As businesses wrap up their 2020 tax returns and compliance, it’s never too early to begin tax planning for 2021. Taxpayers can be incentivized in several ways to evaluate and change accounting methods. With most changes, taxpayers receive audit protection such that the IRS could not challenge prior years on an impermissible method and could not impose interest and penalties for treating an item incorrectly.
Taxpayers can also benefit from current-year adjustments that would reduce taxable income, and accounting methods provide an opportunity for tax planning around optimal methods for revenue and expense recognition.
A notable item to consider for 2021 tax planning—the likelihood of tax rates increasing. Since accounting methods are simply the timing of when to recognize revenue or an expense into taxable income, they are considered a timing, or temporary, item. There are numerous accounting methods and planning items that can shift the recognition of revenue or an expense into an alternate taxable year. Although, if the recognition only moves from one year to the next, many taxpayers may not want the administrative burden of maintaining separate workpapers for book and tax for a specific item when the timing does not result in a significant benefit.
However, when tax rates change, there is an opportunity for quasi-permanent tax savings to recognize an expense in a higher tax rate year or to recognize revenue in a lower tax rate year. Check out the examples below, which demonstrate how a $1,000 deduction for a prepaid expense is not equal when tax rates change:
As noted in the examples above, a $1,000 deduction to accelerate a deductible expense in Year 1 does not necessarily provide a tax advantage by recognizing the deduction in the first taxable year—an accelerated deduction that book would not recognize until Year 2. In the first example, where tax rates remain the same, a taxpayer may wish to accelerate the deduction to recognize in an earlier taxable year.
However, when tax rates change, a taxpayer may wish to defer an expense to a later taxable year to recognize a cash tax benefit. In Example 2 above, the taxpayer’s tax benefit is an additional $70 in tax savings—by simply recognizing the expense in a different taxable year. That $70 difference is a permanent tax benefit that the taxpayer would not have otherwise recognized.
Common Accounting Methods to Analyze
Taxpayers should consider reviewing all accounting methods as part of tax planning for the 2021 tax year. The following is a list of common methods and notable items to consider for 2021:
- Prepaid Expenses—Under the 12-month rule, taxpayers may be permitted to accelerate the deduction of certain prepaid expenses, such as insurance, business licenses, and business (not social or lobbying) dues. Certain prepaid expenses are not eligible for acceleration, including software, materials and supplies, professional services, insurance, and rent.
- Revenue Recognition—Taxpayers need to review and confirm permissible revenue recognition methods for timing of recognition and permissibility of deferral for advanced payments under new rules codified in tax code Section 451 as part of the Tax Cuts and Jobs Act (TCJA).
- Research and Experimentation Expenses—This is a notable change for tax years that begin after Dec. 31, 2021, that will affect many taxpayers who incur R&E expenses. Section 174 no longer permits a direct expense, or immediate tax deduction, for R&E expenditures.
- Taxpayers will now be required to capitalize and amortize R&E expenditures over a five-year period (15-year period for foreign research) beginning with the midpoint of the taxable year in which such expenditures are incurred.
- Taxpayers should be proactive in reviewing tax treatment of R&E expenditures to understand current accounting methods and how they may be required to alter tax treatment of R&E expenditures from the current method because of the tax code changes effective for the next tax year.
- An accounting method change may be required for most taxpayers who have historically expensed R&E costs as incurred to change their method of accounting for the treatment of Section 174 expenses.
- State Tax Accruals—Taxpayers have two options for the timing of the deduction for real property, personal property, and state income or franchise taxes. They may deduct in the taxable year when paid, or they may deduct as accrued on taxpayer’s financial statements.
- Fixed Assets / Capitalization—Taxpayers have a number of items they can review for depreciation and amortization, including:
- performing a cost segregation on new construction or acquired property;
- reviewing fixed asset ledgers for proper tax lives;
- reviewing qualified improvement property for 15-year depreciation, which has now been fixed;
- evaluating required or optional alternative depreciation system treatment;
- ensuring proper tax amortization on goodwill or other acquired intangibles; and
- other fixed assets and intangibles items.
- Inventory / Section 263A Uniform Capitalization (UNICAP)—Ensure proper tax compliance and methods for identification and valuation of inventory.
- Evaluate requirement and permissible methods for UNICAP, notably the simplified methods—simplified production method, simplified resale method, and the modified simplified production method.
- Accrued Bonus / Accrued Vacation—Payroll liabilities that may be deducted under the 2.5 month rule for economic performance; however, often the other two tests for permissibility of the deduction are overlooked—that the expense is fixed and determinable.
- Evaluate the vacation carry-over policy. The following items should all be evaluated to determine if taxpayers may accelerate the accrued bonus:
- Does it all get paid out within 2.5 months of year end?
- Is the full accrued bonus amount guaranteed to be paid out?
- Does it require board approval, and is that board approval made before or after year end?
- Does management have discretion to change bonus amounts after year end?
- Must an employee still be employed on the date of payment to receive their allocated bonus; and, if so, will the amount revert to the company or will it still be paid out and split amongst current employees?
- All of these must be evaluated to determine if taxpayers may accelerate this deduction. In addition, bonus and vacation accruals for the shareholders of S corporations are not eligible for deduction, even if the accruals are fixed, determinable, and paid within 2.5 months of year end.
- Incurred But Not Reported (IBNR)—Self-funded medical expenses for self-insured taxpayers, including for any amounts not covered by insurance such as “deductible” amounts under an insurance policy relating to employee medical expenses. Taxpayers may deduct the cost for the medical services when the service is performed, which may be in a taxable year prior to payment.
- Small Business Taxpayer Accounting Methods—The TCJA expanded the definition of a small business taxpayer; for 2021, these are defined as taxpayers with prior three years average gross receipts of less than $26 million (and not a tax shelter). Taxpayers may qualify to be on the following simplified accounting methods:
Taxpayers who changed to any of these simplified accounting methods after the TCJA expanded eligibility, or who have always been on these simplified methods, should evaluate whether they are still eligible for these methods, and if not, they will need to change to a permissible method.
- Bad Debts—Taxpayers should ensure they are not impermissibly following their book method for deducting bad debts under a reserve method.
- Non-Accrual Experience (NAE)—One exception to the above bad debts method applies to specifically-defined service-based fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, and consulting. Taxpayers in these fields do not have to accrue income attributable to the performance of services that it does not expect to collect under defined NAE methods.
- Deferred Rent / Tenant Improvements—Taxpayers should evaluate whether they are appropriately deducting rent expenses for tax purposes, which may not follow the book method when there is deferred rent. In addition, taxpayers should review rental agreements to determine whether the lessee or the lessor own the tenant improvements, whether the lessee needs to recognize revenue for the receipt of tenant allowances, and determine who recognizes the depreciation deduction on these improvements.
The above list is not an all-encompassing list of accounting methods and only provides a sampling of some of the more common methods taxpayers may or may not be treating permissibly. Now is a great time for taxpayers to evaluate current methods and any potential impact of likely tax rate increases.
This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.
Ryan Vaughan leads Mazars’s Chicago Tax Practice and Global Tax Credits, and Incentives Practice providing expert tax services to companies in a multitude of industries including manufacturing and distribution, energy, technology, real estate, retail, financial services, and healthcare.
Andrew Kosoy is a leader in the Tax Credits & Incentives Practice and has provided federal income tax planning, business advisory, and consulting services for over 13 years, with a specialization in projects and studies related to the research and development tax credit, tax accounting methods, revenue and expense recognition, fixed assets and depreciation, inventory accounting, and the meals and entertainment deduction.
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