As we approach 2025, evaluating the potential benefits and strategic timing of changes to accounting methods and periods is crucial for effective business tax planning. By leveraging the appropriate accounting methods — whether cash or accrual — and aligning them with the correct accounting periods, taxpayers can potentially minimize their taxable income, reduce payable taxes and optimize overall cash flow.

Navigating the evolving landscape of tax legislation, such as the updated gross receipts thresholds and changes brought by the Tax Cuts and Jobs Act (TCJA), will be essential for taxpayers aiming to benefit from exemptions and simplifications. Proper planning and compliance with these tax accounting rules can help secure financial stability and strategic advantages in the year ahead.

Benefits of Different Accounting Methods and Periods

Computing taxable income depends on the accounting method used to report taxable income and the accounting period associated with that taxable income. Both accounting methods and periods involve a mixture of tax law and accounting concepts and apply to virtually all taxpayers across industries. Properly leveraging these concepts may deliver immediate and sustainable benefits, including decreased taxable income, reduced tax payments and improved overall cash flow.

Accounting methods encompass the general rules regularly followed in determining the timing of income, deductions or credits. Accounting periods encompass when taxable income is measured and include rules governing adoptions of or changes to a particular taxable year (e.g., calendar year, fiscal year or fractional part of a year for which taxable income is computed).

Determining the proper accounting method and accounting period is essential to ascertaining the appropriate tax rates, the applicability of new legislation and the timing for tax payment and return filing.

Common Overall Method Changes (Cash or Accrual)

Although there are over 250 accounting method changes that the IRS approves automatically, (i.e., without advanced written approval from their National Office), many taxpayers use one of two overall methods of accounting: cash method or accrual method. Under the cash method of accounting, income and expenses generally are recognized when cash is received or paid. Typically, with certain exceptions, the cash method is available to S corporations, partnerships without C corporation partners and small businesses (as defined below). Alternatively, the accrual method, with certain exceptions, allows taxpayers to accrue deductions for various expenses and receive a deduction currently even if the items are not paid until the following year. This method also generally requires the recognition of income from receivables earned but not yet collected.

Restrictions on the Overall Method of Accounting and Unique Accounting Method Changes

No taxpayer that meets the definition of a “tax shelter” may use the cash method of accounting. Also, no taxpayer can report the purchase and sale of inventories on the cash method of accounting unless the taxpayer is exempt from Internal Revenue Code (IRC) §471. Furthermore, C corporations and partnerships with C corporation partners (collectively, C corporation taxpayers) generally may not use the cash method of accounting.

Prior to the TCJA, C corporation taxpayers with gross receipts exceeding $5 million were not considered “small” taxpayers and were required to use the accrual method of accounting. The TCJA amended the definition of a small taxpayer to include those C corporation taxpayers with average annual gross receipts for the prior three-year period of less than $25 million, permitting more taxpayers to report on a cash basis. The gross receipts threshold is adjusted annually for inflation and is currently at $30 million for tax years beginning in 2024.

Note that a C corporation taxpayer’s qualification as a small taxpayer enables cash method reporting only for its activities other than the purchase and sale of inventories. But all taxpayers (including C corporation taxpayers) may separately qualify for an exemption from IRC §471, thereby enabling (among other things) the use of the cash method to purchase and sell inventories.

C corporation taxpayers frequently overlook the highly technical aggregation rules when calculating their average annual gross receipts. These rules require consideration of the gross receipts of businesses under common ownership by the taxpayer, part of a controlled group (e.g., parent-subsidiary controlled groups, brother-sister controlled groups or a combination of these) or affiliated service groups before determining whether the gross receipts threshold for small business taxpayers is considered. For example, the gross receipts of a 100% corporate shareholder of a U.S. corporation would be included in the calculation of the gross receipts test, whether the owner is domestic or foreign, and the gross receipts of a controlled foreign corporation (CFC) might be aggregated with the U.S. corporate taxpayer.

If a C corporation taxpayer does not consider the gross receipts threshold or aggregation rules mentioned above, the taxpayer may incorrectly report on the cash basis method or unnecessarily report on the accrual basis method and report income when accrued rather than received. Regardless, failing to consider these rules may require requesting an accounting method change.

