Summary of Key Tax Reform Implications on Accounting Methods

January 2018

Summary

Introduced as the Tax Cuts and Jobs Act, the “Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018," P.L. 115-97, was signed into law by the President on December 22, 2017.  Among the many tax disciplines affected by the new law, a number of the tax reform provisions favorably impact accounting methods for federal income tax purposes.  This alert first discusses two tax reform provisions in the Corporate and International tax arena that present unique opportunities for businesses to file accounting method changes to defer income recognition and accelerate deductions in 2017 in order to generate both temporary and permanent tax saving benefits.  Next, the alert provides a summary of the more influential tax reform provisions that affect businesses in a favorable manner, for the most part, such as 100 percent full expensing for assets qualifying for bonus depreciation and the expansion of the use of the overall cash method. 
 

Details

Transition Tax
One of the major international tax developments arising from tax reform is the transition tax generally requiring U.S. shareholders of “specified foreign corporations” (as specifically defined in section 965) to include as subpart F income their pro rata shares of deferred foreign income of such foreign corporations.  Taxpayers are allowed to deduct a portion of the foreign income from the amount of the section 951 inclusion to arrive at a 15.5-percent rate of tax on accumulated post-1986 foreign earnings and profits (“E&P”) held in the form of cash or cash equivalents, and eight percent rate of tax on all other earnings.
 
In general, the E&P of a foreign corporation is computed under the entity’s method(s) of accounting as provided under the section 964 regulations.  Similar to accounting methods utilized for federal income tax purposes, taxpayers that have established a method of accounting for E&P purposes may change their method to maximize tax savings opportunities and/or minimize exposure.  Taxpayers that are considering any opportunities for filing accounting method changes to reduce the E&P of foreign corporations for purposes of the transition tax rules should undertake the following steps:
 
Step 1 - Determine if the E&P of the foreign corporation is significant prior to 2018
 
The taxpayer must first determine if the foreign corporation has adopted/established an accounting method based on whether the foreign corporation’s E&P is significant for U.S. tax purposes with respect to its controlling domestic shareholder.  Under section 1.964-1(c)(6) of the Income Tax Regulations, action by or on behalf of a foreign corporation (other than a foreign corporation subject to tax under section 882) to make an election or to adopt a tax year or method of accounting shall not be required until the due date (including extensions) of the return for a controlling domestic shareholder’s first tax year with or within which ends the foreign corporation’s first tax year in which the computation of its E&P is “significant.”  Note that the filing of the information return required by section 6038 shall not itself constitute a significant event.  Events that cause a foreign corporation’s E&P to have U.S. tax significance include, without limitation:
 
  1. A distribution from the foreign corporation to its shareholders with respect to their stock.
  2. An amount is includible in gross income with respect to such corporation under section 951(a).
  3. An amount is excluded from subpart F income of the foreign corporation or another foreign corporation by reason of section 952(c).
  4. Any event making the foreign corporation subject to tax under section 882.
  5. The use by the foreign corporation's controlling domestic shareholders of the tax book value (or alternative tax book value) method of allocating interest expense under section 864(e)(4).
  6. A sale or exchange of the foreign corporation's stock of the controlling domestic shareholders that results in the recharacterization of gain under section 1248.
 
The determination of “significant event” is applied on a company by company basis (e.g., CFC by CFC).
 
If the foreign corporation has not previously had one of the events listed above, per the Regulations, then the foreign corporation is able to adopt/establish the appropriate tax methods of accounting on the current year return (i.e., no Form 3115, Application for Change in Accounting Method, is required).
 
If the foreign corporation has had one of the events listed in the Regulations, then the foreign corporation would be required to file a Form 3115(s) to request IRS consent to change from the present method of accounting to an optimal method of accounting.
 
Step 2 – Monitor future Treasury and IRS guidance aimed at preventing the impact of E&P reductions through accounting method changes for transition tax purposes
 

Pursuant to newly enacted section 965(o) of the Internal Revenue Code, Congress has instructed the Treasury Department and the IRS to issue regulations or other guidance to prevent the avoidance of the purposes of the transition tax, including, among other things, changes in accounting methods.  Section 965(o) provides:
 
(o) REGULATIONS.—The Secretary shall prescribe such regulations or other guidance as may be necessary or appropriate to carry out the provisions of this section, including —
(1) regulations or other guidance to provide appropriate basis adjustments, and
(2) regulations or other guidance to prevent the avoidance of the purposes of this section, including through a reduction in earnings and profits, through changes in entity classification or accounting methods, or otherwise.
 
