I hardly ever go on LinkedIn. Every time I go on there, it seems as if I am inundated with sales pitches.
By chance I clicked on the newsfeed and saw a post. What got my attention was this guy’s post of a picture of a redacted letter from the Florida Department of Revenue (FDR) showing an amount due of $500. The post stated this guy’s client owed an amount to the tune of $40,000 to the FDR, but this guy changed the method of accounting and got the bill down to $500.
Now, I hate when someone boasts and brags about tax stuff. I have certainly done this before but not for a very long time. I don’t reply to posts, but this was an exception. So I wrote, “before you take your victory lap, you might want to wait for the impending IRS audit.”
There are a few reasons to file Form 3115, which is the application for change in accounting method, and one of those is if you have a Cost Segregation Study. A Cost Segregation Study is when a company comes into one of your client’s place of business and reassess their fixed assets by breaking each asset down from a catch-all classification and longer recovery period to a shorter recovery period.
The promoters of these studies claim that the study, in and of itself, will not trigger an IRS audit. However, with an aggressive stance on depreciation, which can significantly increase deductions, there is a risk. The IRS even has an audit technique guide that addresses Cost Segregation Studies. These studies are costly and could leave collateral damage. Be very careful with them.
Most small businesses choose the Cash Method of Accounting. Under the cash method, income is recognized when it is received and expenses when paid. In most cases, I prefer the Accrual Method of Accounting. Under accrual, income is recognized when earned, and expenses when incurred. When a business meets certain income limits, then the conversion from cash to accrual is automatic. However, if those limits are never met, you should stick with the method of accounting that you started with or inherited.
If you file Form 3115 to change your method of accounting, what you are telling the IRS is that you have never calculated income and expenses correctly. Anytime you draw attention to the fact that you are not calculating income or expenses correctly, the IRS may want to take a second look.
In choosing a method of accounting, we are supposed to weigh the options and select the correct method of accounting that clearly reflects the business’s income and expenses. The absolute correct method is Generally Accepted Accounting Principles (GAAP). The closest method of accounting for tax to GAAP is the accrual method of accounting. For example, every business has customers or clients that owe them money, and people or companies that the business owes money to. This is why there are accounts receivable and accounts payable on most businesses’ balance sheets. However, under the accrual method for tax the income derived from accounts receivable balances isn’t necessarily income, and the balances in accounts payable aren’t necessarily expenses.
The reason for these statements is that going back to the definition I used earlier — income is recognized when earned and expenses when incurred. The best example of this is, let’s say you receive a retainer of $5,000 and your hourly rate is $275. By the end of the year you have only billed five hours against the retainer. Your earned income, under the accrual method of accounting for tax, is $1,375, while the rest of the unearned income is a liability to the company.
Going back to what I said about GAAP, it is the clearest reflection of income and expense. I asked one of my employees the other day, “If I have an audited, reviewed, or compiled financial statement, can I prepare a tax return with that statement?” His answer is what gets most CPAs into trouble. He said yes. The correct answer is no. The statements need to be converted to the Income Tax Basis of Accounting. Under the Income Tax Method of Accounting, certain income has to be adjusted to what is earned and expenses that the company is under contract to pay, can be accrued out for three months.
Please, no hate mail. Not all CPAs make this mistake. However, I have been in practice since 1994, and I have seen most CPAs do a tax return based on an audited, reviewed, or compiled statement. In fact, it wasn’t until recently that the AICPA entertained the idea of a financial statement prepared under the Income Method of Accounting.
The point I am making is that, yes, you can change the method of accounting and perhaps save a client a lot of money. However, does your ego have to be fed, or are you truly looking out for your client?
The last thing I want to do is possibly trigger an IRS audit for something that I did and expose myself to a potential liability of a lawsuit.
Craig W. Smalley, EA is the CEO and Founder of CWSEAPA®, PLLC, located in Orlando, Florida, with clients all over the country in every industry. He has been admitted to practice before the IRS as an Enrolled Agent, and has a Master's Certificate in Taxation from UCLA. He has been in practice since 1994, specializing in individual, partnership...