As the expression goes, change is inevitable. This year, change in accounting method may also be inevitable.
We’ve previously discussed the far-reaching IRS regulations on the deductibility of repairs, maintenance and supplies costs. Those rules provide complex guidelines for determining whether a cost can be expensed in the current year. The regulations also provide avenues for adjusting to this new regime, which can result in one-time tax benefits if your circumstances are right. Even if you won’t see any immediate tax benefit, you will protect your ability to take more advantageous tax positions if you formally adopt the new rules in your 2014 income tax filing. For some, failing to formally adopt these changes could put deductions on 2014 and future tax returns at risk.
In prior discussions, we emphasized the impact on real property owners, who will certainly be affected most heavily by the requirements and opportunities of these rules. Now that we are mere months away from filing calendar year 2014 income tax returns, we felt the time was ripe for reminding all businesses that they probably fall within the scope of the rule changes, and as a result, their 2014 income tax filings should include something unusual: a change in accounting method.
What is a change in accounting method, and why do I need one?
Part of our tax regime includes concepts around the timing for income recognition and expense deductibility. Our tax system (as well as other accounting standards, such as Generally Accepted Accounting Principles, otherwise known as GAAP) calls rules about these things “accounting methods.” For instance, if you are a cash basis taxpayer, you report income when you receive payment. An accrual basis taxpayer would report income when it is earned. Cash and accrual are two examples of an accounting “method.”
In addition to these kinds of overall methods of accounting, our tax system considers smaller decisions about when to report income or expenses as “accounting methods.” Even the life over which you depreciate types of capital asset is an accounting method. Once you are deemed to have adopted an accounting method for tax reporting (often, just by using it consistently on multiple tax returns), you are not allowed to change it informally. Instead, you must make some additional computations and file a special-purpose form (Form 3115) along with your return, as well as picking up the cumulative income tax consequences of the change in method.
Prior to these regulations, when to expense an item was often unclear. The new rules remove quite a bit of the uncertainty, specifying the methods that can be used, and providing a process for taxpayers to clearly adopt specific methods. This process calls for all businesses to adopt the new methods in 2014 – and therefore businesses will need to file Forms 3115 this year.
What changes in method might I be making?
There are up to 25 different accounting methods or elections that might need to be made. The most common general areas are likely to be:
- 1) Formally adopting a method of accounting for treating materials and supplies on hand. Since most businesses have some sort of materials and supplies, we expect this to be a very common method change this year. One of the changes in this area would allow every taxpayer to establish a capitalization threshold, which until now had not been authorized under tax law.
- 2) Adopting the new “unit of property” capitalization regime. Method changes in this area will be particularly important for real property owners, but will likely also apply to manufacturers, or any business that is a tenant in leased real property. This regime also provides for determining deductible repair costs, as well as introducing a new safe-harbor for repairs and maintenance in certain situations.
- 3) Related to the previous method change, any taxpayer adopting the “unit of property” regime may be eligible to take partial dispositions of previously capitalized assets. This could result in accelerating deductions into 2014, which is a welcome raft of good news in this sea of administrative complexity.
What if I don’t want to file a method change this year?
We understand. This all sounds quite daunting and hard to get one’s arms around. But we think it’s important to take these steps now! Here are some of the possible consequences we think filing method changes will allow or avoid:
- The ability to adopt a capitalization threshold (see #1 above).
- The new repairs & maintenance de minimis safe harbor mentioned in #2, above simply isn’t available unless adopted. This is a taxpayer-friendly bright-line ability to expense potentially large expenditures as a repair – but not available unless a method change is filed.
- The IRS may see a failure to adopt any method changes under the new regulations as a red flag, and they may choose to select businesses for audit if they are not pro-actively making them.
- If audited in a future year without having formally adopted the new methods, the burden of proof to demonstrate that acceptable methods are being used will fall heavily on the taxpayer, not on the IRS. Disallowance of methods could result in a loss of deduction – not just a loss in one year, recaptured in a later year, but a complete loss of the deduction forever.
- If a method is not adopted with the 2014 tax filing, a future attempt to adopt the method would fall under more complex method change procedures, which involve seeking IRS approval – and paying a hefty processing fee to the IRS for the privilege of doing so.
We are committed to distilling the analysis necessary for our clients to as few steps as we can, and to generating the various method changes as efficiently as we can. Given that, we strongly urge our clients to let us guide you in determining which method changes to file, as we think that filing is the prudent choice.
Questions about your accounting methods? Now is a great time to consult with your tax professional to plan for 2014 filings.
This blog post is a summary and is not intended as tax or legal advice. You should consult with your tax advisor to obtain specific advice with respect to your fact pattern.