Most long standing businesses have operated in their current legal form and using methods of accounting that were established long ago often without regard to whether these practices at the time were advantageous or whether today they are permissible or beneficial. Often the tax returns for the business are prepared using financial statements prepared to accommodate lenders and generally accepted accounting principles (GAAP, learn more about GAAP from the Financial Accounting Foundation®) without any regard to the requirements or options afforded the business under US tax law. In addition, it isn’t uncommon in hindsight to have misapplied a tax law requirement for how the business reports its gross income and claims its allowable deductions. And a common misperception is that the methods used to report items on a financial statement must conform to the tax treatment of the same item, or vice versa.
The IRS long ago took the view that taxpayers should be allowed a less painful way to correctly handle their tax reporting in situations where in the past what was done was clearly erroneous. In fact, the IRS has permitted certain prospective corrections to “bullet-proof” the taxpayer from an IRS challenge of such items for prior year errors as long as the taxpayer follows some prescribed guidelines and current and future tax reporting. If the corrections result in additional taxable income the IRS permits a spreading of the adjustment over several years to soften the financial blow. Failure to follow the guidelines may open the business up to an immediate tax hit retroactively with penalty and interest to boot. If the corrections result in a favorable impact to the taxpayer the amount can often be taken immediately resulting in refunds of tax on a “catch up” basis. These corrections are to be contrasted with “amended returns” which are often misunderstood for how to handle “changes in accounting methods” (more from the IRS here).
The most overlooked and often taxpayer favorable accounting methods are as follows:
- Overall cash method of accounting for tax purposes where the accrual method is clearly disadvantageous or being misapplied.
- Overall accrual method of accounting for tax purposes where the cash method is clearly disadvantageous or being misapplied.
- The overall accrual method coupled with a deferral of advance payments received from customers.
- Last in first out (LIFO) inventory method versus first in first out (FIFO).
- Accrual basis taxpayers failing to deduct certain items that are allowable as deductions when paid.
- Use of incorrect (or missing out on optional) lives and methods used to recover the cost of an asset that isn’t immediately deductible when first put into service.
- Failure to recognize differences in the tax treatment of items under the regular income tax and the alternative minimum tax.
- Failure to recognize available exceptions to the alternative minimum tax for certain small C Corporations.
- Grouping or un-grouping of activities for purposes of the passive activity rules.
- Not using a contract method of accounting for situations that call for it.
The new tax law, applicable to 2018 and after, is generally more taxpayer-friendly in the area of permissible accounting methods than prior law thus making this the time to re-evaluate past practices. To learn more about how the new tax law will be affecting your business, contact your MMB professional today!
