Simply put, accounting methods are how income and expenses are reported for tax purposes. Changing a taxpayer’s accounting method may seem as easy as switching a setting in QuickBooks, but it’s actually a complex process that requires knowledgeable, experienced professionals to help organizations deal with the required IRS formalities.
A couple of examples of common changes in accounting methods are going from the cash to the accrual method or accelerating the timing of depreciation schedules.
With a process like this, some organizations and/or tax professionals may question if it’s even worth the effort to make the switch. Here, we’ll go through some examples of where it might not only be financially beneficial for the company or client, but required.
So, why make a change? Read on to find out.
Depreciation & Cost Segregation
One popular reason companies change accounting methods is for depreciation changes, such as implementing a cost segregation study. Investments in residential buildings are spread out over 27½ years, but investments in commercial real estate are deducted for an even longer period of 39 years.
However, there are certain parts of a building that include personal property (furniture, carpeting, window blinds, network cabling, desk lighting, etc.) and land improvements, (parking lots and landscaping). When carved out, they can be deducted over five, seven or 15 years versus 27½ years or 39.
With this type of accounting method change, there’s a huge time value for money savings. And when the change is made in 2017, before the reduced 2018 tax reform rates go into effect, accelerating deductions also generates permanent tax savings.
For an example of this change, let’s say a taxpayer has a manufacturing facility. They incur costs for process-related electrical, plumbing, fire protection systems and HVAC systems. These are items that tend to get treated as part of the building. However, under the tax rules taxpayers can depreciate them as equipment. Taxpayers can change these items from building property to equipment property as part of an accounting method change and benefit from the accelerated deductions.
Repair and Maintenance Costs
A new body of tax rules came into effect for 2014 called the Tangible Property Regulations (TPRs). These regulations provide much-needed guidance as far as what taxpayers can treat as an immediately deductible repair and maintenance expense versus an asset.
Before they existed, taxpayers were forced to rely on unclear tax rules and conflicting case law.
The best part about it? These rules can be applied retroactively.
For example, prior to the TPRs, taxpayers and tax professionals capitalized the costs of roof work on a building over 39 years. However, the TPRs provide, (in most situations), an immediate deduction when a taxpayer is only replacing the roof membrane or shingles without making significant replacements of the underlying decking, support structure, or insulation.
This means they can subtract these costs from their taxable income and pay less tax on their net income. If they were to continue to treat it as part of the building, they’d need to spread out the deduction over 39 years.
Some other examples of repair and maintenance costs would be if a taxpayer replaces eight of 20 sinks, replaces three of 10 roof-mounted HVAC units, or replaces 30 percent of a building’s electrical system wiring. These are all things taxpayers tended to capitalize and treat as new assets, but can often be treated as repair and maintenance costs.
§179D Energy Efficient Commercial Building Deduction
Another reason companies change their accounting method is to take advantage of energy efficiency incentives.
For the 179D efficiency incentive, taxpayers can take an immediate deduction of up to $1.80 per square foot of building property rather than depreciate these items over a lengthy 27½ or 39 years.
When a taxpayer constructs a new building or renovates an existing building to incorporate energy efficient lighting, energy efficient HVAC systems or adds insulation to the walls or roof – these things could qualify for the energy efficient commercial building deduction.
It’s akin to getting money today instead of spreading it out over time. It’s worth more to companies to have this deduction sooner.
“We had a client who replaced the lighting systems in a 100,000-square foot hotel,” said Alex Bagne, President of ICS Tax. “Since the building already had an energy-efficient HVAC system, we were able to get the full $1.80 per square foot deduction. This gave the company $180,000 additional deductions that year.”
Dispositions of Tangible Assets
Another reason companies change their accounting method is for dispositions of tangible assets. Taxpayers frequently have ghost assets on their fixed-asset schedules. “We often see this with retail and office buildings where they have tenants. The building owner builds out space for a new tenant and then that tenant leaves,” said Bagne, “At that point, the building owner demos the space and does a new build-out for the next new tenant.”
The problem is that these old tenant improvements don’t properly get written off the books. Most companies will depreciate the disposed of improvements over 39 years.
With the disposition of tangible assets, companies have the opportunity to take an abandonment loss on disposed assets.
Again, rather than continue to depreciate the assets over time, the taxpayer can take an immediate write-off.
Compliance is another reason many companies choose to change their accounting method. This is often the case when a company’s gross receipts exceed $5 million.
The cash accounting method is very easy to follow and provides greater control over when income and expenses are recognized. If companies have a bill they want to pay on December 31st of one year, they can choose to pay it and take the deduction that year. Or, if they’d rather hold off until the following year, they can simply pay it on or after January 1st.
For some companies, however, the accrual accounting method may be mandatory. For example, C-corporations with average annual gross receipts for the previous three years of more than $5 million are required to utilize the accrual accounting method.
Whether to maintain compliance with the tax law or to reduce income tax, there many valid reasons for companies to change their accounting methods. To learn more about how to implement these accounting method changes in your organization or your client’s, register and attend Alex Bagne’s webinar on May 9th through the Clear Law Institute. Alex also presents at various state CPA societies and puts on this webinar for free for CPA firms. To book Alex to come speak at your firm, click here to get in touch.