Tax accounting methods, and the ability to change those methods, are key issues for taxpayers.  Proper tax accounting methods, and continuing IRS changes to their method-change procedures, are at the front and center of all IRS audits. Tax accounting methods and their change procedures certainly have heightened awareness and importance to tax practitioners; and this is the rule yet again for this tax year.

The IRS continues to focus its audit eyes on whether taxpayers are employing the proper tax accounting methods and have adopted the required tax accounting methods where dictated. A 2018 prime example of this is the §451(b)(1)^[1] mandate to match tax accrual to book accrual, if book is an applicable financial statement (AFS). A past, but continuing, required tax accounting method change if not yet done by a taxpayer, is to file a method change to adopt the tangible property regulations (TPRs).

Beyond required method changes, taxpayers, through their tax practitioners, should also adapt voluntary tax methods, the ones that provide the best possible consistent deferrals. Even basic tax accounting methods can be difficult to employ. All taxpayers have to comply with tax method change (TMC) basics, which are the IRS-related rules and procedures. Certain industries have very specialized tax methods that are confusing and prone to mistakes in their employment. Examples include: exempt and non-exempt long-term contract methods, job or process costing, and inventory accounting, not limited to §263A calculations. Even basic method conversions, such as converting books on the accrual method to the cash method annually with proper reversing prior year adjustments, often are not done correctly.

Albeit that TMCs are difficult to employ, and/or to do the basic accounting conversions, taxpayers face several new required and voluntary TMCs proffered by the Tax Cut and Jobs Act (TCJA) of 2017. The “simplification” portion of the TCJA^[2] provides small business taxpayers^[3] (SBT) the choices to:

• Change from accrual to cash as the basic method of accounting;
• Not having to account for §263A responsibilities;
• Move away from current inventory accounting, but only if certain inventory accounting processes are employed; or
• Move away from percentage of completion (PCM) for exempt long-term contracts.

Subsequently the IRS issued Rev. Proc. 2018-40 that provided the detailed rules and procedures to accomplish these changes. The IRS also issued Rev. Proc. 2018-60 for the §451(b)(1) mandate. Whether taxpayers are filing voluntary method change(s), or those who must comply with §451(b)(1), all must complete IRS Form 3115 properly, timely, and in the manners prescribed by the IRS revenue procedures. Understanding method changes takes knowledge of what is allowed and permitted compared to what is not, in addition to those tax methods that provide the greatest potential tax deferrals.

Beyond the mandated TMCs, taxpayers should file TMCs in order to obtain the best potential deferrals. Proper and appropriate methods can defer taxes due by deferring revenues and/or by accelerating deductions. Related to revenue items, potential TMC changes are: accrual to cash, advance payments, prepaid inter-company services, trade discounts, deferral of income (sales, gift card), cash discounts, warranty income, non-accrual experience, changes to the PCM.

Related to deductions, potential TMCs include: prepaid expenses, costs in the PCM formula, materials and supplies, insurance for self-insured, medical portion of workers’ compensation, accrued professional fees and bonuses, depreciation related issues, warranty accruals, payroll taxes on deferred compensation, transaction costs, to §263A issues.

The employment of impermissible/improper TMCs can be expensive, and cost cash, such as taxes, and related interest and penalties, if the taxpayer does not change such TMCs before the IRS comes a calling. Examples of impermissible TMCs include: a large manufacturer not employing §263A; or a producer employing §263A as a reseller; a landlord not employing the TPRs; or a taxpayer not employing the correct depreciation or bonus rules. Opposite to the mandated TMCs, the TCJAs added to the list of those that a taxpayer should change. Those are TMCs, whether under an automatic or nonautomatic filing, that provide a taxpayer with consistent revenue deferrals or expense accelerations. There are many potential TMCs that provide significant benefit to taxpayers if such method changes are filed, but only if the taxpayer is aware of the need for the method change, files the proper method forms, that are properly completed, timely filed, and where the TMC implementation procedures are properly followed.

When a TMC is deemed to be “automatic” by the IRS, it is also considered to be filed voluntary, and the IRS provides a “designated change number” (DCN) in a published revenue procedure. Automatic method changes require no IRS filing fees, and can be filed as late as the potential extended due date of the TMC tax year. The IRS released a new Form 3115 in January 2019, one deemed updated December 2018, that must be used for any TMCs filed. In order for a taxpayer to be able to file an automatic method change, it must be “eligible” to be able to file that method change^[4].