At this time, it is unclear what form or approach the guidance might take, or when such guidance might be issued.  For example, whether the Treasury and IRS may take the approach of negating all accounting methods changes that reduce E&P for transition tax purposes, or only a select list of accounting method changes, remains to be seen.  Further, it also remains to be seen whether accounting method changes to remediate improper methods of accounting and/or method changes that would in effect increase E&P would be excepted out of section 965(o).  That said, it is critical to understand that although the IRS may accept the Form 3115 filing, the impact of the E&P reduction for transition tax purposes generated from filing accounting method changes could potentially be disregarded or eliminated by the IRS under section 965(o) in future guidance.  Accordingly, tax professionals should ensure that taxpayers considering filing E&P method changes are fully informed regarding the possibility of the IRS and Treasury disallowing the favorable impact of implementing such method changes.
 
Corporate Tax Rate Reduction
For tax years beginning after December 31, 2017, the top corporate tax rate has been permanently reduced by 40 percent — from 35 percent to a flat tax rate of 21 percent.  In the first several months of 2018, it is important to evaluate the current methods of accounting established by a taxpayer and determine if there are more optimal methods of accounting available under the Code and regulations.  Taxpayers should consider filing a Form 3115, Application for Change in Accounting Method, for a tax years beginning before January 1, 2018, to request IRS consent to accelerate the timing of deducting expenditures and defer the timing of revenue recognition.  The benefits of filing accounting method changes include tax savings resulting from reduction of taxable income via a cumulative catch-up adjustment, including a one-time permanent benefit from tax rate reductions in 2018 generated by taking deductions in 2017 at the current higher tax rate and deferring revenue to future years when tax rates are reduced.
 
Popular accounting method changes that can still be made for the 2017 tax year include, among other things, 1) one-year deferral method for advance payments; 2) accelerating prepaid expenses under the 12-month rule; 3) accelerating software development costs; 4) changing to an optimal recovery period for fixed assets and intangible assets; 5) catching up missed bonus depreciation; 6) accelerating certain accrued expenses; and 7) accelerating accrued sales incentives, rebates, and allowances using the recurring item exception.  Please refer to Rev. Proc. 2017-30 for more accounting method change opportunities.  To effect an automatic consent change for the 2017 tax year, a Form 3115 must be attached to the timely filed (including extensions) federal income tax return for the year of change and a copy must be mailed to the IRS Covington, KY office no later than the filing date of that return. 
 
Highlights of Tax Reform Provisions Impacting Accounting Methods
 
The following table summarizes several key provisions related to accounting methods, as well as the implications and potential actions steps for taxpayers and tax professionals to consider.
 

Tax Law Change

BDO Observations

Bonus Depreciation
 
The new law extends and modifies bonus depreciation through 2026 (through 2027 for longer production period property and certain aircraft) as follows.  The 50-percent bonus depreciation is increased to 100 percent for property placed in service after September 27, 2017, and before January 1, 2023 (January 1, 2024, for longer production period property and certain aircraft).  The 100-percent allowance is phased down by 20 percent per calendar year for property placed in service in taxable years beginning after 2022 (after 2023 for longer production period property and certain aircraft).
 
Bonus depreciation is now permitted on both new and used property acquired by purchase provided the property was not used by the taxpayer before the taxpayer acquired it and it was not used by a related party.
 
The bonus election is not permitted for property used in certain utility services and property used in a trade or business that has floor plan financing indebtedness.  These properties are excluded as they are not subject to the interest expense limitation under section 163(j).
 
Effective date:  The provision generally applies to property acquired and placed in service after September 27, 2017.
 
 
Under the new provision, the phase-down of the 50-percent allowance for property placed in service after December 31, 2017, is repealed.
 
However, the present-law phase-down of bonus depreciation is maintained for property acquired
before September 28, 2017, and placed in service after September 27, 2017.
 
