Changing Your Accounting Method Text Size:

You initially choose an accounting method for your business when you file your first income tax return. Once you've set up your accounting method, you must get approval from the Internal Revenue Service (IRS) before you can change to another method. A company wanting to make a change must file Form 3115 in duplicate and pay a fee. One copy needs to be attached to your income tax return and the other copy must be sent to the IRS Commissioner.

Initial Accounting Method

Generally, you can choose any permitted accounting method when you file your first tax return. You don't need to obtain IRS approval to choose the initial accounting method. You must, however, use the method consistently from year to year and it must clearly reflect your income. You must also maintain records that will enable you to file a correct return. This includes your permanent books of account, and any other records necessary to support the entries on your books and tax returns.

IRS Initiated Change of Method

If you don't regularly use an accounting method that clearly reflects your income, your income will be refigured under the method that, in the opinion of the IRS, does clearly reflect your income.

Taxpayer Initiated Change of Method

Any company that is not currently under examination by the IRS is permitted to file for approval to make a change. In general, a current Form 3115 must be filed to request a change in either an overall accounting method or the accounting treatment of any item. A change in your accounting method includes a change not only in your overall system of accounting but also in the treatment of any material item. A material item is one that affects the proper time for inclusion of income or allowance of a deduction. Although an accounting method can exist without treating an item consistently, an accounting method is not established for that item, in most cases, unless the item is treated consistently.

The following are examples of changes in accounting method that typically require IRS approval:

• A change from the cash method to an accrual method or vice versa
• A change in the method or basis used to value inventory
• A change in the depreciation or amortization method

The following are examples of changes that aren't changes in accounting methods so they don't require IRS approval:

• Correction of a math or posting error
• Correction of an error in figuring tax liability
• An adjustment of any item of income or deduction that doesn't involve the proper time for including it in income or deducting it
• Certain adjustments in the useful life of a depreciable or amortizable asset

Timing

Applications can be made at any time during the tax year, but the earlier the better. Taxpayers are granted automatic six-month extensions provided they file income taxes on time for the year in which the change is requested. The amended tax returns using the new accounting method must also be filed within the six-month extension period.

Approval Process

In considering whether to approve a request for a change in accounting methods, the IRS looks at both of the following:

• Whether the new method will accurately reflect income
• Whether the new method will create or shift profits and losses between businesses

Adjustments to Taxable Income

Changes in accounting methods generally result in adjustments to taxable income, either positive or negative. If the total amount of the change is less than $25,000, the business can elect to make the entire adjustment during the year of change. Otherwise, the IRS permits the adjustment to be spread out over four tax years. If the accounting change is required by the IRS because the method originally chosen didn't clearly reflect income, the business must make the resulting adjustment during the current tax year.

Questions for Your Attorney

• How often can a company change its accounting method?
• What straight-line method changes require IRS approval?
• If the total amount of the change is less than $25,000, may a taxpayer spread the adjustment out over several years?

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