Business taxpayers facing potential tax rate increases under the proposed House Ways and Means reconciliation bill may benefit from making accounting method changes to generate permanent cash tax savings by accelerating income to a lower rate tax year. To illustrate, if the top corporate tax rate increases to 26.5% from 21% in 2022 (as currently proposed under the House Ways and Means reconciliation bill), a taxpayer can realize permanent cash tax savings of 5.5% by accelerating income into the lower rate 2021 year or, conversely, by deferring deductions until 2022 to offset higher-taxed income in that year.
Accelerating taxable income may provide additional tax benefits in the form of increased deduction limits under the global intangible low-taxed income (GILTI) regime and the section 163(j) interest expense provisions as well as reduced exposure to the base erosion and anti-abuse tax (BEAT) minimum tax. Similarly, a taxpayer that incurred a significant COVID-19-related net operating loss (NOL) in 2020 may need to increase income in 2021 in order to use expiring tax attributes (e.g., foreign tax credits, pre-2018 NOLs, deductions and losses limited under section 382). However, taxpayers should carefully evaluate alternative scenarios and monitor the status of pending legislation before implementing strategies to increase taxable income because the tax rules governing the various provisions are complex and are subject to change under the proposed reconciliation bill. See the legislative update for details.
The following discussion highlights some widely applicable and easily implemented ideas to increase taxable income by filing an automatic method change (Form 3115), making an election or taking certain action(s) to defer deductions to a later tax year. See also the list of automatic method changes in Rev. Proc. 2019-43 for additional changes that may increase taxable income depending on the taxpayer’s facts.
Automatic changes are made by attaching Form 3115 to the timely filed (including extensions) federal income tax return for the change year and filing a duplicate copy with the IRS national office. No user fee is required.
The accounting method changes discussed below require a section 481(a) “catch-up” adjustment. Taxpayers filing changes for 2021 should be aware that the permanent rate arbitrage savings for these changes will be limited to the amount reportable in 2021 (25%) because a positive adjustment (increase to taxable income) must be spread ratably over four tax years rather than reported entirely in the year of change. The remaining three installments will be recognized in higher tax rate years (2022-24).
Additionally, taxpayers considering making an automatic method change should be conscious of the eligibility rule that prohibits filing an automatic change if a taxpayer has made a change (with or without filing Form 3115) for the same item in the last five tax years, unless a waiver is provided for the specific change. Accordingly, before filing Form 3115 for 2021, the taxpayer should ensure it meets the eligibility requirement or is eligible for a waiver and, further, should be aware that it generally will not be able to file another automatic change for the same item until 2026 under this rule. Thus, for example, this rule may prevent a small business taxpayer that made a change in 2018, 2019 or 2020 to use one or more of the “simplified methods” pursuant to the Tax Cuts and Jobs Act of 2017 (TCJA) amendments (e.g., change to cash overall method or exemption from uniform capitalization (UNICAP)) from filing an automatic 3115 in 2021 to change these methods. Similarly, a taxpayer that changes to the full inclusion method in 2021 to recognize income from advance payments entirely in the year of receipt will be precluded from automatically changing back to the deferral method for five tax years (until 2026).
Revenue recognition and advance payments: Optional methods to accelerate income under the final revenue recognition regulations include: (1) recognizing income to which the taxpayer does not have an enforceable right under the “alternative AFS revenue method,” (2) foregoing cost offsets to income and advance payments from sales of goods, (3) treating advance payments (e.g., goods, services, subscriptions, gift card sales) as income in the year of receipt. Additionally, a taxpayer that needs to avail themselves of the five-year eligibility rule waiver to file an automatic change to comply with the final regulations must act quickly given the unusually short waiver period provided under the recently issued administrative procedures. Otherwise, they will be required to file under the more costly and onerous advance consent procedures or, alternatively, must wait for the eligibility period to expire before filing an automatic change.
Inventory: Common method changes to defer inventory deductions include: (1) terminating the last-in, first-out (LIFO) election for one or more LIFO pools; (2) changing to the cost method of valuing inventory to defer lower of cost or market (LCM) or subnormal good inventory write-downs and; (3) changing to UNICAP methods that increase capitalized mixed service costs such as the simplified service cost method based on production costs and discontinuing use of the 90/10 rule for classifying mixed service costs. Additionally, a taxpayer using noncompliant methods that improperly accelerate inventory deductions (e.g., deducting book inventory reserves or not capitalizing costs in accordance with the final UNICAP regulations) should voluntarily file Form 3115 as soon as possible to obtain audit protection benefits as well as permanent tax rate savings.
