IRS Modifies Guidance for Terminated S Corps Changing from Cash to Accrual Accounting

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This story was published in December 2018

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In Revenue Procedure 2018-44, the IRS modified Revenue Procedure 2018-31 to add temporary rules for corporations changing from a cash to an accrual method of accounting in connection with revoking S corporation status.

Under tax reform (the Tax Cuts and Jobs Act of 2017), C corporations are now taxed at a flat rate of 21 percent, but the top individual tax rate remains high at 37 percent. This naturally provokes a discussion on whether a C corporation would be a better choice of entity under tax reform. This is a very complex question that requires in-depth analysis.

Typically, a C corporation’s earnings and profits are taxed at the corporate level and then its dividends are taxed again at the shareholder level, which increases the effective tax rate higher than 21 percent. Operating as a C corporation involves additional complexity, as C corporations are more regulated than S corporations. However, C corporations offer limited liability protection to shareholders, as they operate as a separate legal entity from the owners, and provide much more tax planning opportunities to reduce taxable income.

An S corporation’s taxable income is taxed at the individual level, and it may be reduced by a 20 percent deduction for qualifying business income under tax reform. However, if an S corporation revokes its S corporation status to take advantage of the lower C corporation tax rate, it would have to wait five years to revert back to S corporation status.

Further, S corporations generally use a cash method of accounting; many C corporations must use an accrual method of accounting. Thus, when a corporation using a cash method of accounting terminates its S election, it may be required to change to an accrual method of accounting for its first C corporation year.

Congress recognized that the corporate income and individual tax rate changes enacted under tax reform might result in many S corporations electing to terminate S corporation status and, in turn, be required to change to an accrual method of accounting. In so doing, Congress added Section 481(d)1 to the tax code, requiring eligible terminated S corporations to take into account ratably over six years, beginning with the year of change, any Section 481(a) adjustment resulting from the revocation of an S corporation election.

Section 481(d)(2) defines an eligible terminated S corporation as any C corporation that was an S corporation on Dec. 21, 2017; that revokes its S corporation election after Dec. 21, 2017, but before Dec. 22, 2019; and that has the same shareholders owning the corporation’s stock in identical proportions on Dec. 22, 2017, and on the date the revocation is made.2

The Tax Cuts and Jobs Act also allows more taxpayers to use the cash method of accounting by increasing the threshold for the gross receipts test from $5 million to $25 million. Under tax reform, taxpayers satisfy the gross receipts test if their annual average gross receipts do not exceed $25 million for the period of the three prior tax years.3 The $25 million amount applies to tax years beginning after Dec. 31, 2017, and is indexed for inflation for tax years beginning after 2018.4

Revenue Procedure 2018-44

Revenue Procedure 2018-44 provides temporary rules for corporations changing from a cash to an accrual method of accounting when revoking its S corporation status.

Revenue Procedure 2018-44 requires an eligible terminated S corporation that must change from a cash method to an accrual method of accounting as a result of a revocation of its S corporation election – and makes the accounting method change for the first tax year it is a C corporation – to take into account the Section 481(a)(2) adjustment, both positive or negative, ratably over a six-year period beginning with the year of change.5 In general, the taxpayer takes a net negative Section 481(a) adjustment into account in the year of change, and a net positive Section 481(a) adjustment into account over four years (year of change and the next three taxable years). An eligible terminated S corporation that is permitted to continue to use the cash method after the revocation, but wants to change to the accrual method for the first tax year it is a C corporation, may also take into account the Section 481(a)(2) adjustment, both positive and negative, ratably over the six-year period beginning with the year of change. Such a corporation must indicate in the statement required by line 26 of Form 3115 that it is making an accounting method change with the spread period allowed under Section 15.01(3)(a)(ii)(B) of Revenue Procedure 2018-31.6

The new rule related to Section 481(a) adjustments could be beneficial to an eligible terminated S corporation with a positive Section 481(a) adjustment resulting from the revocation of the S corporation election, as the impact of the unfavorable change would be spread over a six-year period. On the other hand, if such revocation results in a negative Section 481(a) adjustment (i.e., a favorable Section 481(a) adjustment), an eligible terminated S corporation wouldn’t be able to enjoy immediate reduction of taxable income in the year of change provided under the general rule.

Revenue Procedure 2018-44 only applies to a change to the accrual method of accounting, not to any other changes in method of accounting that result in adjustments required by Section 481(a) that are attributable to a corporation’s revocation of its S election.

Conclusion

Revenue Procedure 2018-44 requires an eligible terminated S corporation that changes its overall method of accounting to the accrual method for the first tax year it is a C corporation to take into account a positive and negative Section 481(a)(2) adjustment ratably over a six-year period beginning with the year of change. This could be an unintended consequence resulting from the revocation of the S corporation election, and all possible tax implications should be taken into consideration before an S corporation makes a final decision on this matter.

Further, the IRS limits the scope of Revenue Procedure 2018-44 to a Section 481(a) adjustment required by a change to an accrual method of accounting that is only attributable to a corporation’s revocation of its S election.  

1 Public Law 115-97, Section 13543, 131 Stat. 2155.
2 Id.
3 Public Law 115-97, Section 13102, 131 Stat. 2102.
4 Id.
5 Section 3.01 of Revenue Procedure 2018-44.
6 Id.

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Brendan P. Cox, CPA, is a member of both the Pennsylvania CPA Journal Editorial Board and the PICPA Federal Taxation Committee. He can be reached at bpcox1970@gmail.com.