Section 446 and Permissible Accounting Methods

For federal income tax purposes, an accounting method is the consistent set of rules a taxpayer uses to determine when to report income and deduct expenses. This applies to a taxpayer’s overall system and the specific treatment of any single item. Internal Revenue Code (IRC) Section 446 provides the framework for these methods, requiring that a taxpayer’s chosen method be the one used to compute income while keeping their books. The function of these rules is to ensure income and expenses are accounted for in the appropriate period.

Permissible Methods of Accounting

The Internal Revenue Code permits several accounting methods, with the two most common being the cash and accrual methods. Under the cash method, a taxpayer includes income in the taxable year it is received and deducts expenses in the year they are paid. This method is straightforward and is commonly used by individuals and many small businesses.

The accrual method requires income to be reported when all events have occurred that fix the right to receive it and the amount can be determined with reasonable accuracy, known as the “all-events test.” Expenses are deducted when all events have occurred that establish the liability, the amount can be determined, and economic performance has occurred. This method provides a more accurate picture of financial performance by matching revenues with the expenses incurred to generate them.

The use of the cash method is restricted for certain entities under IRC Section 448, including C corporations, partnerships with a C corporation partner, and tax shelters. However, an exception exists based on a gross receipts test. A business may use the cash method if its average annual gross receipts for the three prior taxable years do not exceed a certain threshold, which is adjusted for inflation. For 2024, this amount is $30 million.

The tax code allows for other methods, including special treatments for items like inventory or depreciation. Taxpayers may also use a hybrid method, which combines features of both the cash and accrual methods. For instance, a small business might use the cash method for most items but be required to use an accrual method for tracking inventory.

The Requirement to Clearly Reflect Income

A guiding principle for accounting methods is that they must clearly reflect income. This standard gives the Internal Revenue Service (IRS) significant authority. If the IRS determines a taxpayer’s method does not clearly reflect income, it can recompute the taxpayer’s income using a method that it deems appropriate. This authority acts as a safeguard against distorting taxable income.

The concept of clearly reflecting income is not explicitly defined in the tax code but is understood to mean the method must be fair and honest in its application. Consistency is a component of this standard, meaning a taxpayer cannot switch between accounting methods from year to year simply to reduce their tax bill. The consistent application of a method ensures that income and expenses are treated uniformly over time.

A method that follows Generally Accepted Accounting Principles (GAAP) may be regarded as clearly reflecting income, but this is not a guarantee. Tax law and GAAP have different objectives, as tax law is designed to collect revenue while GAAP focuses on providing useful information to investors. A practice acceptable for financial reporting may not be permissible for tax purposes if it fails to clearly reflect income to the IRS.

Information Required to Change an Accounting Method

A taxpayer who wishes to change their accounting method must file Form 3115, Application for Change in Accounting Method. This form requires a thorough analysis of the taxpayer’s current and proposed methods and the justification for the change. The taxpayer must identify their present accounting method for the item being changed and provide a detailed description of the proposed new method.

A component of this process is the calculation of the Section 481 adjustment, which is designed to prevent items of income or expense from being duplicated or omitted. For example, if a business switches from the cash to the accrual method, there may be accounts receivable that have been earned but not yet reported as income. The adjustment captures this amount and ensures it is included in taxable income.

The calculation involves comparing what the taxpayer’s income would have been in prior years using the new method to what was actually reported. An increase to taxable income is a positive adjustment, while a decrease is a negative adjustment. This calculation must be attached to Form 3115 and forms the basis for how the tax impact of the change is spread over one or more years.

The Process for Changing an Accounting Method

To change an accounting method, a taxpayer must obtain consent from the IRS by filing Form 3115. There are two pathways for obtaining this consent: automatic and non-automatic. The correct procedure depends on the specific type of accounting method change being requested, as outlined in IRS revenue procedures.

For an automatic change, the taxpayer does not pay a user fee, and consent is considered granted if the form is completed correctly and filed on time. A copy of Form 3115 is attached to the taxpayer’s timely filed federal income tax return for the year of the change. The original form is filed with the IRS according to current instructions.

For non-automatic changes, the taxpayer must file Form 3115 with the IRS National Office during the tax year for which the change is requested and pay a user fee. The taxpayer must wait to receive a formal letter ruling from the IRS granting permission for the change. The IRS may request additional information before making a determination.