Small business owners have several options when it comes to positioning their business for an optimal income tax profile through an accounting method change for tax purposes. Learn about some common situations below where an accounting method change may be advantageous for your business and consult a Denver CPA or other licensed tax professional today.
Cash or Accrual Method of Accounting
If you have been using an accrual method of accounting for tax purposes, switching to the cash method of accounting could potentially lower your taxable income, provided you are eligible to use the cash method. In general, if your average gross receipts for the prior three years are less than $32 million, you are eligible to use the cash method of accounting. The cash method does not preclude you from keeping your books on the accrual method internally, which can be ideal for lending, investing or scaling purposes.
See also this earlier post on methods of accounting: Cash or Accrual Method Accounting – Which One is Right for Your Business? | Sync CPA
Correcting Errors or Missed Depreciation
A common problem for businesses that are capital intensive and have many assets is that the depreciation expense can be over or under stated or completely missed in a tax period. While an amended return may seem like the logical avenue to correct issues, oftentimes an accounting method change via filing Form 3115 is the best path forward. This removes to need to file potentially several years of amended returns, which can take months to process.
Inventory Changes
For businesses that hold products, how you value that inventory changes your cost of goods sold (COGS), which directly impacts your taxable income.
Switching from “First-In, First-Out” (FIFO) to “Last-In, First-Out” (LIFO) during periods of high inflation can be a massive tax saver. Since the most recently purchased (and likely more expensive) items are sold “first” on paper, your COGS goes up, and your taxable income goes down. This only accelerates your LIFO COGS deductions and doesn’t increase them as compared to the default of FIFO. But in the tax world, deferral of tax liability is considered to be the holy grail, as eliminating tax is often, how can I say this, illegal?
Revenue Recognition and Accelerated Expenses
Depending on several technical factors, revenue can be deferred and expenses can be accelerated into a later tax year assuming the company qualifies. This can be a powerful method to decrease taxable income assuming all eligibility is met.
For example, an insurance policy that is effective in December through November of the following year has a default treatment of only deducting the December premiums for the earlier tax year, and deducting the remainder in the next year. While its not a significant acceleration of deductions, the more expenses you can accelerate will be a net benefit for lowering taxable income.
Regulatory Compliance
As referenced in the first section, the gross receipts limitation of ~$32M average for the prior three years is also the threshold from being able to use the cash method of accounting to being forced into using the accrual method of accounting. As mentioned, for internal purposes you can keep your books however you would like, assuming you aren’t required to use certain accounting principles because of loan covenants or investors, but if you are considered to be a large enough business then you may be forced to report as accrual.
In conclusion, because an accounting method has been used historically, doesn’t preclude the business from changing into something more advantageous. A proper legal analysis and modeling of the tax consequences is prudent before executing an accounting method change.
Denver, Colorado and US based businesses should consult a licensed Denver CPA or other licensed professional such as an enrolled agent to help them determine whether an accounting method change would be beneficial to them.
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