Accounting method changes under Rev. Rul. 90-38.

Accounting Method Changes under Rev. Rul. 90-38

Tax Executives Institute (TEI) is concerned about the tax policy and administration implications of Rev. Rul. 90-38, 1990-1 C.B. 57. Rev. Rul. 90-38, which was issued by the Internal Revenue Service on April 10, 1990, holds that a taxpayer may not, without the Commissioner's consent, retroactively change from an erroneous to a permissible method of accounting by filing an amended return, even if the period for amending the return for the first year in which the erroneous method was used remains open.

Summary of Position

TEI respectfully submits that the position set forth in Rev. Rul. 90-38 is wrong and that it represents a questionable and unnecessarily harsh interpretation of the tax law. Whether or not legally defensible, Rev. Rul. 90-38 embodies unwise tax policy:

* It creates an imbalance between the rights of taxpayers and the IRS in circumstances where equal treatment is more appropriate.

* It undermines the IRS's objectives of encouraging good accounting practices and ensuring clear reflection of income.

* It is fundamentally inconsistent with basic rights granted taxpayers by Congress in establishing the statue of limitations for filing amended returns (and refund claims).

For the foregoing reasons, TEI believes that the ruling be withdrawn and replaced by a more flexible and balanced approach. Specifically, the IRS should adopt the following two-pronged test for automatically granting requests for a retroactive change in a method of accounting:

* The request must be for a change from a clearly erroneous to a permissible method; and

* The first use of the erroneous method must be in a year for which the statute of limitations on assessment remains open, and the permissible method must be consistently applied in that and all subsequent years.

The balance of this letter discusses the background of Rev. Rul. 90-38, details TEI's reasons for believing it represents a questionable interpretation of the tax law and bad tax policy, and explains why the adoption of the Institute's recommendations will vindicate the legitimate interests of both taxpayers and the government.

Background

Rev. Rul. 90-38, 1990-1 C.B. 57, reconsiders the factual situation in Rev. Rul. 70-539, 1970-2 C.B. 70. In Rev. Rul. 70-539, a corporation that was engaged in developing real estate capitalized interest, taxes, and carrying charges in the tax basis of its property in the first three tax returns it filed. In the fourth year, the taxpayer determined that this method of accounting was erroneous because the election statement required by the regulations under section 266 had not been filed. Since the year in which the erroneous capitalization method was first used remained open, the taxpayer filed a claim for that year to adopt as its accounting method the expensing of interest, taxes, and carrying charges. Expensing was deemed a permissible method in the absence of a valid election to capitalize. The IRS held in Rev. Rul. 70-539 that the claim, made on a timely filed amended return for the first year of use, was allowable.

In Rev. Rul. 75-56, 1975-1 C.B. 98, the IRS clarified that a change from an erroneous to a permissible method of accounting is not allowable where the year of first use of the erroneous method is closed. Thus, in that ruling, the taxpayer's erroneous method of accounting was deemed to have been previously adopted because the statute of limitations for the year of first use had expired. Prior adoption of the erroneous method triggered the requirement in section 446(e) of the Code and Treas. Reg. [section] 1.446-(e) that the Commissioner's consent to a change be obtained. Because the taxpayer had not timely sought the Commissioner's consent, its claimed deduction based on the permissible method of accounting was denied. Rev. Rul. 75-56 distinguished Rev. Rul. 70-539 by noting that the taxpayer in the earlier ruling, by timely amending its first return, was effectively adopting (not changing) its method of accounting.

In Rev. Rul. 90-38, the IRS revoked Rev. Rul. 70-539. It also modified Rev. Rul. 75-56 to eliminate any inference that the statute of limitations for the year of first use must have expired for the taxpayer to have adopted a method of accounting and, consequently, revoked the modified 1975 ruling as obsolete. Specifically, Rev. Rul. 90-38 holds that the filing of returns for two consecutive years using an erroneous method of accounting constitutes adoption of that method of accounting. Such adoption triggers the prior consent rule of section 446(e) and Treas. reg. [section] 1.446-1(e)(2)(ii).

