Financial: Changing Tax Horses

By Mark E. Battersby / Published June 2015

 

After the tax returns were filed and the annual tax bill paid, many contractors and pressure washing business owners found themselves asking why certain transactions were handled in the way that they were. Was it really necessary to use the complex and often confusing accrual method of accounting when basic cash accounting might have produced better results?

Unfortunately, changing the way a pressure cleaning business accounts or has accounted for income and expenses is considered to be accounting changes requiring permission of the IRS to undertake. IRS permission is required before changing the way things are accounted for—even  accounting method changes demanded by an IRS auditor are necessary to comply with new tax laws. And those requests to change accounting methods all require certain adjustments to avoid distorting the pressure washing operation’s income and/or deductions.

One Exception for Permisiable Changes

Tax return filings for last year saw more Forms 3115, Application for Change in Accounting Method, than usual thanks to the so-called “repair regulations.” Taxpayers with depreciable, tangible, personal property are required to be in compliance with the new repair regulations.

The IRS recently made it easier for small pressure cleaning businesses, including sole proprietors, with assets totaling $10 million or less to comply with the final regulations for repair write-offs. The new repair rules distinguish between “improvements,” which have to be capitalized and “repair” expenses, which can be deducted.

Changing for Savings

Because the IRS doesn’t want anyone to change accounting methods willy-nilly, changing the “method of accounting”—the way something is accounted for on the tax return that affects the timing of income or expenses—timing is everything for tax purposes. After all, according to our tax laws, a change in the method of accounting occurs when the method to be used by a taxpayer for an item when computing taxable income is different than the operation’s “established” method of accounting. A change in a method of accounting does not include correcting mathematical or posting errors, or errors in the computation of tax liability.

The IRS’s latest guidelines for changing the way a pressure cleaning business accounts for things, outline the steps for obtaining the advance (non-automatic) consent of the IRS Commissioner to change the pressure washing operation’s method of accounting as well as for obtaining an “automatic” consent.

Method of Accounting

The term “method of accounting” includes (a) an overall plan of accounting, such as for gross income and deductions, and (b) the treatment of any “material item” that involves the proper timing for inclusion in income or claiming the item as a deduction, or both.

Once a pressure washing business adopts a method for treating income, expenses, deductions, or transactions in a manner that property reflects income, it is considered to have “adopted” that method of accounting.  It is not necessary to treat the item consistently in two or more consecutive returns in order to have “adopted” a method of accounting.

Changing Accounting Methods

In order to obtain the IRS’s consent to change a method of accounting, a pressure cleaning business must usually file a Form 3115, Application for Change in Accounting Method, during the taxable year for which the change is proposed. With many Forms 3115 filed for non-automatic changes requiring additional information, the IRS recommends filing a Form 3115 as early as possible during the year of change.

Unfortunately, there is no such thing as a “retroactive” change in a method of accounting. Unless specifically authorized by the Commissioner or by law, no one may request, or otherwise make, a retroactive change in method of accounting.

Situations Ripe for Change

Many small pressure washing businesses find it easier and less expensive to use the “cash” method of accounting. Under the IRS’s recently-relaxed rules, any business with “average annual gross receipts” less than $10 million can change to the overall cash receipts and disbursements (cash) method—with permission.

The IRS uses the deduction for so-called “energy-efficient commercial buildings” to illustrate a situation in which a business may want to change its method of accounting for the expense of installing energy-efficient property, equipment, or systems. The deduction for energy-efficient commercial building property is, of course, subject to limits and must be claimed in the tax year in which the energy equipment or improvements are placed in service.

The basis or book value of the energy efficient commercial building property is reduced by the amount of the deduction taken and the remaining basis of the energy-efficient commercial building property is depreciated over its recovery period. Any pressure cleaning business making this change must, of course, attach a statement of adjustments to its Form 3115.

Adjustments for Change

The “adjustment” required when changing accounting methods involves computing the amount necessary to prevent amounts from being duplicated or omitted when the pressure washing operation computes its taxable income for the year of change and thereafter using a different method of accounting. Of course, the IRS may decide that certain changes in methods of accounting can be made without an adjustment. 

When there is a change in the method of accounting, taxable income for the tax year before the year of change must be determined under the method of accounting that was then employed. Taxable income for the year of change and the following taxable years must also be determined using the method of accounting for which consent is granted as if that method of accounting had always been used.

When a change in method of accounting is made without an adjustment (for example, on a cut-off basis), generally only those items arising on or after the beginning of the year of change, or other operative date, are accounted for under the method of accounting for which consent has been granted. Any items arising before the year of change, or other operative date, must continue to be accounted for using the pressure cleaning operation’s previous method of accounting.

It is no secret that accounting method changes are often required as the result of an IRS audit or examination.  The tax rules also state that if a taxpayer does not regularly employ a method of accounting that clearly reflects its income, the IRS may change the method of accounting to one that, in their opinion, does clearly reflect income. 

In situations where the pressure cleaning contractor or business is compelled to change its method of accounting, especially a change that results in a positive adjustment, the change will ordinarily be made in the earliest taxable year under examination with a one-year adjustment period.

Automatic Approval

Under a recent IRS Revenue Procedure, taxpayers will be given automatic approval from the IRS to change their method of accounting for a number of listed changes. Instead of amending an earlier-filed tax return, the pressure cleaning business simply attaches Form 3115 to a timely filed federal tax return for the year in which the change applies, as well as sending a copy to the IRS national office.

As mentioned, the cumulative negative effect (taxpayer favorable) of the change in the taxpayer’s method of accounting is reported as an adjustment, which can be deducted immediately in the taxable year of change. A positive adjustment (taxpayer unfavorable) can be amortized over four consecutive years (beginning with the first year in which the change was applicable). 

Included within these automatic method changes is a change from an impermissible method of depreciation under which the taxpayer did not claim the depreciation allowable, to a permissible method for depreciation under which the taxpayer will claim the depreciation allowable and expensing versus capitalization.

The IRS has issued new procedures every pressure washing business should use to make accounting method changes. The Revenue Procedure contains the rules to be followed to make non-automatic changes in methods of accounting, which are changes that require the IRS’s consent as well as the procedures for applying for automatic changes in accounting method, which do not require the IRS’s consent.

The tax laws require all businesses to get IRS permission to change a “method of accounting.” In general, a “method of accounting” change occurs when the way something— income, deductions, or transactions—is accounted for on the annual tax return that affects the timing of income or expense, but not the total amount over time. In other words, it’s temporary vs. permanent differences.

Obviously, the IRS doesn’t want changes made that might distort the operation’s tax bill. Fortunately, since the IRS doesn’t have the time to consider every accounting method change, it publishes a long list of “automatic” method changes each year.

Unfortunately, even an automatic change isn’t free, especially if it is necessary to go through old records to determine the catch-up deduction.  However, if a pressure washing business has significant depreciable property, it’s probably worth the effort to investigate the advantages—and potential pitfalls—involved in changing accounting methods. Naturally, the assistance of a qualified professional will make things go smoother as well as possibly unearth other areas that might benefit from a change in accounting methods.