Depreciation: Taxpayers should review the tax depreciation work papers to identify assets that have been over-depreciated under erroneous methods such as using the wrong asset class, depreciation method, recovery period, convention or claiming bonus depreciation for ineligible property (e.g., qualified improvement property not “made by the taxpayer”).
Overall accounting method: Cash method taxpayers that bill customers in arrears (significant accounts receivable) may accelerate income recognition by changing to the accrual method of accounting. Conversely, accrual method taxpayers that qualify as a “small business” (meet the gross receipts test under section 448(c) and are not a tax shelter) and routinely incur significant accounts payable and deductible accrued expenses may want to consider changing to the cash method to defer deduction of these expenses until the year of payment.
Lease income and expenses: Taxpayers should review leasing arrangements if they have not already done so in connection with ASC 842 implementations to identify accounting method changes that may increase taxable income. Typical examples include: (1) a lessor that improperly defers advance rentals; (2) a lessee that impermissibly follows the book straight-line method for recognizing rent expense for a section 467 lease; (3) misclassified sales, lease or financing transactions (e.g., followed book lease classification or misinterpreted the agreement provisions); (4) improper depreciation of property acquired with a tenant construction allowance (e.g., followed book treatment); and (5) undercapitalized lease acquisition costs (e.g., erroneously deducted legal costs and broker fees).
Accrued tax expenses: Taxpayers may defer deductions for accrued real and personal property taxes and state income and franchise taxes by changing from the recurring item exception method to deducting the amounts in the year paid.
The following are common accounting method elections to defer deductions. Unlike the accounting method changes discussed above, elections may often be made on an annual basis, require no Form 3115 filing or section 481(a) adjustment, and are not subject to the five-year eligibility rule. Thus, elections can provide much-needed tax planning flexibility in these uncertain times. Note, however, that elections are generally irrevocable.
Prepaid expenses and internal transaction costs: Taxpayers may elect to capitalize rather than deduct prepaid expenses covered under the 12-month rule and certain employee compensation and overhead costs incurred in connection with the acquisition or creation of intangible assets (e.g., by the loan origination department of a bank).
Depreciation: Taxpayers with significant fixed asset additions may delay the recovery of these costs by electing out of bonus depreciation for qualified property (currently 100%) or by electing the alternative depreciation system (ADS), which requires using the straight-line method over longer recovery periods. Both elections are made annually on a class-by-class basis for newly acquired property.
Tangible property: Taxpayers looking to increase taxable income may elect to capitalize all otherwise deductible repairs that are capitalized for books or may elect to recognize gain on partial dispositions of assets on an asset-by-asset basis.
R&D expenses: Rather than currently deducting research and development (R&D) costs, taxpayers may capitalize and amortize them over 10 years by making a section 59(e) election or, alternatively, may elect to capitalize and amortize them over a period of not less than 60 months under section 174(b). The latter election is made for current-year costs for new projects on a project-by-project basis. Note that, pursuant to amendments made by the TCJA, R&D costs (including software development costs) incurred for years beginning after 2021 must be capitalized and amortized over either five years (research performed in the U.S.) or 15 years (research conducted outside the U.S.). The reconciliation bill proposes to defer this provision for four years until 2026. See our legislative update for details.
The following actions may defer significant deductions and may often be implemented easily without time-consuming and potentially costly negotiations, third-party approvals and agreement revisions.
Bonus liabilities: Taxpayers may defer deducting accrued discretionary bonus liabilities by delaying the date the board of directors approves the bonus (i.e., the date the liability becomes “fixed”) until after year-end or, alternatively, by paying the bonuses more than 2.5 months after year-end.
Payment liabilities: The payment date for accrued payment liabilities (e.g., insurance, refunds, warranties) may be delayed so the deduction falls in a later year.
Pension contributions: Taxpayers that maintain a defined contribution plan may defer a 2021 tax deduction to 2022 for discretionary profit-sharing plan contributions by delaying payment until after the due date (including extensions) for filing the 2021 federal income tax return. The delayed payment will result in the contribution being made on account of the 2022 plan year rather than the 2021 plan year.
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The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.