The Decision in Diebold

In support of its conclusion, Rev. Rul. 90-38 cites Diebold, Inc. v. United States, 16 Cl. Ct. 193 (1989), aff'd, 891 F.2d 1579 (Fed. Cir. 1989), cert. denied, __U.S.__ (U.S. Oct. 1, 1990) (No. 89-1999). In Diebold, the Claims Court denied the taxpayer permission to convert its method of accounting from an asserted erroneous method to a permissible method of filing amended return. Diebold sought to switch from the inventory method of accounting for rotatable spare parts to the depreciation method. In awarding summary judgment to the government, the Claims Court held that filing returns for two consecutive years using an erroneous method of accounting constituted "regular" use and, hence, adoption of the method. This triggered the requirement that the Commissioner's prior consent be obtained by means of the Form 3115 procedure set forth in Treas. Reg. [section] 1.446-1(e)(3).

In considering the validity of Rev. Rul. 90-38, three aspects of the Diebold decision should be noted. First, the courts acknowledged conflicting interpretations by other courts on the question of when the Commissioner's consent is required for a change from an erroneous method. Second, the year of first use of the erroneous method was a subject of dispute between the parties in Diebold, with the IRS apparently asserting that the adoption of the inventory method was in a closed year. (1) Third, like many change-in-method cases, Diebold involved not only the policy issue whether a taxpayer should be permitted to change from an impermissible method of accounting, but also the factual question whether the taxpayer's proposed action constituted a method change at all (as opposed to the correction of an error). Although the two questions are intimately intertwined, (2) in this letter we address only the policy issue.

Taxpayers' Right to File

Amended Returns

Section 6511 of the Code, which is captioned "limitations on Credit or Refund," sets forth basic rules governing the time within which taxpayers may file claims for refund. Section 6511 offers basic protection to the Commissioner against stale claims and administrative inconvenience, but it also accords taxpayers a clear window in which to correct errors discovered in prior tax filings, whether in their own or in the IRS's favor.

Taxpayers' obligation to make such corrections is set forth in Treas. Reg. [section] 1.461-1(a)(3), which provides, in part --

If a taxpayer ascertains that a deduction should have been claimed in a prior taxable year, he should, if within the period of limitations, file a claim for credit or refund of any overpayment of tax arising therefrom. Similarly, if a taxpayer ascertains that a deduction was improperly claimed in a prior taxable year, he should, if within the period of limitation, file an amended return and pay any additional tax due.

In crafting section 6511, Congress clearly contemplated that taxpayers would from time to time make errors of law or fact in the IRS's favor and would later discover and need to correct those errors. TEI submits that restrictions on any taxpayer's statutory right to correct errors in its returns in a timely manner should be both narrowly crafted and expressly authorized by statute.

The Limits of Section 446(e)

Section 446(e) of the Code carves out an appropriate exception to taxpayers' rights under section 6511. (3) When a taxpayer initiates a change from one method of accounting to another after using the first method in tax years inaccessible to the IRS because the statute of limitations has expired, the government's revenue can be threatened by double deductions, excluded income, or distortion of income. A principal purpose of section 446(e) is to prevent such "whipsaws" and potential income distortions.

TEI submits that the overriding purpose of section 446(e) must be kept in mind in constructing barriers to a taxpayer's filing amended returns to correct erroneous methods of accounting. Thus, the requirement that taxpayers secure the Commissioner's consent to a method change should not be construed to eviscerate the right to correct errors, especially where the timely correction of those errors by the filing of amended returns would neither produce an untoward "whipsaw" nor otherwise offend any substantive tax law principle.

For example, when the tax year in which the erroneous method was first used remains open and the taxpayer proposes to make the change for all affected years, no possibility exists for double deductions, excluded income, or other income distortions. By definition, income must be more clearly reflected by the permissible method that the taxpayer proposes to adopt than by the erroneous method reflected in its filings. Consequently, any purported justification for restricting a taxpayer's right to avail itself of section 6511 in this circumstance dissipates.

Although the accounting provisions of the Code have on occasion been elevated above its substantive provisions, the rationale for such a pre-emption has always been to achieve a clearer reflection of income. (4) That rationale, however, is not furthered by Rev. Rul. 90-38. Indeed, under the ruling, the fundamental, statutory right to file amended returns is sacrificed to vindicate a rigid accounting rule in circumstances where the result, by definition, will be to reflect income less clearly.

Section 446(e) was not meant to place taxpayers that make an inadvertent, good faith mistake at the mercy of the Commissioner; it should not be interpreted to preserve distortions in the government's favor. Consequently, a taxpayer should be permitted to change its method without securing the Commissioner's consent as long as the statute of limitations remains open for the first year of use.

