In this post, we’re delving into a topic that garners significant attention for a myriad of reasons: Form 3115 and the intricacies of accounting method changes. If you’ve ever explored the frequency with which this topic is searched, the results might surprise you.
A brief about my professional journey with Form 3115
I embarked on my career in 2012 with KPMG. Initially, I believed I was venturing into the realm of federal tax. However, I soon realized that while accounting methods do fall under tax, they present a distinct set of challenges. This led me to join the AMCs group. My initial roles were split evenly between compliance and methods and Credit Services. This experience was invaluable, introducing me to the complexities of Form 3115.
During this period, there was a significant shift in the regulatory landscape. Congress was introducing new laws concerning repair regulations. This posed a pivotal question for businesses, especially those with significant capital expenses like heavy equipment: Should maintenance costs be expensed or capitalized? This debate was particularly pronounced in Houston, a hub for oil and gas, where many businesses grappled with these capital expenditure decisions. Our office was at the forefront, pioneering the first repairs regulation study. The tool for these changes? Form 3115.
What is Form 3115 for?
At its core, Form 3115 is about altering accounting methods. These changes can be driven by various factors: regulatory shifts, strategic advantages, or rectifying past accounting errors. My experience in Houston highlighted the positive impact of these regulations. Many clients found themselves in a favorable position, able to deduct expenses more rapidly, leading to significant tax benefits.
Form 3115 serves a clear purpose: to inform the IRS of a change in your accounting method. These methods are broadly categorized into two: automatic methods, which are straightforward and favored by clients and practitioners, and non-automatic methods, which are more complex. If you’re looking to understand specific changes, the instructions at the end of Form 3115 provide a comprehensive list.
What is an accounting method?
In essence, an accounting method dictates how transactions are recorded, encompassing both income and expenses. It’s the foundational framework that determines how businesses recognize and report their financial activities.
How is an accounting method established?
Recording income and expenses using permissible methods in any year establishes a specific accounting method.
However, if you use an impermissible method for two consecutive years, this too becomes an established method. Notably, if this impermissible method is used for just one year, it doesn’t establish a method. This means you have NOT established a method. Instead, you would need to amend the return for that year. But as mentioned, if the impermissible method is used for two years, rather than amending, you’d file a Form 3115. This is a crucial detail that many might overlook.
Examples of accounting methods
One primary example of an accounting method is income recognition via the cash or accrual method. These methods are particularly relevant for small businesses.
It raises the question: Should income be reported to the IRS when received or when accrued? For many business owners, it’s logical to record income when received. However, in some scenarios, it’s more beneficial to record when accrued, especially considering the expense side. The decision hinges on whether expenses are recorded when cash is spent or when they are accrued. The best method often mirrors the business’s reality and minimizes adverse tax implications.
When do you need to change your accounting method?
The need to change an accounting method can arise from various reasons. Perhaps the current method is incorrect, or a more permissible method has been identified. Sometimes, regulatory changes, such as new laws passed by Congress, mandate a specific method. Form 3115 encompasses all these scenarios, from regulatory shifts to tax benefits and business growth considerations. For instance, a business categorized as “small” (earning under $25 million) might transition to a “large” business based on a three-year revenue average. This transition can automatically trigger certain accounting methods.
Navigating Form 3115
Automatic or Non-Automatic Changes
As discussed previously, the instructions at the end of Form 3115 provide an extensive list of automatic changes. When considering making an accounting method change, the first step is determining whether it is an automatic or non-automatic change.
Finding Automatic Changes
When I’m trying to change a specific accounting method, I often use the CTRL+F function to search for keywords related to the desired method. For instance, if I’m working with a construction company aiming to alter their revenue accounting to the percentage of completion method, I’d search for “percentage of completion.” If this doesn’t yield results, I’d manually sift through the method changes. However, be prepared: there are hundreds of automatic accounting method changes. If you can’t pinpoint a specific change using this shortcut, finding the right method can be time-consuming.
When To File
When filing Form 3115, there’s typically a “when to file” section in the instructions. Generally, you should submit it with a timely follow-up return. This involves sending a signed copy to a designated IRS location responsible for reviewing accounting method changes. Additionally, attach another signed copy to your tax return for that year. This primarily pertains to automatic changes. Delving into non-automatic changes isn’t our focus here, as they’re more intricate. These require a review fee and, since they’re not automatic, they undergo a manual review process, which can be pricier and more time-consuming. Ideally, if you’re aiming for a method change, it’s best to find an automatic change and adhere to its instructions.
Often, the instructions will reference a “rev proc” for further details. This rev proc provides comprehensive information about eligibility and specific stipulations for the method change. If the method change you’re considering refers to a rev proc, it’s crucial to read and understand it. The automatic method change descriptions in the Form 3115 instructions are typically brief, spanning only a few sentences. For a thorough understanding, consulting the referenced rev proc is essential.
Selecting The Correct Change Number
Furthermore, while many parts on the Form 3115 might seem irrelevant, their relevance depends on the specific method change you’re pursuing. When you identify your method change, it will indicate which sections to complete, or the rev proc will provide this guidance. Key elements to focus on include the specific method you’re adopting and the automatic change number. Remember, Form 3115 can accommodate multiple method changes, so ensure you’re attentive to all details.
A common pitfall with Form 3115 is overlooking its intricate instructions or failing to select the appropriate automatic change number. Additionally, depending on the accounting method you’re transitioning to, you might need to list any previous methods you’ve changed. For example, if you’re switching from a cash to accrual method (or vice versa), there’s generally a five-year window before you can revert. The IRS wants to ensure compliance by knowing if such a change has occurred in the past five years.
Form 3115 is a pivotal tool for businesses navigating the complexities of accounting method changes. Whether driven by regulatory shifts, strategic advantages, or the need to rectify past accounting errors, understanding the intricacies of this form is crucial. With the ever-evolving landscape of tax regulations and the nuances of accounting methods, it’s essential to stay informed and seek expert guidance when needed. For those looking for professional assistance or further insights into Form 3115 and other accounting topics, visit jagcpa.com.
About The Author
Joe is s a Certified Public Accountant (C.P.A.) and a Certified Valuation Analyst (C.V.A.). Joe’s professional career in public accounting began in 2012 with one of the “Big 4” internationalaccounting firms. Since 2012, the focus of his professional engagements has been primarily in the area of business tax planning, cash flow planning and management, business valuations, and small business financial consulting.