Accelerating Bad Debt Deductions for Service Companies

David W. Swatosh, CPAEmail: david.swatosh@rehmann.com

Ext. 7147

August 16, 2010

Table of Contents

• Overview of Sec. 448(d)(5)• What types of companies are eligible?• Different methods of computing the deduction• Making the election to use this method• Examples – Time permitting

• Generally, Sec. 448(a) states, taxpayers are not allowed to use the cash receipts and disbursement method of accounting if it is a C Corporation, partnership with a C Corp partner, or a tax shelter.

Exceptions listed in Sec. 448(b)

Sec. 448 – Limitation on use of cash method of accounting

Sec. 448(d)(5) – Special Rules for Certain Services

• Generally, in the case of any taxpayer using an accrual method of accounting for amounts to be received for the performance of services then the taxpayer is not required to accrue any portion of such amounts which (on the basis of such person's experience) will not be collected if:

– The services are in the fields described in Sec. 448(d)(2)(A)

– The taxpayer meets the $5,000,000 gross receipts test

Eligible Fields of Service

• Sec. 448(d)(2)(A)– Health– Law– Engineering– Architecture

– Accounting– Actuarial Services– Performing Arts– Consulting

Exception to the General Rule

• This method cannot be applied to any amount if interest is required to be paid on any amount if paid late, or there is any penalty for failure to pay timely.

Non-Accrual Experience (“NAE”) Methods Treas. Reg. Sec. 1.448-2

• Applicable for tax years ending on or after August 31, 2006. For tax years prior to 8/31/06 and after 3/9/02 see temporary regulation.

• In general, in determining the portion of any amount due that, on the basis of experience, will not be collected, a taxpayer may use any NAE method that clearly reflects the taxpayer’s NAE, however, must comply with “self test” requirement.

• Or, Treas. Reg. Sec. 1.448-2 outlines 5 “safe harbor” NAE’s presumed to clearly reflect a taxpayers NAE.

Non-Safe Harbor Method

• A taxpayer using, or desiring to use, a nonaccrual-experience method must self-test its nonaccrual-experience method for its first taxable year for which the taxpayer uses, or desires to use, that nonaccrual-experience method (first-year self-test) and every three taxable years thereafter (three-year self-test). Each self-test must be performed by comparing the uncollectible amount (under the taxpayer's nonaccrual-experience method) with the taxpayer's actual experience.

Methods for Computing NAE

• 5 Safe Harbor NAE methods of accounting.– Revenue Based Moving Average Method– Actual Experience Method– Modified Black Motor Method– Modified Moving Average Method– Alternative NAE Method

Revenue Based Moving Average

• Multiply accounts receivable at the end of the current taxable year by a percentage.– % = Bad debts sustained, adjusted by recoveries received

during the applicable period divided by total revenue resulting in accounts receivable during the applicable period.

Bad debts sustained, adjusted by recoveriesTotal revenue resulting in accounts receivable

X Ending Accounts Rec.

Actual Experience Method

• Option A: Single Determination Date• Multiply accounts receivable at the end of the current

taxable year by a percentage and then increasing the result by 5%.– % = Bad debts sustained, adjusted by recoveries received

during the applicable period, by the determination date of the current taxable year related to the taxpayer's accounts receivable balance at the beginning of each taxable year during the applicable period divided by the sum of the accounts receivable at the beginning of each taxable year during the applicable period.

Actual Experience Method

• Option A: Single Determination Date

Bad debts sustained, adjusted by recoveries received during the

applicable period, by the determination date of the current taxable year related to the taxpayer's accounts receivable

balance at the beginning of each taxable year during the applicable period

Sum of the accounts receivable at the beginning of each taxable year

during the applicable period.

X Ending Accounts Rec. X 1.05

Actual Experience Method

• Option B: Multiple Determination Dates• Multiply accounts receivable at the end of the current

taxable year by a percentage and then increasing the result by 5%.– % = Sum of, for each taxable year during the applicable

period, bad debts sustained, adjusted by recoveries received that are allocable to the bad debts, by that taxable year's determination date and related to the taxpayer's accounts receivable balance at the beginning of the taxable year divided by Sum of accounts receivable at the beginning of each taxable year during the applicable period.

Actual Experience Method

• Option B: Multiple Determination Dates

Sum of, for each taxable year during the applicable period, bad debts sustained, adjusted by recoveries received that are

allocable to the bad debts, by that taxable year's determination date and

related to the taxpayer's accounts receivable balance at the beginning of

the taxable year

Sum of accounts receivable at the beginning of each taxable year during

the applicable period.

X Ending Accounts Rec. X 1.05

Modified Black Motor Method

• Multiply its accounts receivable balance at the end of the current taxable year by a percentage and then reducing the resulting amount by the bad debts written off during the current taxable year relating to accounts receivable generated during the current taxable year.– % = Bad debts sustained, adjusted by recoveries received,

during the applicable period divided by the sum of accounts receivable at the end of each taxable year during the applicable period.