Some taxpayers may prefer to claim 50-percent bonus depreciation for assets otherwise eligible for the 100-percent depreciation.  A transition rule provides that, for a taxpayer’s first taxable year ending after September 27, 2017, the taxpayer may elect to apply a 50-percent allowance instead of the 100-percent allowance. Guidance as to how to make the allowance is pending.
 
Another favorable development is that bonus depreciation may be taken on both new and used qualified property.  This will benefit taxpayers that acquire assets that constitute a trade or business, rather than stock acquisitions.  The purchasing entity can fully expense much of the purchase price in the year of purchase.
 
Section 179 Expensing
 
Section 179 expensing election is increased to $1 million (up from $500,000).  The dollar limitation would be reduced to the extent the total cost of section 179 property exceeds $2.5 million (up from $2 million).  
 
The act expands the expensing election to depreciable tangible personal property used in lodging.  In addition, the act expands the election, at the taxpayer’s election, to include roofs, HVACS, fire protection and alarm systems and security systems, if made to nonresidential real property and placed in service after the date the realty was first placed in service. 
 
Effective date:  For property placed in service in tax years beginning after 2017.
 
The amount of the section 179 election and the limitation has increased allowing additional opportunities to fully expense property.  Further, allowing the taxpayer to elect to include qualified real property provides the taxpayer planning opportunities to reduce or avoid the dollar limitation in certain cases.  
 
Timing of Revenue Recognition
 
Under section 451, accrual basis taxpayers generally include income at the earliest of when the income is due, earned or received. In certain instances (e.g., involving contingent consideration), tax may accrue income at a later point in time than books.
 
Under the new tax reform bill, accrual basis taxpayers must now recognize income no later than the taxable year in which such income is taken into account as revenue in an applicable financial statement. For taxpayers with contracts that contain multiple performance obligations, such as the provision of goods with services, the bill allows taxpayer to allocate the transaction price to the multiple performance obligations in accordance with the allocation made in the taxpayer’s applicable financial statement.
 
Additionally, the tax reform bill specifies that advance payments/deferred revenue shall either be included in gross income in the taxable year received, or deferred in accordance with books in the year received, with the remaining amounts to be included in the subsequent year. If the taxpayer wishes to defer in accordance with books in the first year, this will be treated as an election effective for the first taxable year in which it is made and for all subsequent taxable years, unless the taxpayer changes its method of accounting.
 
Effective date: Taxable years beginning after December 31, 2017
 
 
Taxpayers that are presently deferring income for a period longer than books or using Treas. Reg. section 1.451-5 (or another deferral provision other than Rev. Proc. 2004-34) to defer advance payments for inventoriable goods may need to file a method change to conform to the new rules. These changes are presently not included as automatic method changes under Rev. Proc. 2017-30, although it is possible that the government will add them to the list. Further, it is unclear as to how these new rules will interact with the new revenue recognition standard under ASC 606. We expect the government to address these issues in future guidance.
 
In addition, we expect some guidance/transition rules for taxpayers that are currently using Revenue Procedure 2004-34 and whether or not the taxpayer would need to file a method change to conform to the new rules.
 
 
Expanded Use of the Overall Cash Method of Accounting
 
The gross receipts threshold that exempts certain taxpayers (C corporations, partnerships with C-corporation partners and tax shelters) from the requirement to use accrual method of accounting was increased under the tax reform bill from $5 million under current law to $25 million.
 
Effective date: Taxable years beginning after December 31, 2017
 
 
 
Taxpayers that are presently using accrual but now fall under the $25 million gross receipts threshold should consider filing an accounting method change to change to cash. This is currently a non-automatic change, but presumably the government will update Rev. Proc. 2017-30 (the latest guidance governing automatic changes) to include this fact pattern as an automatic method change.
 
Exemption from Requirement to Keep Inventory & Expansion of Exemption from UNICAP
 
Taxpayers normally subject to sections 471 and 263A (e.g., producers/resellers of tangible property) are now exempt if they can meet the gross receipts test of $25 million under section 448 (consistent with the exemption from using the accrual method of accounting). Accordingly, taxpayers that fall under the gross receipts threshold will not have to compute section 263A, and can treat inventory as non-incidental materials and supplies (i.e., deduct in the year the materials and supplies are used/consumed), or conform to the taxpayer’s method of accounting reflected in an applicable financial statement or books and records.
 
