From Uncertainty to Advantage: Harnessing the Power of Accounting Methods

Perhaps the most common answer to any given tax question is, “It depends.” This uncertainty is, in many cases, due to the fact that there are multiple ways to account for an item on a tax return depending on the taxpayer’s accounting method. While this may seem frustrating, there is power in being able to leverage different accounting methods when tax planning.

What Is an Accounting Method?

An accounting method is a broad term that applies to almost every aspect of reporting on a tax return. It can refer to how a specific item is accounted for – such as when to deduct an accrued expense – or it can refer to an overall method of accounting, such as whether to use the cash method or accrual method of accounting.

Accounting methods relate to when an item of income or expense is recorded and does not have a permanent impact on lifetime taxable income. They relate to when, not if, a taxpayer deducts and expenses or recognizes income. For example, accounting methods determine whether a taxpayer deducts an accrued bonus in the year that it is accrued or the year that it is paid. On the other hand, the process for identifying and calculating non-deductible entertainment expenses is not a method of accounting because entertainment expenses are nondeductible in any year regardless of the method of accounting.

The following situations are not accounting methods:

• Errors, such as a deviation from an existing accounting method or a mathematical or computational mistake¹
• A change in the underlying facts
• Characterization of an item. For example:
  • Whether an item is a personal or business expense
  • Whether it should be a capital or an ordinary item
  • Whether a salary payment is a business expense or a dividend

Why Is It Important to Understand Accounting Methods?

Understanding accounting methods and how they can be changed allows taxpayers the opportunity to change an existing, valid accounting method to a more favorable method. It also allows an impermissible or “bad” accounting method to be corrected before the IRS identifies it.

It is important to note that a more favorable method may not always be the method that accelerates expenses or defers income. There may be instances where a taxpayer should employ “reverse tax planning” and accelerate taxable income.

Two hypothetical situations:

1. Service business using the accrual method

• • Service businesses tend to have low amounts of accounts payable and accrued expenses, and often have a large amount of accounts receivable.
  • Under the cash method of accounting, the business would not be able to deduct the accounts payable or accrued expenses, but it would receive the benefit of not having to include the accounts receivable as income, yielding a favorable result.
  • While the accrual method is a permissible method of accounting, the cash method would typically give the taxpayer a better result.

2. Taxpayer with an impermissible accounting method

• • While less fun to talk about, sometimes a taxpayer may discover an improper method of accounting. For example, an accrual basis company accrues a bonus for 2023 that is discretionary and not fixed until 2024. Even though it is not fixed, the taxpayer has been deducting the bonus payment in the year that it is accrued rather than paid.
  • The proper treatment would be to deduct the bonus in the year that it is paid. An impermissible method of accounting has been identified and needs to be changed.

How To Change an Accounting Method

A taxpayer can generally adopt its accounting methods in its initial year or the first year that the taxpayer has that specific item. (It is best to identify the optimal accounting method in the initial year whenever possible to be able to avoid the accounting method change procedures.) After the taxpayer has an established method, it must follow the accounting method change procedures, which can be grouped into two categories:

1. Automatic method changes

• • The IRS has identified various accounting method changes that can be made “automatically” without advance consent from the IRS.
  • To make such a change, a Form 3115 is filed according to the relevant IRS guidance before the due date of the tax return (with extensions). This form provides the IRS with detail on a taxpayer’s present and proposed method.
  • Taxpayers will generally not receive a response from the IRS regarding these forms. Filing constitutes permission so long as all the requirements for that method are met.

2. Non-automatic or advance consent method changes

• • Non-automatic method changes require advance consent from the IRS. A Form 3115 must be filed with the IRS before the last day of the tax year of change. There is also a user fee.
  • The application is reviewed by the IRS, and there is generally correspondence between the taxpayer and the IRS. Whether the IRS grants the change is at the discretion of the IRS and dependent on both the method being requested and the taxpayer’s specific facts and circumstances.
  • If the IRS agrees to the change, a closing agreement with the IRS will be signed.

When an accounting method change is filed, there is typically a Section 481(a) adjustment, and the taxpayer generally receives “audit protection.”

• 481(a) adjustment:

If a taxpayer were to change its method of accounting and only apply the new method prospectively, the taxpayer could potentially omit an item of income or expense. To prevent this, most method changes require a Section 481(a) adjustment, which represents the cumulative difference between the new and the old method of accounting as of the beginning of the tax year. Positive adjustments (an increase to taxable income) are included in taxable income ratably over four tax years (the year of change plus the following three tax years). For taxpayers who have an impermissible method of accounting, this provides an incentive to self-correct the issue and take advantage of the four-year spread. If audited, the IRS could push through 100% of the adjustment in the earliest open tax year, resulting in not only increased income but also penalties and interest.

A favorable adjustment (a decrease to taxable income) is taken 100% in the year of change. In the example of the service business above, the business would take the cumulative difference between the accrual method and the cash method all in the year of change, which could represent a significant tax deduction in the year of change plus the ongoing tax deferral.

• Audit protection

Besides using accounting methods to change taxable income, they can also be used to mitigate risk. As part of the voluntary accounting method change process, the taxpayer generally receives audit protection. ³ This means that, so long as the taxpayer properly files the accounting method change, audit protection prevents the IRS from making adjustments related to that issue in earlier open tax years. Audit protection, coupled with the favorable treatment of Section 481(a) adjustments, provides taxpayers with a significant incentive to self-correct issues.

Putting the Pieces Together

Whether the goal is changing the timing of certain items or self-correcting known issues, accounting methods can be a powerful tool to help with tax planning objectives. Knowing how to use these methods advantageously is a significant asset.

For help reviewing the effectiveness of your accounting methods, contact a KSM advisor or complete this form.

¹An impermissible method of accounting is generally not established until the second year that it is utilized. So if a one-time error or deviation is made from an accounting method, it is generally not an accounting method. If the same error is consistently repeated, however, it could become an accounting method.