Modified Black Motor Method

sum of accounts receivable at the end of each taxable year during the applicable

period.

Bad debts sustained, adjusted by recoveries

received, during the applicable period

Ending Accounts Rec.X -

Bad debts written off during the

current taxable year relating to

accounts receivable

generated during the current

taxable year.

Modified Moving Average Method

• Multiplying its accounts receivable balance at the end of the current taxable year by a percentage.– % = Total bad debts sustained, adjusted by recoveries

received, during the applicable period other than bad debts that were written off in the same taxable year the related accounts receivable were generated divided by the sum of accounts receivable at the beginning of each taxable year during the applicable period.

Modified Moving Average Method

(Total bad debts sustained, adjusted by recoveries

received, during the applicable period) – (bad debts that were written off in the same taxable

year the related accounts receivable were generated)

X Ending Accounts Rec.Sum of accounts receivable at the beginning of each taxable

year during the applicable period.

Alternative NAE Method

• A taxpayer may use the Alternative NAE method that clearly reflects the taxpayer’s actual NAE, provided that the alternative NAE method meets the “self-test” requirements (Safe Harbor Comparison Method)

• If a taxpayer is using one of the 4 “safe harbor” NAE method’s outlined in Treas. Reg. 1.448-2 then it is not subject to the self testing requirements.

Safe Harbor Comparison Method

• A taxpayer using, or desiring to use, a nonaccrual-experience method under the safe harbor in paragraph (f)(5) of this section must self-test its nonaccrual-experience method for its first taxable year for which the taxpayer uses, or desires to use, that nonaccrual-experience method (first-year self-test) and every three taxable years thereafter (three-year self-test).

• Each self-test must be performed by comparing the uncollectible amount (under the taxpayer's nonaccrual-experience method) with the uncollectible amount that would have resulted from use of one of the safe harbor methods described in paragraph (f)(1), (f)(2), (f)(3), or (f)(4) of this section.

NAE Requirements

• A taxpayer using, or desiring to use, a nonaccrual-experience method must self-test its nonaccrual-experience method for its first taxable year for which the taxpayer uses, or desires to use, that nonaccrual-experience method (first-year self-test) and every three taxable years thereafter (three-year self-test). Each self-test must be performed by comparing the uncollectible amount (under the taxpayer's nonaccrual-experience method) with the taxpayer's actual experience.

• A taxpayer using the safe harbor “Alternative NAE Method” must self-test using the “safe harbor comparison method” in paragraph (e)(3) of this section.

Change in Accounting Method

File Form 3115• Automatic Change Number 35, pursuant to Sec.

14.04 of Rev. Proc. 2008-52• Calculate Sec. 481(a) adjustment

Automatic Changes

Generally, automatic change for the following:1) Change to a safe harbor NAE method provided in § 1.448-2(f)(1) (the revenue-

based moving average method), (f)(2) (the actual experience method), (f)(3) (the modified Black Motor method), (f)(4) (the modified moving average method), or (f)(5) (the alternative nonaccrual-experience method);

2) Change to a periodic system (for further guidance, see, for example, Notice 88-51, 1988-1 C.B. 535);

3) Change from a NAE method to a specific charge-off method;

4) Change from a sub-method of its current NAE method provided in § 1.448-2 regarding applicable periods to another sub-method regarding applicable periods that is permitted under § 1.448-2, other than a change to exclude taxable years from an applicable period under § 1.448-2(d)(6);

5) Change from a sub-method of its current NAE method provided in § 1.448-2 regarding tracing of recoveries to another sub-method regarding tracing of recoveries permitted under § 1.448-2(f)(2)(iii);

Non-Automatic Changes

Generally, non-automatic change for the following, which require advance consent:

6) Change a sub-method unrelated to the applicable period or to the tracing of recoveries for a taxpayer currently using a NAE method provided in § 1.448-2(f);

7) Change to a NAE method other than a safe harbor method provided in § 1.448-2(f)(1) through (5)

Examples

• See Treas. Reg. 1.448-2(g)

Rehmann Services

• Analysis and cost/benefit• Tax filing requirements

Questions??

Please Note: This document is intended for internal training purposes only

NOTICE TO PERSONS SUBJECT TO UNITED STATES TAXATION: DISCLOSURE UNDER TREASURY CIRCULAR 230

The United States Federal tax advice, if any, contained in this document and its attachments may not be used or referred to in the promoting, marketing, or recommending of any entity, investment plan, or arrangement, nor is such advice intended or written to be used, and may not be used, by a taxpayer for the purposes of avoiding Federal tax penalties.

Circular 230 Statement