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Method of Accounting for Security Deposits

Technical topics regarding tax preparation.
#1
Chay  
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Client has been in business for many years doing a commercial rental through an S corp, and has always accounted for security deposits as rental income and for deposit refunds as a reduction in income. This treatment was mirrored on the books and on the return.

It seems to me they've adopted a method of accounting. The closest analogue I can find to this situation is the treatment of Commodity Credit loans as loans instead of income, DCN 1 and Section 2.01 of Rev. Proc. 18-31. I'm thinking the method of accounting applies to all deposit amounts (as opposed to each deposit individually), no automatic change is available, and a change would be done on the cutoff basis if implemented.

Opinions?

Also, assuming I'm correct about all of that, what would you do in this situation? The cost of obtaining a non-automatic consent would be $2,800 to the corporation. The result would be that about $12,000 of deposits that could be received over maybe five years or so wouldn't be taxable income, and the taxpayer is at a marginal rate of 33.3% federal + state. How would you approach advising the client about this issue? Would you consider changing the method without obtaining consent?
 

#2
Coddington  
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The Commodity Credit Corp loans arise from a statutory election where a change in the election is treated as a method change under the regs. It does not seem like a good place to build an analogy. Instead start with CCA 201442050. (I should note that I think that CCA might involve Exxon, who is currently litigating a method change with similar issues. Their briefs would be helpful in coming to a decision.)

Unless the security deposits and refunds always net to zero, it seems like the unrefunded portion of the deposits would increase lifetime taxable income. If the item is defined at that level, then it would not be an accounting method change. If, on the other hand, you define the item to include the deposit, the repairs/maintenance/improvements that reduce the deposit, and the refund, then it should always net to zero and you could receive accounting method treatment. Personally, I am sympathetic to the first view, but the Humphrey, Farrington and McClain, P.C. v. Commissioner, T.C.Memo.
2013-23 case discussed in the CCA may be more apt.

For such small potatoes, I would probably disclose the relevant facts on Form 8275 and define the item to include only the deposit and the refunds. The taxpayer would just need to understand that the Service could challenge the change as an unauthorized method change until the statute closes on the year of change.
-Brian
Tax accounting methods and credits consultant for hire.

http://www.coddingtontax.com
 

#3
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I seem to recall that the rule is that if the security deposits are held in an operating account the way your client has treated them is correct. Of course, if he has kept them in a separate account then he is in error.
Because on T.A. ten was the most you were allowed
 

#4
Chay  
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Coddington wrote:For such small potatoes, I would probably disclose the relevant facts on Form 8275 and define the item to include only the deposit and the refunds.

Thanks for your advice. Under the position you suggested, the inclusion of the initial deposit amounts in income was an error rather than part of a method of accounting. So, when the deposits are refunded, there's no way to invoke the accounting method rules to allow a reduction in gross income.

My thought is that for tax purposes, the refunds would simply be treated as ordinary and necessary business expenses when the initial deposit was recognized as income. The client has multiple rental units with multiple deposits, some of which are still being held, so there will be additional refunds in future years. Because the treatment as expenses relies on the position that there was no accounting method, and that position is what calls for filing Form 8375, it seems like that form should be filed for any year there is a refund of an amount previously included in income. Am I on the right track here?

Tenletters wrote:I seem to recall that the rule is that if the security deposits are held in an operating account the way your client has treated them is correct.

I couldn't find anything to that effect from IRS sources. Their position is "[d]on't include a security deposit in your income if you may be required to return it to the tenant at the end of the lease".
https://www.irs.gov/taxtopics/tc414
 

#5
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It was something I remember from a business law class. Not a tax class or IRS pub.
Because on T.A. ten was the most you were allowed
 

#6
Coddington  
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The QA guys would agree with you on the annual filing requirement. I’d lean towards doing that until the SOL closes for the first year it happened under the Brookshire Bros case.
-Brian
Tax accounting methods and credits consultant for hire.

http://www.coddingtontax.com
 


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