Last week I was visiting with a friend of mine who runs a family-owned business in Colorado. I have historically removed myself from any financial or tax discussions with him as they have used the same local advisor for many years. However, as we were visiting the new local brewery the topic of taxation came up, and since that is what I do for my day job I thought I could provide him some useful information. It was time for a chat about tax method changes.
We talked about general tax topics like capital gain rates, individual tax rates, corporate tax rates, standard vs. itemized deduction and child tax credits, but then we landed on the cash versus accrual method of accounting. He explained to me that his advisor had them on the accrual method of accounting for tax purposes. We talked about their operations, their level of gross receipts, their balance sheet, etc. Through our discussions, it was determined that they were potentially a good candidate to be on the cash method of accounting for tax purposes with very large Accounts Receivable, and very small Accounts Payable. I asked him if he understood why his advisor had him on the accrual basis for tax purposes – he had no idea.
I explained to him that as advisors we look for tax deferral opportunities most of the time. If their business was on the cash method for tax purposes, they could defer the income recognition on their Accounts Receivable until it was collected. On the flip side, the accounts payable would not be deducted until paid – but under this fact pattern, the deferral of the Accounts Receivable could potentially result in a large favorable tax deferral opportunity for them.
I explained that they are not tied to this accounting method for tax purposes. The IRS allows for the filing of Form 3115 to switch to the cash method. This method change is an automatic change and does not require IRS consent. It is also important to consider your accounting methods on your initial year return. This can avoid the need to file a Form 3115 in a later year.
Tax laws are changing all the time. It is always a good idea to sit down with your advisors to understand these changes and how they may impact you. Your current accounting methods as well as potential method changes are often topics overlooked but can provide very favorable tax results under the right circumstances. After our discussion I had an interested friend, and a free drink.
If you have any questions about your processes or wish to look into making adjustments, contact your Henry+Horne advisor.
Ryan D. Gorman, CPA