A Change in Method of Accounting:  A Change You Can Benefit From

Jenny Kramer, CPA, Tax Senior Manager   email
May 2010

Every business uses a number of accounting methods to determine tax liability each year.  However, few businesses and their key management may realize the structure of these methods and the impact of any change in accounting method.  Generally, once a method of accounting is established for tax purposes (even if improper), it must be followed consistently, unless a change in method is made.  Many taxpayers assume a change in method only occurs when changing the overall method of accounting, such as from the cash method to the accrual method.  A change in accounting method for tax purposes, however, can apply in a number of situations, and is defined as "any change in the treatment of a material item which affects the proper timing of income or a deduction."  A change in methods may present tax savings opportunities or perhaps situations to minimize tax exposure.  

The following are examples of situations that would require a change of accounting method for tax purposes:To correct overstated or understated depreciation or amortization deductions from prior years; To deduct the employer portion of accrued payroll taxes (e.g. FICA and FUTA) relating to accrued compensation and vacation pay;To deduct payments for medical and dental services to employees under a self-insured medical and dental plan even when some payments are made beyond 2½ months after the end of the tax year in which the services were provided; To deduct certain prepaid expenses that meet the "12-month rule" requirements; and to make a change in the UNICAP inventory method.

Some accounting method changes could be viewed as opportunities as they may lead to tax benefits.  For instance, accelerating the deduction of certain prepaid costs could generate significant immediate tax savings when the change is made.  Conversely, other accounting method changes may be seen more as protective measures to be employed to minimize damages.  For example, if a company learns it is using an improper method of accounting, the company could initiate a change in method with the Internal Revenue Service (IRS) to a proper method and spread the additional tax impact over the next four years, rather than being forced under an IRS audit to take a one-year hit in the earliest open tax year.   Accounting method changes require consent from the IRS.  Consent is split into two formats: automatic and non-automatic (or IRS permission required) consent.  Currently, IRS Revenue Procedure 2008-52 (as modified by Revenue Procedure 2009-39) provides the process for obtaining automatic IRS consent, as well as the specific changes in accounting method that are classified by the IRS as an automatic consent.  Also refer to the instructions for Form 3115 for a list of automatic accounting method changes.  The following items outline the differences between an automatic and non-automatic change in accounting method:

1. Federal Form 3115, the application for change of accounting method (automatic and non-automatic), is due with a timely filed (including extensions) original tax return for the year of change.  Form 3115 for a non-automatic change, however, must be filed during the tax year of the requested change, and if filed at year's end, it may not be acted on by the IRS before the deadline for the filing of that year's tax return.  As a result, the taxpayer may need to file the tax return, wait for IRS action, and if approved amend the return. 
2. An application for an automatic change in accounting method is deemed accepted and approved by the IRS if filed according to IRS regulations as part of a timely filed (including extensions) original return for the year of change.  A taxpayer requesting a non-automatic change, however, will need to wait for IRS approval before implementing the change.
3. The IRS charges a user fee for requesting a non-automatic change in accounting method.  The fee ranges from $625-$4,200 depending on the taxpayer's gross income.  There is no fee for Form 3115 for an automatic accounting method change.  
4.  An automatic accounting method change requires less information and detail for Form 3115 than for a non-automatic change.  Please note that the IRS released a new version of Form 3115 on April 22, 2010.  Form 3115 (Rev. December 2009) is now the current Form 3115 and replaces the December 2003 version.  The IRS will accept either version of the form through May 30, 2010; however, taxpayers are required to use the December 2009 version after that date.

While a request for an automatic accounting method change is easier to apply for, if the desired change of method is not identified as an automatic change, there are still circumstances where a non-automatic accounting method change will prove worthwhile to the taxpayer.  For example, generally, an accounting method change will result in audit protection for the taxpayer.  Therefore, in the event the taxpayer is using an impermissible method of accounting and applies to change to a permissible method, the change will be taken into account in the year requested by the taxpayer if approved by the IRS.  If, however, the taxpayer has been contacted by the IRS to schedule an audit, a request for change in accounting method can no longer be filed and the taxpayer may be required to retroactively change the method in question to the earliest open tax year. A change in accounting method should be considered by taxpayers as a tax planning strategy to generate tax savings or to minimize tax exposure.  If you have any questions regarding a change in accounting method, please contact Jenny Kramer jkramer@kolbco.com at or 262/754-9400 ext. 256.