Accrual to Cash Basis

[Unregistered]

I have a client, who was a C-Corporation for 2003 and 2004 and on the accrual basis for those years. They made an S-Election effect for the tax year 2005. They are a Heating and Air Conditioning Company, no inventory. Their sales for 2005 was $1,700,000. They want to go to the cash basis of accounting since they carry a large A/R, restricting their cash flow for paying the taxes (which will reflect on the k-1) each officers k-1 will be $126,000.00. The A/R at the year end was $660,000.00. My questions is, since this is the first year of S-Corp, can we just make the change on the 1120S without filing the form
3115, they are on extension but running out.

I haven't yet figured out the difference manually what his tax would be if on the cash basis, I was first concerned about changing the method, since that is what the client wants.

So far for 2006 the profit on the accrual basis is $233,000.00 that a large tax liability for the owners on their 1040.

If you have any ideas that would help, I am open for suggestions... Thank you for all of your help...

Mandy

[BOB W]

Guest.......

Your client has an operational problem, not a tax problem. 40% of his annual sales is locked up in A/R, not good. Maybe he should void old invoices that are not collectible. Better followup is needed to collect his A/R.

My guess is that this company is in business less than 5 years or the kids took over the business. Running a business means turning sales into cash in the bank, anything less is a waste of time and money.

[Unregistered]

Watch out for Built in Gains

Built in Gains can be an issue where you have cash basis A/R

[OldJack]

The corporation tax adviser in all likelihood has given bad advice. A corporation with this level of income should probably not be a S-corp and dump all the income in high personal tax brackets.

I believe a form 3115 is required to change the method of accounting for this corporation.

A C-corp that elects S-corp status must maintain 3 sub-accounts of Retained Earnings Account. The AE&P (balance of retained earnings while a C-corp), the AAA account (earnings as a S-corp), and OAA (other S-corp not AAA).

Distributions as a S-corp:
AAA account - not taxable when distributed as profit added has been taxed on 1120S-k1 in year earned.

AE&P - Taxable as a dividend reported on 1099DIV (double tax as C-corp already paid tax). Your profit (from accounts receivable of $660,000 ) is in this retained earnings account and for them to get the money out now they are going to pay as ordinary taxable dividends as it can no longer be taken by way of salary to get a deduction (unless the year results in a loss with salary wipes out AAA). However, it would be capital gain if liquidating the corporation.

As a S-corp all income each year is reported taxable on the 1040. Thus, no ability to save taxes by splitting the 2 entity tax brackets for overall lowest tax. not a good thing.

Limited tax-free fringe benefits as a S-corp.

It would appear strange that this corporation should elect S-corp status.

[Snaggletoof]

Changeover

I agree with Bob W. About 170 days in Accts Receivable. I hope these are all Trade Receivables and officers and family is not tied up somewhere in this gargantuan number.
There can be many causes of inflated Receivables, but almost all of them fall under the category of mismanagement. Occasionally a large customer will go belly-up but even then there are warning signs.

One favorite is the salesman who brings in the orders with a smile and makes his sales to customers who are uncreditworthy. I encountered this once and suggested that his commission structure change to where it was payable only on collection. You would have thought I had shot his mother.

I believe there is a 9-year phase-in associated with a change in accounting method. Under the circumstances, I don't even think the IRS will approve it. I've only had a couple in my years of practice, and I think the taxpayer can opt out of the 9-year phase-in.

This customer has more problems than his accounting methods. I agree with Old Jack also - changing to a sub S appears to be a desperate move to address taxation, when taxation will only be made worse.

[OldJack]

Built-in-gains tax

I expect the 9 year phase-in you are talking about is actually the 10 year rule on built-in-gains tax for a S-corp and has nothing to do with a change in accounting. It has to do with changing from a C-corp to a S-corp.

The built-in-gains tax is actually a replacement tax for taking C-corp income out of the S-corp by way of selling the prior C-corp assets. On the day a C-corp elects S-corp status all assets are valued at fair-market-value to determine taxable gain as though they were being sold, however, that gain is not taxable until the S-corp sells the asset at which time the S-corp pays the built-in-gains tax on the S-corp tax return as though it was still a C-corp. But........ if the S-corp does not sell the asset until after 10 years, the S-corp does not have to pay the built-in-gains tax.

edit: BTW... not only does the S-corp pay built-in-gains tax on the sale of a prior C-corp asset, the 1120S-k1 also reports the gain on the sale to the shareholder for 1040 taxes (ye ol double tax).

[Snaggletoof]

Change in Accounting Method

The phase-in applies to change in accounting method only. All of the factors mentioned in converting with built-in gains are true, but were not addressed in the nine-year amortization. If I remember correctly, the taxpayer has the option of reducing the nine years to one year.

[veritas]

Your client has an operational problem, not a tax problem. 40% of his annual sales is locked up in A/R, not good. Maybe he should void old invoices that are not collectible. Better followup is needed to collect his A/R.

My guess is that this company is in business less than 5 years or the kids took over the business. Running a business means turning sales into cash in the bank, anything less is a waste of time and money.

"Running a business means turning sales into cash in the bank, anything less is a waste of time and money."

I like this quote may I use it?

[OldJack]

The phase-in applies to change in accounting method only. All of the factors mentioned in converting with built-in gains are true, but were not addressed in the nine-year amortization. If I remember correctly, the taxpayer has the option of reducing the nine years to one year.

Are you maybe referring to code § 481. "Adjustments required by changes in method of accounting." I believe that code §481 gives, under certain cases, the tax as an effect of the accounting change can be spread over 3 years.

[Snaggletooth]

3 years?

Jack, it may have changed. I was last involved in this issue 6-7 years ago.

[BOB W]

Years ago....

,,,,, when I ran seminars as a tool for attracting clients while I was building my practice I used that phrase as part of my presentation. Too many businesses are focused on getting sales and not enough energy making sure that they can get paid.

Hope it works for you with your clients..