The Intricacies of Tax Accounting Method Changes and Form 3115

By Adam Aucoin December 9, 2024

There are a variety of reasons, including anticipating tax rate changes, that banks and corporations start to dive deeply into tax planning, the topic of tax accounting method changes comes up in conversation. Many of you may recall how broadly potential tax accounting method changes were discussed a decade ago related to repair and capitalization regulations. Additionally, in our last issues Issues of Interest, we briefly touched on the topic of accounting method changes due to a new method for bad debt deductions for banks. Today, we delve deeper into this important subject to give some background ahead of a potential need for accounting method changes resulting from expected tax reform/extensions coming in 2025. 

Overview of Accounting Methods 

The definition of an accounting method for tax purposes (which may differ from GAAP) is “any practice involving the treatment of the overall plan of accounting for items or the treatment of any specific material item of income or expense” (Treas. Reg. Sec. 1.446-1(e)(2)(ii)(a)). 

Once you treat an item of income or expense in the same manner for two years or more you have adopted a method of accounting, even if you did so unintentionally or the method is not recognized as a proper one. Perhaps the simplest example of accounting methods involves the cash and accrual methods of accounting. Those two methods impact how and when an item of income or expense is recognized for tax return purposes.

Changes in corporate tax rates and tax laws tends to be a good time to review a company’s various tax accounting methods. By adjusting their accounting methods, businesses can better manage their tax obligations and take advantage of potential tax savings. For example, if the corporate tax rate is set to decrease in a future year, a company might benefit from accelerating expenses or deferring income to minimize its tax burden in the higher rate period. Conversely, if the tax rate is set to increase in a future year, deferring expenses and accelerating income could be advantageous. All these items should be modelled out and considered.  

Any change must involve a new accounting method that is recognized as a permittable one, which could limit whether a change is even possible or practical. However, any lever you can even potentially pull in tax planning should be considered. 

Form 3115: Application for Change in Accounting Method 

Before we dive into a few examples of accounting methods it is a good idea to know how an accounting method change is made for tax purposes:  To request a change in an accounting method, taxpayers must file Form 3115 with the Internal Revenue Service (IRS). This change can be necessary for various reasons, including alignment with new tax laws or correcting previous accounting errors. This form requires detailed information about the current and proposed methods, the reason for the change, and its impact on the business.  

Accounting method changes involve one of two forms: an automatic or nonautomatic procedure. 

1.  Automatic accounting method changes are pre-approved by the IRS and typically involve a streamlined process with fewer requirements and faster approval times. These changes are listed in the IRS’s annual revenue procedures and generally do not require a user fee. 

1.  On the other hand,  nonautomatic accounting method changes require explicit IRS approval through the filing of Form 3115, “Application for Change in Accounting Method.” This process is more complex, often involves a user fee, and may require additional documentation and justification for the change.  

Sometimes an adjustment to taxable income is needed to implement the new accounting method. Section 481(a) of the Internal Revenue Code addresses adjustments required when a taxpayer changes an accounting method, and these adjustments ensure that there is no duplication or omission of income or expenses due to the change. 

When a business adopts a new accounting method, it must calculate the cumulative effect of the change on its taxable income as of the beginning of the year of change.  This adjustment, known as a Section 481(a) adjustment, can either increase or decrease taxable income. If the adjustment results in an increase in taxable income, the taxpayer typically may spread the adjustment over four years to mitigate the immediate tax impact. Conversely, if the adjustment decreases taxable income, the taxpayer can recognize the entire benefit in the year of change. Some changes in methods are done on a cut-off basis and no “catch-up” is needed. 

Examples of Accounting Method Changes 

Prepaid Expenses 

Under the current method, prepaid expenses (primarily prepaid insurance) might be expensed over the life of the prepaid asset. However, by changing to a different method, businesses would recognize these expenses when paid (using a so-called 12-month rule), which could provide an opportunity to accelerate deductions. 

Depreciation Methods 

Depreciation methods represent some of the most common accounting method changes. It may involve correction of incorrect class lives or implementation of the results of a cost segregation study. The timing of the cost segregation study and the period in which a Section 481(a) adjustment might apply should be considered, especially if you are straddling years with different tax rates. 

Accrued Bonus 

Another change in accounting method we see often relates to ensuring that accrued bonuses are deducted in the correct period. More information on when to deduct an accrued bonus can be found in the accrued bonus section of this article. Often such method changes are corrective actions. 

Loan Origination Costs 

Lastly, a bank may also use an accounting method change regarding its treatment of loan origination costs, moving to a method that allows current deduction of de minimis loan origination costs. 

Conclusion

Understanding and effectively managing accounting method changes is essential for financial institutions. When tax reform or legislation is expected, it is a good time to review all tax accounting methods to make sure they are both proper and advantageous.  

For more information or a discussion on how this may impact your bank, please contact  Adam Aucoin or your BNN tax advisor at 800.244.7444.