Effective date: Taxable years beginning after December 31, 2017
 
 
 
 
 
Taxpayers that are presently subject to sections 471 and section 263A but now fall under the $25 million gross receipts threshold should consider filing an accounting method change(s) to no longer compute UNICAP and treat inventory as materials and supplies (or conform to book accounting).
 
In addition, we expect some guidance/transition rules on updating the list of automatic method changes (Revenue Procedure 2017-30) to cover taxpayers that are currently required to keep inventory/subject to section 263A but under the new provisions would be exempt.
 
 
 
Expansion of Exemption from Percentage-of-Completion Method
 
The new law expands the exception for small construction contracts from the requirement to use the percentage-of-completion method.  Under the provision, contracts within this exception are those contracts for the construction or improvement of real property if the contract: (1) is expected (at the time such contract is entered into) to be completed within two years of commencement of the contract and (2) is performed by a taxpayer who (for the taxable year in which the contract was entered into) meets the $25 million gross receipts test.
 
Effective date: For contracts entered into after December 31, 2017
 
 
 
Taxpayers must generally use the percentage-of-completion method to determine income under a long-term contract.  Currently, there is an exemption from the percentage-of-completion method if the contract is expected to be completed within two years of commencement and is performed by a taxpayer whose average annual gross receipts do not exceed $10 million. The tax reform bill increases the gross receipts threshold from $10 million to $25 million. 
 
Application of the new $25 million threshold will be applied on a cutoff basis for all similarly classified contracts; as such, taxpayers will not compute a section 481(a) adjustments for contracts entered into before January 1, 2018. Consistent with the expanded rules regarding the cash method of accounting and exemption from sections 263A and section 471, we expect some guidance/transition rules addressing what taxpayers who are currently required to use percentage of completion, but under the new provisions would be exempt, should undertake to apply the new rule.
Modification of treatment of S corporation conversions to C corporations
 
Under the provision, any section 481(a) adjustment of an eligible terminated S corporation attributable to the revocation of its S corporation election (i.e., a change from the cash method to an accrual method) is taken into account ratably during the six-taxable-year period beginning with the year of change.
 
An eligible terminated S corporation is any C
corporation which (1) is an S corporation the day before the enactment of this bill, (2) during the two-year period beginning on the date of such enactment revokes its S corporation election under section 1362(a), and (3) all of the owners of which on the date the S corporation election is revoked are the same owners (and in identical proportions) as the owners on the date of such enactment.
 
Effective date: Taxable years beginning after December 31, 2017
 
 
 
Taxpayers that meet this fact pattern can now spread the unfavorable section 481(a) adjustment ratably over six tax years, as opposed to four tax years, beginning with the year of change.
 
A C corporation, a partnership that has a C corporation as a partner, or a tax-exempt trust or corporation with unrelated business income generally may not use the cash method.  Exceptions are made for farming businesses, qualified personal service corporations, and the aforementioned entities to the extent their average annual gross receipts do not exceed $25 million.
 
In addition, the cash method generally may not be used if the purchase, production, or sale of merchandise is an income producing factor.  Such taxpayers generally are required to keep inventories and use an accrual method with respect to inventory items (unless exempted based on the new law mentioned above).
 
In summary, the tax reform bill provides a multitude of accounting method planning opportunities that can result in permanent tax savings for taxpayers.  As many of these planning ideas can only be implemented in a limited time frame, taxpayers and tax professionals are encouraged to begin gathering information and evaluating action items as soon as possible in order to properly comply with the procedural rules for making accounting method changes.
 
If you have any questions, please contact a member of the Accounting Methods group.  The Accounting Methods group within BDO USA’s National Tax Office has extensive experience assisting taxpayers of all industries and sizes with their accounting method issues and filing accounting method change requests with the IRS.
 
Dave Hammond
Technical Practice Leader
  Travis Butler
Tax Managing Director

 
Yuan Chou
Tax Managing Director
  Connie Cunningham
Tax Managing Director

 
Marla Miller
Tax Managing Director