Chapter 29: Changing accounting methods.
A taxpayer may generally choose any permitted accounting method (see Chapter 10) when filing the taxpayer's first tax return. Any method of accounting selected must clearly reflect the taxpayer's income and expenses, but no specific IRS approval is needed when making the initial choice. After the initial choice, a taxpayer must use the selected method consistently from year to year.
In general, a taxpayer may change accounting methods only with the permission of the IRS. A change in accounting method includes not only a change in the taxpayer's overall accounting method, but also a change in the treatment of any material item.
WHEN IS IT INDICATED?
When an existing method of accounting does not provide the most favorable tax treatment, a taxpayer should consider whether a change in accounting method is desirable. A taxpayer may potentially change to any acceptable accounting method, provided the taxpayer obtains approval for the change from the IRS. See Chapter 10 for a discussion of permitted accounting methods.
WHAT ARE THE REQUIREMENTS?
1. In general, a taxpayer may change accounting methods only with the permission of the IRS. Permission is required whether a taxpayer is changing the taxpayer 's overall accounting method or merely changing the accounting treatment of a single item.
2. To request an accounting change, a taxpayer must file IRS Form 3115 during the tax year for which the change is requested, and must generally pay a user fee. (1) The application requires the taxpayer to account for all items that will be duplicated or omitted as a result of the proposed accounting change, and to calculate the adjustments necessary to prevent the duplications or omissions. (2)
3. The IRS has set up procedures and requirements for a number of specific changes that will be automatically granted by the IRS. These changes still require Form 3115, but require no user fee. Revenue Procedure 2008-52 (3) sets out the procedures for obtaining automatic consent, and lists, in the appendix, the areas in which a taxpayer can obtain automatic consent. The list is quite extensive and includes accounting method changes ranging from the commonplace to the obscure. The following are just a few examples of changes that will be granted with automatic consent:
a. Changing the overall accounting method from cash or hybrid to accrual;
b. Certain small taxpayers changing to the overall cash method;
c. Changing from the reserve method to the specific charge-off method of accounting for bad debts;
d. A restaurant or tavern changing its method of accounting for the cost of restaurant small-wares;
e. Changing the treatment of timber fertilization costs from capital expenditures to ordinary and necessary business expenses; or
f. Changing accounting methods to obtain the Liberty Zone bonus depreciation deduction.
4. Taxpayers who have received approval from the IRS for an accounting change, or who have been ordered by the IRS to make an accounting change, must make adjustments to income to account for the net effect of the accounting change. Where the net effect of an accounting change is small, the adjustments must be accounted for in the year of the change. Where the net effect of an accounting change is greater than $3,000, either positive or negative, however, a taxpayer is entitled to use either of two alternative methods: the three-year method or the reconstruction of income method. (4)
Under the three-year method, the net amount of the adjustment is divided by three. This amount is then added to the taxable income for the current year and for each of the two prior years. (5) Where an accounting change is made voluntarily, the period can be extended to four years. (6)
Under the reconstruction of income method, the income for prior years is recomputed using the new method of accounting for all prior years during which the taxpayer used the former accounting method. (7) The adjustment for the current tax year is then limited to the combined net increase for the prior years. For a business that has been operating for a while, reconstructing income for prior years can be cumbersome. For that reason, this method is not often used.
HOW IS IT DONE--AN EXAMPLE
Joseph runs a small computer business as a limited liability company taxed as a sole proprietorship and uses the cash method of accounting. Joseph decides that after ten years in business, his company has grown to a size that he should switch to the accrual method of accounting.
Joseph's business currently has $50,000 in accounts receivable that were not reported in income last year, because he was operating on the cash basis. Likewise, the business has $15,000 in accounts payable that were incurred in the prior year, but were not deductible because they were not paid.
Joseph files Form 3115 requesting a change for which the IRS has granted automatic approval in Revenue Procedure 2008-52. Joseph calculates the adjustments required to include the $50,000 accounts receivable in income and to obtain the $15,000 deduction for the accounts payable. The net adjustment is positive, $35,000, so Joseph elects to take the $35,000 into income evenly over four years, $8,750 per year.
WHERE CAN I FIND OUT MORE ABOUT IT?
1. IRS Publication 334, Tax Guide for Small Business (Revised Annually).
2. IRS Publication 538, Accounting Periods and Methods (Rev. March 2008).
QUESTIONS AND ANSWERS
Question--Can changing the method of accounting for inventory benefit a taxpayer?
Answer--For taxpayers who maintain inventories for their businesses, the method of accounting for the costs of inventory can have a major impact on taxable income. Inventory methods of accounting are used to match up costs between the purchase or manufacture of inventory and the subsequent sale of that inventory. The First-In-First-Out (FIFO) inventory method matches up the oldest item in inventory with the current sale. The Last-In-First-Out (LIFO) inventory method matches up the newest item in inventory with the current sale.
In most industries, where inventory costs are inflationary, the LIFO inventory method helps taxpayers reduce income by matching up the latest --and more expensive--items in inventory with current sales, leaving older and less expensive items remaining in inventory. These taxpayers, if currently using the FIFO or another inventory method might benefit from a switch to LIFO. In certain industries, such as the computer industry, where costs are constantly declining, LIFO would reduce the cost of goods sold and increased taxable income.
Because inventories are so important, there are special requirements for taxpayers changing to the LIFO accounting method. (8) Advance approval is generally not required to change to the LIFO method, but Form 970 should be filed along with the taxpayer's tax return for the year of the change. Form 970 includes an analysis of the beginning and ending inventories.
(1.) Treas. Reg. [section] 1.446-1(e)(3).
(2.) IRC Sec. 481; Treas. Reg. [section]1.446-1(e)(3).
(3.) 2008-36 IRB 587.
(4.) IRC Sec. 481.
(5.) IRC Sec. 481(b)(1).
(6.) IRC Sec. 481(c); Rev. Proc. 97-27, 1997-1 CB 680.
(7.) IRC Sec. 481(b)(2).
(8.) IRC Sec. 472.