The recent four SBT method changes of the TCJA include the following DCNs: 233 for “Small business taxpayer changing to overall cash method”; 234 for “Small business taxpayer exception from requirement to capitalize costs under §263A”; 235 for “Small business taxpayer exception from requirement to account for inventories under §471” and 236 for “Small business taxpayer exceptions from requirement to account for certain long-term contracts under §460 or to capitalize costs under §263A for certain home construction contracts”. DCN 233, 234, and 235 can be filed concurrently, on the same IRS Form 3115, while 236 cannot. The eligibility rule that would restrict most of these methods from being able to be filed has been waived by the IRS for tax years 2018 to 2020.^[5]

DCN 233, TMC from accrual to cash, is permitted for all taxpayers, whether such taxpayer is a C corporation or required to account for inventories, as long as some other tax section does not prohibit the use of the cash method. For all taxpayer types, except C corporations, the retention of the cash method can be employed even once the taxpayer’s AAGR exceeds the $25MM threshold. It is advantageous for a taxpayer to change from the accrual to the cash method if its tax attributes so indicate, such as where the net of accounts receivables and other current assets exceeds its current liabilities. For example, a taxpayer with accounts receivables of $2.0MM and accounts payable of $1.0MM would obtain a negative §481(a) adjustment, which is a tax deduction, in the year the IRS Form 3115 was properly filed for the taxpayer employing DCN 233. Note that a DCN 233 filing will not apply to a taxpayer who employs an accrual PCM method to account for its long-term contracts. Those contracts will continue to be required to employ the same tax method unless the taxpayer also files DCN 236.

DCN 234, away from the employment of §263A is fairly straight forward. If an SBT currently has to employ §263A for any reason, it can file DCN 234 and take as a tax deduction its previous deferred §263A amounts. Additionally, if a taxpayer should have complied with §263A, but did not, DCN 234 can be filed to obtain audit protection from past noncompliance.

DCN 236 on the ability to not to have to employ the PCM on its long-term contracts is more difficult to understand and employ. A long-term contract is a contract that does not start and finish within the same taxable year. An exempt long-term contract is one that is not required to employ a PCM for its long-term contracts whereas a non-exempt contract is one that is. Prior to the TCJA one of the thresholds that required the employment of the PCM was for taxpayers in excess of AAGR of $10MM. Under the TCJA, that threshold is now $25MM of AAGR. If an SBT currently employs the PCM for any of its exempt long-term contracts and previously employed a different tax method for its exempt long-term contracts, it can unilaterally change back to its previous method employing the IRS cut-off method. Under a cut-off method, only the items arising on or after the beginning of the year of change are taken into account under the new method of accounting. Any items arising before the year of change continue to be taken into account under the taxpayer's former method of accounting. The cut-off method does not duplicate or omit any amounts from income; therefore, a §481(a) adjustment is not necessary or required. On the other hand, if the taxpayer never employed an exempt long-term contract method and now wishes to move away from the PCM, the taxpayer  has to file DCN 236 and pick a new tax method. Potential tax methods that are available for a switch away from the PCM include the cash or accrual method, the exempt-PCM, the PCM, or the competed contract method.

The change away from accounting for inventories, DCN 235, is the difficult one to understand and yet, even more, difficult to employ. Recall that the prior §471(a) general rule stated that a taxpayer had to employ the accrual method and account for inventories. The TCJA provides a new rule for SBTs under §471(c)(1)(B), that a taxpayer can account for its inventory purchases if it either treats inventory as non-incidental materials and supplies (M&S), or conforms its tax accounting that reflected in an AFS or, if no AFS, “the books and records of the taxpayer prepared in accordance with the taxpayer’s accounting procedures.”

The ability not to have to deduct the cost of inventories is obviously attractive to taxpayers who currently have to. The methodology outline by Rev. Proc. 2018-40 and the rules of TMCs related to M&S accounting changes do not, however, necessarily permit a taxpayer to deduct its ending tax year 2017 inventory amounts in its DCN 235 filing. Let’s review the processes of the two choices that the TCJA provides to account for inventory.

The first one is to account for inventory purchases as non-incidental M&S. Under the TPRs, non-incidental M&S purchases have to be deferred until such M&S are used or consumed in the taxpayer’s operations. Such M&S purchases are able to be immediately deducted upon purchase, however, only if the taxpayer properly employs the de minimis safe harbor (DMSH)^[6]. Knowing that inventory items can be deducted upon purchase if the DMSH is properly employed does not provide clarity on all inventory types.

The TCJA is not clear on what is a "unit of property" for application of the inventory as a non-incidental item, and consequently the DMSH rules, and how those are applied. It seems clear that if a taxpayer purchased $10 items, such as a liquor store bottles of wine, no matter what the total amount was, it could deduct those under the DMSH for purchases in 2018 and after. On the other hand, it seems that a wine maker who purchases bulk, such as a truckload of grapes, cannot employ the DMSH to deduct that at the time of the purchase^[7]. I conclude that the DMSH cannot be easily employed for a manufacturer to deduct either its bulk purchases nor its finish goods.

The second option under the TCJA is to match its tax accounting for its inventory to its AFS and if no AFS, to its books and records. Books and records are defined by the §1.989(a)–1(d) as underlying journals, ledgers, and books of original entry. Therefore, a taxpayer who wishes to deduct all or a portion of its inventory costs under the books and records option of the TCJA, it truly must not defer those inventory costs on its underlying accounting. This option is also not an all or none choice. For example, a taxpayer could choose to inventory account for its material and labor costs but not any other costs if both tax and books and records treated all costs in a similar fashion.

While tax method changes are a difficult and complex subject, a taxpayer who understands what optional and permitted methods are available, and those TMCs that must be avoided, can enjoy the additional working capital that these deferrals offer.