvements. They should attempt to maximize the unit of property to which the repair and maintenance costs relate to minimize the chance of the costs incurred rising to the level of bettering, restoring, or adapting the unit of property, at which point those costs incurred would need to be capitalized and recovered through depreciation.

Editor notes

Kevin Anderson, CPA, J.D., is a managing director, National Tax Office, with BDO USA LLP in Washington, D.C.Contributors are members of or associated with BDO USA LLP. For additional information about these items, contact Anderson at 202-644-5413 or kdanderson@bdo.com.