Accounting On Us
How to lower your current tax bill
Accounting method changes that can help you defer tax
Phillip R. McCollum, Jr., CPA, JD
You have a business and your annual tax burden seems to be increasing each year. You’re happy with the success of the company and understand taxes need to be paid. However, are there ways to reduce your company’s annual tax burden without major operational or structural changes? Yes – thanks to several accounting method changes that can reduce your current year tax bill and defer the recognition of income until future years when you may be in a lower tax bracket.
New tax law: $25 million gross receipts threshold and accounting methods
Under the previous tax law, C Corporations that had more than $5 million average annual gross receipts had to be on an accrual basis of accounting, which records revenue when earned and expenses when incurred. The IRS likes the accrual method for tax returns because it matches revenue with current expenses. Now, if your C Corp’s average annual gross receipts are $25 million or less, you can use the cash method of accounting, which is simpler. This change can help you because it’s easing the administrative burden of smaller companies to maintain an accrual method of accounting.
Companies that had more than $10 million average annual gross receipts and who maintained items for production or resale, under the old law had to either maintain inventory on their books or had to capitalize indirect costs to inventory on their books. Thanks to tax reform, if your company’s average annual gross receipts are less than $25 million and you have been maintaining inventory or capitalizing indirect costs because you exceeded the $10 million threshold under the old law, you can now change your method of accounting to account for inventory as a supplies expense and remove the requirement to capitalize indirect costs.
Why is this a good change? Well, your company can deduct the supplies expense and the indirect costs (i.e., freight, storage) in the current year rather than maintaining inventory (and the indirect costs) on your balance sheet as an asset, which is not deductible until it is sold. And, if you have slow-moving inventory, that asset may be on your balance sheet a very long time without it being deductible.
To make either of these two accounting method changes, you will need to file Form 3115, Application for Change in Accounting Method. When you’re deciding if a change is best for you, be sure to also consider the potential long-term impact on your company.
Cost segregation study
Let’s assume that you own a building and the building cost has been depreciated over 39 years. What this means is that you will be able to depreciate 1/39th of the cost each year and take that as a deduction on your tax return. That is a long time to recover your initial investment, but it doesn’t have to be. A cost segregation study involves having an analysis done on the original cost of your building and breaking those costs down into five, seven, 15- and 39-year depreciable lives. You’re then allowed a catch-up deduction in the current year for the depreciation you could have taken based on the shorter depreciable lives from the day you purchased the building.
Here’s an example of the significant tax savings. A cost segregation study on two commercial buildings owned for approximately five years and purchased at $4 million allowed a client to take a catch-up deduction of over $600,000 and saved him over $200,000 in current year taxes.
Keep in mind – your tax basis is lower after a cost segregation study, so when you sell the building in the future, your gain will be larger.
Prepaid expenses are certain qualifying expenses that can be deducted by accrual basis taxpayers in the current year rather than expensed as the asset is used over some time. If the term of the prepayment expires within the next calendar year, a deduction can be taken in the current year to the extent of the prepayment. Expenses that qualify for this accounting method change include prepaid insurance and commissions. One of our clients used this accounting method change for prepaid insurance of $1.4 million and was able to take a $1.4 million deduction for that tax year.
The general rule for revenue recognition is that when you receive cash, you have to record the revenue. With many businesses, cash is received upfront, rather than after the work has been completed. For an accrual basis taxpayer, cash received may be considered deferred revenue because the work to earn the revenue has not yet been performed. So, for tax purposes, you can use this accounting method that allows the recognition of the cash as income to be deferred until the work is done. This deferral can be made for cash you receive for work to be done within the next tax year.
Talk to your CPA
Deferring the payment of tax can be a smart strategy but be sure to contact your Henry+Horne tax advisor if you’re considering making any major changes.
Phillip R. McCollum, Jr., CPA, JD, Partner, specializes in tax planning, consulting and compliance work for privately held businesses and their owners. He can be reached at (480) 839-4900 or PhilMc@hhcpa.com.