The change made by the TCJA to modify the dollar threshold for small business taxpayers has additional effects on other tax accounting issues, such as an exemption from the requirement to account for inventories under IRC §471, exemption from uniform capitalization rules (commonly referred to as UNICAP) under §263A, exemption from the limitation on the deductibility of business interest under §163(j) and simplified reporting requirements for long-term contracts, e.g., often seen in construction accounting, under §460. These scenarios are discussed below.

Inventory (§263A and §471)

IRC §471 generally governs all inventory and requires merchandise on hand to be taken into account at the beginning and end of the year in computing taxable income and further requires the purchase and sale of these items to be reported on the accrual basis of accounting. When the UNICAP rules come together with inventory accounting, certain taxpayers above the gross receipts threshold can also be required to capitalize on certain indirect costs associated with the production and acquisition of inventory. These additional capitalized costs then become part of the inventory value and are recovered as part of the cost of goods sold (COGS) when the inventory is sold.

All taxpayers, including S corporations, partnerships without C corporation partners and C corporation taxpayers, other than tax shelters are eligible for an exemption from either or bothIRC §471 and IRC §263A by meeting the small taxpayer criteria. If an eligible small taxpayer is no longer subject to IRC §471 and IRC §263A, they may be able to change their method of accounting to the cash basis for the purchase and sale of inventory items. Accounting for the sale of inventories on the cash basis would then complement the aforementioned cash basis reporting used for all other activities.

Such taxpayers also would benefit from no longer capitalizing other indirect costs under IRC §263A to inventory. Although such taxpayers generally cannot deduct inventory purchasing costs upon payment, they may achieve simplification by determining COGS deductions by reference to the policy used for book purposes. Alternatively, a similar result is possible by treating inventories as non-incidental materials and supplies.

Exemptions from either or both of IRC §471 and IRC §263A may allow the taxpayer to decrease taxable income, thereby improving cash flows.

Long-term Contract Accounting (§460)

The TCJA amended §460(e)(1)(B) to simplify certain accounting rules by increasing the gross receipts ceiling amount that is used to determine eligibility for the exemption from the requirement to use the percentage of completion method for long-term construction contracts. Taxpayers that meet such exceptions would be permitted to use the completed contract method, exempt contract percentage of completion method or any other permissible exempt contract method. The immediate benefit of using the completed contract method over the percentage of completion method is the ability to defer the recognition of revenue and expenses until the project is complete, thereby deferring income tax liabilities to future periods, allowing for greater cash flow during the construction phase and more accurate reporting.

Limitation to Business Interest Expense Deduction (§163(j) and §266)

To determine whether interest expense incurred is deductible in the year paid or accrued. if at all, taxpayers must first allocate the interest expense among several different categories, which have their own interest expense limitation rules: trade or business interest, personal interest and investment interest. For amounts identified as business interest expense, the associated limitation rules are provided by IRC §163(j). IRC §163(j) limits the deductibility of business interest expense to an amount generally equal to the sum of business interest income, floor plan financing interest and 30% of the taxpayer’s adjusted taxable income. However, there may be occasions where business interest expense can or must be capitalized to other property, which will preempt the IRC §163(j) limitation. In this regard, certain situations may permit optional capitalization.

Generally, §266 is a provision in the IRC that allows taxpayers to capitalize items such as taxes, interest and carrying costs to the basis of property rather than deducting the items currently. For example, in a year with minimal receipts but large expenses, capitalizing costs under §266 would save these expenses, allowing the taxpayer to offset income when the property is ultimately sold, whereas deducting the expenses currently could yield a loss that may be limited and carried forward to a future year due to basis or NOL deduction limitation issues.

The use of §266 to avoid the §163(j) business interest expense limitation is an area of tax law that has generated differences of opinion among commentators. For example, although the Treasury Regulations state (in one instance) that provisions requiring interest to be capitalized apply before §163(j), other parts of the Treasury Regulations, as well as the TCJA legislative history, suggest that optional capitalization provisions (such as IRC §266) also apply before IRC §163(j) is to be considered. Under this argument, although a present interest deduction is denied, all capitalized interest is charged to the basis of the subject property (e.g., real estate, machinery and other fixed assets). This permits this business interest expense to be recovered as depreciation of fixed assets (consider bonus depreciation applicability) rather than be potentially limited under the §163(j) business interest expense limitation provisions. Although some practitioners believe that §266 also allows interest to be capitalized to inventory (or even accounts receivable), the legal authorities supporting that view are weak.

