Charlene and Yousaf ask:
Both Charlene and Yousaf had a question about 481a this month. It must be a good one! Charlene said: Our client, an S corp., has other income on line 10 which includes 481 income. The client changed his accounting method and had $200K added to his income for the last 3 years. This year there is no $200K.
The lender wants to subtract $200K from each of the prior 3 years to figure out the company’s debt ratio. The senior underwriter and I never saw this one. A QC investor saw this. This adjustment will sink the loan if handled in this method. Your thoughts?
Linda says:
The 481(a) adjustment only comes into play when a taxpayer changes their accounting method, and we just do not see that all of the time. So as with many other items, the simplifying assumption is that you look at ‘Other Income’ on line 10 and leave it in if it appears to be recurring. And clearly, if you had those three years, it was recurring.
Let me explain what is causing it. Then I’ll weigh in on whether to use it or not.
A cash-basis taxpayer switches to accrual basis.
The company received a $300k deposit in December of the cash-basis year and earned the revenue in January of the accrual-basis year.
Year One: Cash Basis company recognizes $300k as part of their taxable income because it was received that year.
Year Two: Accrual Basis company recognizes $300k as part of their taxable income because it was earned that year.
The company files a Form 3115 Change in Accounting Method and calculates how much it will be over-reporting revenue due to the change.
In this case, there is $300k over-reported which will be included on Line 10 of Year Two (accrual-basis) as a negative 481(a) adjustment.
A cash-basis taxpayer switches to an accrual basis.
The company earned $300k in December of the cash-basis year which they received in January of the accrual-basis year.
Year One: Cash Basis company recognizes none of the revenue because it was not yet received.
Year Two: Accrual Basis company recognizes none of the revenue because it was earned in the previous year.
Since they are under-reported, they must add the under-reported amount on Line 10 of Year Two. But if it is over $50,000, they may spread it out over four years (the year of the change plus three more years).
What best predicts cash flow?
Now that you understand what happened, let’s talk about what best predicts cash flow. If your analysis of two or three years includes the year before and after the change, you will be off if you do not include the adjustment from Line 10. It is absolutely necessary to avoid either double-counting income (example one) or not counting income at all (example two).
But if your analysis does not include the year before the change, as in the example that it is all the accrual-basis returns, then leaving off the Line 10 figure makes sense because it is income accrued in the year before the change.
To be absolutely correct, if they are still in the four-year window to add the not-yet-reported income from the year before the change, you’d need to add the entire amount they will include (all four years) if you know that amount.
As to your example, if the total of the three years is $600k and the year before the change is still in the averages, the $600k needs to be included. If the year before the change has dropped out, the $200k each year needs to be left out to accurately reflect the accrual-basis ratios.
DOES THAT MAKE SENSE?
This is pretty rare which is why you have not seen it. And in the past, it is quite possible no one spotted it even if it was there.
More questions?
Anyone can ask. I always answer. Here is the link to my contact page.
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