Accrual to Cash – It’s All About Timing: Tax Reform Loosens Up Cash-Basis Rules

I wouldn’t blame you if you missed Revenue Procedure 2018-40.

First, it deals with accounting method changes and filing Form 3115, Application for Change in Accounting Method. When was the last time you filled out one of those? It only happens every once in a while, and completely goes against the standard training for new staff, from “look at how we did it last year” to “Yeah, we didn’t do one last year; pass.”

Second, the procedure deals with something only you as the tax preparer understand, but it’s way easier to show off your tax knowledge to clients when you discuss the Opportunity Zone investment or the Qualified Business Income deduction. Those sound slightly more interesting than telling your clients you’re going to charge $1,000 just to see if switching from the accrual to cash method might allow them to claim a favorable 481(a) adjustment.

Here’s what you’ll need to know to identify good candidates to switch methods, as well as give you just enough information to avoid missing a good planning opportunity.

Before the Tax Cuts and Jobs Act, some small businesses were forced into using accrual basis on their tax returns. For certain taxpayers, once average gross receipts ran above $5 million, the IRS forced their hand. What’s so bad about that?

• There are more things to start tracking, such as inventory or accrued expenses. This requires more time each year asking the client additional questions for accrued rent, interest, outside services, compensation, insurance and taxes.
• Another negative is picking up income before receiving payment from customers. That large accounts receivable (AR) balance does the client no good come tax time, and can only be paid with income from paying customers.

To ease the burden on these taxpayers, the IRS expanded the definition of a small business. Now, taxpayers with average annual gross receipts of $25 million or less can keep the cash method.

Key Point #1: How many of your clients are on the accrual basis, with less than $25 million in average annual gross receipts?

Now, to the procedure, which simplified the process of changing the method from accrual to cash. Yes, it came out in 2018, but I’m still not blaming you for missing this. The IRS has pumped out tons of tax reform-related guidance, and on matters that have retroactive effective dates that need to be kept up on, such as extenders.

The procedure provides four new automatic method changes for any tax year beginning after Dec. 31, 2017:

1. Change from overall accrual to overall cash method.
2. Change to discontinue capitalizing costs under Sec. 263A.
3. Change to discontinue capitalizing inventories under Sec. 471, and either treat inventories as non-incidental materials and supplies, or follow the applicable financial statement method.
4. Change to either discontinuing the percentage of completion method for certain long-term contracts under Section 460 or discontinuing capitalizing costs under Section 263A for certain home construction contracts.

We’re discussing #1, which you would use the designated control number 233 for on Form 3115. The procedure also waives a rule that a taxpayer is not allowed to change the overall method of accounting if already done so in the prior five taxable years.

So, let’s take a simple example. A client with $1 million in AR and $400K in accounts payable (AP) that switches from the overall accrual method to the overall cash method would have a favorable adjustment of $600K. The accrual basis requires the $1 million to be picked up in income, and the $400K allowed as deductions on the return. Switching to the cash method removes both of those from the picture, until the client actually receives payment on the AR or spends their cash on the AP.

Key Point #2: How many of your clients have AR larger than their AP?

You can see this procedure also deals with a few other things. While they tend to be niche issues, I’m hoping anyone having the pain of dealing with them decided very swiftly to escape using the procedures. If you can get rid of it, it’s well worth the time investment, especially when calculating a Sec. 263A adjustment. That’s just one less confused look on a client’s face that happens every time you say the IRS wants to capitalize more costs to inventory.

Hopefully this is enough information that now you don’t have an excuse to at least give your clients a cursory check. And, if your staff says, “But that isn’t what we did last year,” you can tell them to embrace their role in providing quality tax advice to the clients you serve.