When was the last time you looked at your accounting methods for tax purposes as a strategy to save money? Does this question make you ask yourself, What is an accounting method and when did I make an election for it? Many banks do not realize that they have made an accounting method election because it is done on the first tax return, and most banks do not revisit the election as they continue to grow.
An accounting method determines when and how you record income and expenses for tax purposes, such as depreciation and bad debts. The Internal Revenue Service will allow you to make changes to your accounting method as long as your new method is permitted and you provide it notice that you are making a change to your accounting method. Most taxpayers need to file two copies of Form 3115 - Application for Change in Accounting Method with the IRS. One is sent to the Internal Revenue Service Center, and the other is attached to your tax return in the year that you are making the change. Since you need to file Form 3115 with your tax return, you have until the due date of your tax return to file the form, including extensions. A calendar year taxpayer has until September 15, 2017, to make a change in accounting method. There are two types of accounting method changes: automatic and non-automatic changes. There are currently over 200 accounting method changes that are considered automatic changes. The non-automatic changes require you to pay a user fee, which for most requests is $2,500.
We do not know what the future holds, but all indications lead us to believe we are entering a period of lower tax rates for both corporation and individuals with our new president. The current maximum corporate tax rate is 35% and the individual rate is 39.6%, plus the 3.8% for the Medicare surcharge tax. President Trump has stated he would like to lower the corporate tax rate to 15% and the individual rate to 33% as well as repeal the Medicare surcharge tax. If the tax rates decrease in 2017, as many are predicting, it means that your deductions will be worth more in 2016 than in 2017. The following are some accounting methods to consider as ways to accelerate deductions in the 2016 tax return to reduce your tax bill:
- A cost segregation study on a recent new building or remodeling project can increase depreciation expense by identifying property that can be classified as personal property instead of real property. This will change an asset life from 39 years to 5, 7, or 15 years and also may qualify for bonus depreciation.
- Many times it is advantageous for eligible banks to be on the cash basis for tax purposes. The reason is the accrued interest on loans at the end of the year is greater than accrued interest on deposits. The eligibility is different for C-corporation banks and S-corporation banks. A C-corporation bank has to have its three-year average annual gross receipts be less than $5 million. An S-corporation bank does not have an average annual gross receipts test but a total asset test. If an S corporation’s total assets are over $50 million, then the bank needs to file a non-automatic change in accounting method and pay the user fee.
- Many banks that are under $500 million in assets account for their tax bad debt expense on the experience method instead of the specific charge-off method. All banks that are over $500 million in assets are required to be on the specific charge-off method. Using the specific charge-off method, banks receive a tax deduction for their net charge-offs for the year. The experience method calculates the tax deduction based on a six-year moving average of net charge-offs compared to the base year. In certain situations, such as a bank that has a net operating loss (NOL) that could expire unused or has deferred tax assets that are disallowed for regulatory purposes, the bank can file an accounting method change to switch to the specific charge-off method. If a bank uses the experience method and changes to the specific charge-off method, it must recapture into income its tax bad debt reserve. The benefit of recapturing the tax bad debt reserve is that the bank can use its NOL before it loses its value when the tax rates change.
- The general rule for an expense deduction is if a benefit is created that is extended beyond the end of the tax year, then an asset is created and the expense is recognized ratably over that benefit. The best example of this is if a bank pays its annual insurance premium in December 2016 and its coverage is from December 1, 2016, through November 30, 2017, then a prepaid is created. The bank will only receive a tax deduction for one-twelfth of the insurance premium in 2016. In 2003 Regulation 1.263(a)-4(f) was enacted and allows an exception to the capitalization of prepaid expenses for tax purposes. It allows prepaids to be expensed if the benefit is used 12 months after the payment is made or by the end of the taxable year following the payment.
Other accounting method opportunities to accelerate tax deductions or defer taxable revenues could include methods of accounting for loan origination fees, mortgage servicing rights, discount accretion, accrual of real estate taxes, pension and retirement plan contributions, and so forth. There are numerous permissible accounting methods for tax purposes that differ from GAAP accounting, and contemplating these differences in accounting as part of your 2016 tax return filing could save your bank significant money in 2017, if tax rates do in fact go down.