While this high-level, generic interpretation appears simple, this is an extremely fact-specific undertaking requiring a significantly detailed analysis tailored to each taxpayer’s unique situation. In fact, in a letter dated Aug. 30, 2024, the American Institute of CPAs requested that the IRS confirm that §163(j) applies after a taxpayer elects to capitalize interest expense under §266 (or any other provision that allows elective capitalization of interest expense). CBIZ continues to monitor the major tax publications to determine whether the IRS will respond.

How to Request and Report a Change

Each accounting method change requires filing Form 3115, Application for Change in Accounting Method. These forms can be complex, and in most instances a separate form is required for each type of change. Accounting method changes often result in a §481(a) adjustment, the cumulative impact of the change in comparison to the former method of accounting. These changes can either be favorable, resulting in additional deductions available, or unfavorable, resulting in additional income to be reported. All favorable adjustments must be recognized in the year of the change. Unfavorable adjustments are generally recognized ratably over four years, thus deferring some taxable impacts to future periods. However, the taxpayer can elect to recognize an unfavorable adjustment not exceeding $50,000 in the year of the change.

Annual Updates

Consistent with prior years, the IRS updated its list of automatic change procedures in Revenue Procedure 2024-23. Although many updates address the removal of obsolete provisions or other updates needed since the publication of the prior year's revenue procedure, this year’s updates include, but are not limited to:

• Taxpayers may no longer use automatic procedures for certain §263A (UNICAP) sub-methods, including the direct reallocation method, the step-allocation method and the 90-10 de minimis rule for mixed service department costs.
• All changes to the timing of when to report income to comply with the all-events test under Regulation §1.451-1(a) must be made using nonautomatic procedures. This now requires advanced consent by filing Form 3115 with the IRS National Office in Washington, D.C.
• Provide a method of accounting for specified research or experimental expenditures consistent with §174 and the related administrative guidance.

Timing Issues Under Section 451(b)-(c) and Section 263A UNICAP Sub-Methods

Section 16 of Revenue Procedure 2024-23 was modified to exclude changes to comply with the all-events test under Regulation §1.451-1(a). It provides a modified ordering rule for taxpayers making specific inventory method changes, allowing them to file a single Form 3115. Revenue Procedure 2024-23 also removed several §263A uniform capitalization (UNICAP) sub-methods from the list of automatic changes, which restricts taxpayers' ability (under the automatic consent procedures) to determine which types of expenditures they capitalize into the basis of self-constructed assets and inventory.

Both changes made in Revenue Procedure 2024-23 are highly technical and taxpayer-specific and, therefore, exceed the scope of this publication.

Research and Experimental Expenditures [(c) §174]

Effective for tax years beginning in 2022, the TCJA requires taxpayers to capitalize specified research or experimental expenditures (SRE) in the year the amounts are paid or incurred and amortize the amounts over a specified period, depending on whether the costs incurred were domestic or foreign. Section 7 of Revenue Procedure 2024-23 was updated to provide taxpayers with automatic change procedures for SREs to comply with §174 in tax years subsequent to the first tax year after Dec. 31, 2021.

Without the modification, those taxpayers would have to file a method change under the nonautomatic change procedures, as the waiver of the five-year same-item restriction for using the automatic change procedure would not have applied.

Conclusion

Although over 250 accounting method changes are available for automatic approval, this discussion is restricted to some of the more common method changes used. Furthermore, this discussion does not address other changes in the method of accounting that may be beneficial but require advanced consent from the IRS National Office (“nonautomatic” accounting method changes). When considering an accounting method change, it is essential to evaluate the impact the change could have on other tax items, including but not limited to invoicing practices, cost of goods sold, income tax provisions, state and local taxes, the business interest expense limitation, capitalization methodologies and depreciation or amortization strategies.

It is essential to discuss all options with your CBIZ tax advisor to ensure appropriate implications are considered to maximize tax savings. Our accounting methods team is available to assist with analyzing how the above items may benefit you and your company. Connect with Financial Services to learn more.