Change in accounting method for trade discounts.

The IRS National Office recently corrected its "heads we win, tails you lose" approach to Form 3115, Application for Change in Accounting Method, filed for trade discounts. Trade discounts are adjustments to the purchase price granted by a vendor based on the volume or quantity of items purchased or other factors established by the vendor. Trade discounts do not include reductions in the purchase price attributable to payment within a prescribed period of time, compensation for services provided or a reimbursement of expenditures.

There has been no recent disagreement as to the proper method of accounting for trade discounts. Regs. Sec. 1.471-3(b) clearly provides that cost means "in the case of merchandise purchased since the beginning of the taxable year, the invoice price less trade or other discounts, except strictly cash discounts approximating a fair interest rate, which may be deducted or not at the option of the taxpayer, provided a consistent course is followed." Accordingly, trade discounts are taken into account in arriving at inventory cost as a reduction to the invoice price of merchandise in the year purchased if the taxpayer has a fixed right to the discount in that year; see Rev. Ruls. 76-96, 84-41 and 85-30. In this manner, the profit attributable to a trade discount is properly included in taxable income in the year the inventory is sold, in accordance with the taxpayer's FIFO or LIFO inventory method.

Rather, the disagreement has been over the terms and conditions imposed by the Service for receiving permission to change from an improper method to a proper method of accounting for trade discounts. More specifically, the disagreement has been over the spread period allowed by the IRS in the case of a positive or negative Sec. 481 (a) adjustment resulting from the change, which in turn depends on whether the improper method is viewed as a Category A or Category B method of accounting. A Category A method is defined as a method of accounting the taxpayer is specifically not permitted to use, or that differs from a method the taxpayer is specifically required to use, under the Code, the regulations or a Supreme Court decision. A Category B method is a method that is not a Category A method. (See Rev. Proc. 92-20, Sections 3.06 and 3.08.)

The Service, before its recent correction, appears to have been taking an inconsistent position on this question, with the consequence that a positive and negative Sec. 481 (a) adjustment were treated differently. An improper method of accounting for trade discounts which, when changed, would result in a positive adjustment was treated the same as a Category A method, with the result that the positive adjustment was spread over three years. An improper method of accounting for trade discounts which, when changed, would result in a negative adjustment was treated as a Category B method, with the result that the negative adjustment was spread over six years (instead of deducted in full in the year of change if treated as a Category A method).

To illustrate, in Rev. Rul. 84-41, an accrual method automobile dealer was entitled to a trade discount from the manufacturer in the year of purchase, but received the discount in the following year. The taxpayer did not take the trade discount into account in the year of purchase as a reduction of the invoice price, but included the discount in income in the following year when received. Accordingly, the taxpayer's cost of goods sold was overstated for automobiles purchased and sold in the same year. Citing Regs. Secs. 1.471-3(b) and 1.1012-1 (a), the IRS determined the taxpayer's present method to be improper and stated that a change to the correct method (which would have resulted in a positive adjustment) would be a change of accounting method to which Secs. 446 and 481 applied.

Also, the Service identified the ruling as a "designated ruling." It is the IRS's unofficial and informal position that a designated ruling issued before Rev. Proc. 92-20 is a "Designated B method of accounting" and generally is treated the same as a Category A method, if a taxpayer files a Form 3115 more than two years after the date the method is designated. Accordingly, a change from an improper method of accounting for trade discounts, as described in Rev. Rul. 84-41, will be treated the same as a change from a Category A method.

However, for the past several years, the Service appears to have been limiting Rev. Rul. 84-41 to its particular facts. For example, assume a taxpayer did not reduce the invoice price of inventory purchased by the trade discount it had a fixed right to receive. Instead, the taxpayer included in income all trade discounts in the year in which it had a fixed right to receive the discount regardless of when received, or included the discount in income when received but before the year in which the inventory was sold. In such cases, the IRS (at least, for the past several years) appears to have been treating a change to the proper method as a change from a category B method, with the result that the negative Sec. 481 (a) adjustment was spread over six years. This position appears to have been based on the view that use of a method that did not reduce the invoice price by a trade discount was not specifically precluded under the Code, the regulations or a Supreme Court decision.

(This treatment differs from the Service's position several years ago when the change in method of accounting for trade discounts resulting in a negative adjustment also was treated as a Category A method. See Tax Clinic, "Obtaining Most Advantageous Treatment for Trade Discounts," TTA, May 1994, p. 285.)

In any event, the IRS recently corrected its view and returned to its prior position of treating an improper method of accounting for trade discounts as a Category A method, regardless of whether the resulting Sec. 481 (a) adjustment is positive or negative. If permission has been received by a taxpayer to change an improper method of accounting for trade discounts where a resulting negative Sec. 481 (a) adjustment was required to be spread over six years, it may be advisable to ask the IRS National Office whether that requirement can be changed to allow a one-year deduction--to conform to the Service's recently corrected view.