Specifically, the IRS should rule that where the statute of limitations for the first year of use remains open, section 446(e) will not apply because the taxpayer will not be treated as having "regularly used" the method of accounting at issue. (The Commissioner's authority to withhold consent to a method change extends only to changes in the method of accounting on the basis of which the taxpayer "regularly computes" its income.) Holding that an accounting method will not be deemed "regularly used" until the year of first use is statute barred reflects a proper balance of the taxpayer's rights under section 6511 and the policy underlying section 461(e). See Silver Queen Motel v. Commissioner, 55 T.C. 110 (1971).

Rev. Rul. 90-38 Represents

Unwise Tax Policy

Withouth regard to the IRS's legal authority to issue Rev. rul. 90-38, the revenue ruling represents unwise tax policy for the following reasons:

1. The Ruling Is Asymmetrical 

Rev. Rul. 90-38 introduces a fundamental asymmetry between the rights of taxpayers and the IRS. The IRS retains the right to correct errors in all open years, whereas the taxpayer is denied the right to correct errors in open years for which a subsequent year's return has been filed. "Heads I Win, Tails You Lose" rules cannot help but undermine taxpayer confidence in the fairness of the system.

2. The Ruling Will Perpetuate 

Erroneous Methods

Rev. Rul. 90-38 sanctions the perpetuation of erroneous accounting methods by blocking changes to correct methods even in those situations where an erroneous method was used and even where no "whipsaw" potential exists. TEI submits that taxpayers should be encouraged to use the best possible accounting practices regardless of the revenue effect and that the IRS's administrative procedures should facilitate the correction of errors, not their perpetuation.

3. The Ruling Will Exacerbate

Compliance Burdens

Rev. Rul. 90-38 unnecessarily complicates taxpayer's compliance efforts by imposing a tight and artificial deadline for discovering such errors (i.e., before a second return is filed). In the current tax environment where taxpayers and the IRS alike frequently grapple to apply ever-more-complicated tax laws, preservation of a taxpayer's right to correct prior errors in a timely manner -- within the period prescribed by section 6511 -- is more important than ever.

4. The Ruling Provides

Insufficient Guidance

to Field Personnel

Rev. Rul. 90-38 allows discretion to field personnel to effect retroactive method changes without offering guidance on the use of that discretion. This lack of guidance has led to inconsistencies and disparate treatment of similarly situated taxpayers. The ruling also provides an incentive for agents to stretch the definition of accounting method to encompass clerical errors, oversights, and misunderstandings, because such an approach affords the IRS with the means of avoiding the merits of the taxpayer's claims. Thus, examining agents in some cases have adopted a sweeping interpretation of what constitutes a method change, apparently to render unnecessary any consideration of the merits of the proposed method change.

5. The Ruling Is Aimed at

Chimerical Abuses

Rev. Rul. 90-38 is a classic example of "bad facts" giving rise to "bad law."

The ruling seizes upon an atypical situation in which a potential for abuse arguably exists and, then, prescribes a "cure" that disadvantages taxpayers in circumstances where not even the potential for abuse exists. TEI acknowledges that there are some situations (such as that presented in Rev. Rul. 70-539) where the taxpayer has the option of choosing between two permissible methods of accounting and that, with the benefit of hindsight after the return has been filed for the year of first use, the taxpayer may rethink its choice; in those situations, the IRS may have a legitimate interest in guarding against so-called adverse selection (even where the taxpayer can point, as was the case in Rev. Rul. 70-539, to a technical error that prevented its valid adoption of the first method). (8)

In the more usual situation reached by Rev. Rul. 90-38, however, the taxpayer does not elect among permissible methods when it files its returns. Rather, it inadvertently or otherwise institutes a method not properly available to it under any circumstances. To require the Commissioner's consent where the taxpayer seeks to change from an always-erroneous and unavailable method to a permissible method is neither necessary nor appropriate.

