Adherence to utility regulations is an accounting method.

In FPL Group, Inc., 115 TC 554 (2000), the Tax Court held that an electric utility had chosen an accounting method when it characterized capital expenditures and repair expenses using the accounting method required for regulatory purposes. Thus, the company's attempt to recharacterize those items without the Service's consent was impermissible.

The decision highlights once again that a taxpayer's decision on how to report an expense can be just as important as the transaction itself, and can even supersede the transaction's true nature.

Background

Florida Power & Light Co., a subsidiary of FPL Group, adhered to regulatory rules and guidelines for recording capital expenditures and repair expenses, not only for regulatory accounting and financial reporting purposes, but also for Federal tax purposes. (According to the Tax Court, regulatory rules required Florida Power to adhere to regulatory accounting for financial-reporting purposes.)

After the IRS determined deficiencies for 1988-1992, FPL argued that it was entitled to a greater deduction for repair expenses, some of which it had improperly characterized as capital expenditures on returns. It deducted repairs to the extent allowed under Regs. Sec. 1.162-4, and used the amount of repair expenses determined for regulatory accounting purposes only as a reasonable approximation of that allowed for tax purposes, intending to make adjustments later.

Tax Court

In FPL, the court followed Southern Pac. Transp. Co., 75 TC 497 (1980), a case similar to FPL, involving a taxpayer subject to the Interstate Commerce Commission's (ICC's) regulatory accounting rules on capitalization. The taxpayer had attempted to change from capitalizing expenditures to expensing them; the court held that, even if the expenditures were properly deductible, the change was impermissible, because it involved a question of proper timing and the taxpayer had not obtained the Service's consent. The court in Southern Pac. did not consider whether following the ICC rules was an accounting method for tax purposes.

In FPL, the Tax Court also relied on Wayne Bolt & Nut Co., 93 TC 500 (1989), which held that a taxpayer could not change its consistently used inventory accounting method without the IRS's consent, even though the method used was "flawed."

FPL argued that the inventory case did not apply, because inventories follow separate rules for determining accounting method. The court refused to make that distinction, finding that the same basic principle applies (i.e., "a consistent method used to determine the tax treatment of a material item is a method of accounting").

Southern Pac., which was directly on point, was decided 20 years ago and was not appealed. In Northern States Power Co., 151 F3d 876 (8th Cir. 1998), an appeals court held that a utility's change from capitalizing to expensing fuel costs did not represent a change in accounting method.

What Is the Accounting Method?

Before deciding whether there has been a change in accounting method, it is necessary to determine the taxpayer's current method. In Northern States Power, the utility mistakenly capitalized losses on unneeded fuel contracts, while it had consistently expensed similar fuel costs. In that case, the utility could have expensed the fuel-contract losses on its original returns if it had realized the mistake. The government stipulated that the utility might have done so.

The Eighth Circuit concluded that the utility had not attempted to change its treatment of a "class of assets." Rather, because the utility had consistently expensed similar items, the court held that the mistake was no more than a posting error, which the utility could correct without IRS consent. Thus, Northern States Power's accounting method was to deduct those types of items currently.

On the other hand, the Tax Court found that FPL's accounting method was to treat certain repairs as capital expenditures on its returns in accordance with its regulatory reporting method. FPL did not seek to deduct the repair expenses until after it had challenged the Service's deficiency determination in Tax Court.

FPL alleged that it intended to expense the items; it used the regulatory method only as a "starting point" and intended to make adjustments to increase deductible repair expenses for tax purposes when it became aware of the erroneous capitalization. The court was not convinced, saying that choice of accounting method is a factual issue; it found that the facts supported the conclusion that FPL's intent was to report repair expenses for tax purposes consistent with its regulatory accounting method. Although FPL made some adjustments after filing its returns, none related to the repair-expense issue.

The Tax Court found that FPL consciously chose to follow its regulatory reporting method for tax purposes; the attempted deduction of repair expenses was really an afterthought. This decision, however, says nothing about the propriety of expensing such repairs on an original tax return. However, any similarly situated taxpayer that has followed financial or regulatory reporting methods (or both) for tax purposes should consider requesting the Service's advance consent for any change in tax reporting.

Which Is Better?

In FPL, the court found that the taxpayer had an accounting method already in place for repairs, while the taxpayer wanted to establish that its reporting of the disputed repair expenses was a posting error. In some circumstances, a taxpayer may benefit by treating a situation like FPL's as an accounting method, because requesting a change may prevent the IRS from reviewing prior years. Further, a Sec. 481(a) adjustment effectively ensures that no prior deductions attributable to barred years are lost. Deciding which position is better for a particular taxpayer requires consideration of all facts and circumstances.

FROM ELIZABETH MAGIN, J.D., LL.M., AND FRANK DEVLIN, CPA, J.D., WASHINGTON, DC