Recommendations

Rev. Rul. 90-38 does not vindicate or further any legitimate purpose of the prior consent rule; indeed, it is inconsistent with the IRS's mission of ensuring that taxpayers pay the correct amount of tax -- no more and no less -- and conflicts with taxpayers' rights under section 6511. The ruling is not necessary to protect the fisc against "whipsaws" or income distortion; indeed, it can create a taxpayer-adverse "whipsaw" or distortion. The ruling does not promote consistent or correct accounting practices; indeed, it encourages the perpetuation of erroneous methods and runs counter to decades of effort by the IRS to encourage proper accounting practices and the prompt correction of errors. Finally, the ruling is not necessary to protect the IRS from administrative inconvenience; indeed, it exacerbates taxpayer hardship and the IRS's auditing burdens.

For the foregoing reasons, TEI strongly recommends that REv. Rul. 90-38 be withdrawn and replaced by a more flexible and balanced approach. Specifically, the IRS should adopt the following two-pronged test for automatically granting requests for a retroactive change in a method of accounting:

* the request must be for a change from a clearly erroneous to a permissible method; and

* The first use of the erroneous method must be in a year for which the statute of limitations on assessment remains open, and the permissible method must be consistently applied in that and all subsequent years. (6)

This approach -- essentially a return to the rules that applied under Rev. Rul. 70-539 and Rev. Rul. 75-56 -- would obviate the need for the taxpayer to file a Form 3115 for later tax years. It would also relieve the taxpayer of the burden of computing, and the IRS of the burden of auditing, a section 481 adjustment. At the same time, it would accord the IRS sufficient opportunity to evaluate the taxpayer's assertion that its original accounting method was erroneous and the proposed method permissible.

TEI also recommends that the IRS develop a revenue procedure setting forth the factors to be considered in evaluating the propriety of proposed method changes. For example, the revenue procedure could require a taxpayer seeking to make a change (i) to identify that it relates to a change from an erroneous to a permissible method of accounting, (ii) to describe the erroneous method and set forth the reasons why the taxpayer believes it to be erroneous, and (iii) to document that the first use of the erroneous method was in the year for which the claim is made.

Even if Rev. Rul. 90-38 is not withdrawn, it should be amended to provide guidance to taxpayers and IRS field personnel on those situations in which a taxpayer's attempt to change from an erroneous to a permissible method should be honored. Such guidance should emphasize the need for examining agents to evaluate claims on their merits, encourage good accounting practices, and enforce the law in an even-handed manner. For example, we believe a liberal approach to retroactive changes should be adopted where a taxpayer in good faith believes that a particular situation involved a change in facts and not a method change requiring consent.

TEI appreciates this opportunity to present its views on Rev. Rul. 90-38. If you have any questions, please do not hesitate to call Lester D. Ezrati, chair of TEI's Federal Tax Committee, at [phone], or TEI's professional staff (Timothy J. McCormally or Mary L. Fahey) at [phone].

(1) For purposes of the government's summary judgment motion, however, the court assumed that the year of first use was in an open year.

(2) For example, in Rev. Rul. 90-38, the IRS states that it will not follow the Court of Claims decision in Gimbell Brothers v. United States, 535 F.2d 14 (Ct. Cl. 1976), even though that case involved the correction of an error rather than a method change. Indeed, the ruling misstates that Gimbel involved the taxpayer's ability to effect a change in method by the filing of an amended return; the court clearly held that a change in method was not involved.

(3) Arguably, section 446(e) should never prevail over section 6511 because the former provision begins with the prefatory clause "Except as otherwise expressly provided." The argument goes that section 6511 is an "expressly provided" exception to the method change rules, especially when the change is from an incorrect to a correct method. See Seago, Horvitz & Linton, When Is the Correction of an Error a Change in Taxpayer's Method of Accounting?, 73 J. Taxation 76, 79 (Aug. 1990).

(4) See, e.g., General Counsel Memorandum 34959 (July 25, 1972), which discusses the immutability of section 263 relative to the accounting provisions in the context of minimum capitalization conventions.

(5) We submit, however, that where no possibility of a "whipsaw" exists (because all years remain open), the likelihood that taxpayers will initiate only taxpayer-favorable corrections should rightfully pose no bar to a taxpayer's pursuing Judge Learned Hand's dictum to "arrang[e] one's affair as to keep taxes as low as possible . . . for nobody owes any public duty to pay more than the law demands . . . . To demand more in the name of morals is mere cant." Commissioner v. Newman, 159 F.2d 848 (2d Cir. 1947).

(6) Alternatively, the taxpayer's change in method could be limited to those situations where the mitigation provisions of section 1311 operate to prevent the IRS from being "whipsawed."