Discontinuing the mark-to-market method under sec. 475.

At the end of 1996, the IRS issued final regulations addressing the Sec. 475 mark-to-market rules. These regulations allow a taxpayer to make certain elections resulting in the taxpayer's treatment as a dealer in securities. As a dealer, a taxpayer must mark to market all securities, unless otherwise identified as exempt from Sec. 475, as if the securities had been sold for their fair market value (FMV) on the last business day of the tax year.

Sec. 475(c)(2)(C) defines the term "security" to include any "note, bond, debenture, or other evidence of indebtedness." Regs. Sec. 1.475(c)-1 (b)(2) states that a debt instrument is customer paper if (1) a person's principal activity is selling nonfinancial goods or providing nonfinancial services, (2) a debt instrument was issued by a purchaser of goods or services at the time of purchase to finance the purchase and (3) at all times since the debt instrument was issued, it has been held either by the person selling the goods or by a corporation that is a member of the same consolidated group as that person.

Many taxpayers took the position that their accounts receivable that met this definition of customer paper were securities, and elected dealer treatment under Regs. Sec. 1.475(c)-1(b)(4) and-l(c)(1). Accordingly, an electing taxpayer had to determine the FMV of its nonfinancial customer paper (i.e., trade accounts receivable) on hand at the end of each tax year and recognize gain or loss equal to the resulting increase or decrease in value.

However, the Internal Revenue Service Restructuring and Reform Act of 1998 (IRSRRA '98) modified the definition of security under Sec. 475. Under new Sec. 475(c)(4), for tax years ending after July 22, 1998, "nonfinancial customer paper" is excluded from the definition of security, effectively prohibiting taxpayers from marking to market their trade accounts receivable. In addition, the IRSRRA '98 states that any change resulting from the new law is considered an accounting method change initiated by the taxpayer, and any resulting Sec. 481(a) adjustment must be taken into account over four years beginning with the change year.

Guidelines for Method Change

Rev. Proc. 98-60 (superseding Rev. Proc. 97-37) provides procedures for obtaining automatic consent to change the accounting methods listed in the procedure's appendix. Section 10A of that appendix provides guidelines for discontinuing the mark-to-market method as a result of the IRSRRA '98 modifications to Sec. 475.

Rev. Proc. 98-60 allows taxpayers either (1) to discontinue use of the mark-to-market method for nonfinancial customer paper or (2) in conjunction with a method change, to discontinue use of the mark-to-market method for all securities. In either case, Rev. Proc. 98-60 requires a taxpayer to attach Form 3115, Application for Change in Method of Accounting, to its original tax return for the change year and to file a copy with the IRS National Office on or before the date the original tax return is filed. The taxpayer must attach to the Form 3115 a statement describing all items that were marked to market and that will no longer be marked to market.

Observation: It is generally recommended that a taxpayer that must change its method of accounting as a result of the IRSRRA '98 should use the appropriate procedures to revoke its entire status as a dealer in securities. Simply put, although taxpayers must discontinue use of the mark-to-market method only with respect to nonfinancial customer paper, they should consider discontinuity use of the method for all securities. If a taxpayer chooses to discontinue use of the mark-to-market method only for nonfinancial customer paper, it could be at risk for potentially having to mark to market certain securities that it would otherwise not have to. Taxpayers that discontinue the mark-to-market method for all securities are ensured that they no longer must mark any of their securities to market.

If a taxpayer is under examination, before an Appeals office or before a Federal court (Section 4.02), it cannot change its accounting method under Rev. Proc. 98-60. However, Section 10A.01(1)(b) of the appendix states that if a taxpayer is changing a method governed by Section 10A, it is not subject to the scope limitations under Section 4.02. Although the Section 4.02 scope limitations do not apply to changes made under Section 10A, if the taxpayer is under examination, before an Appeals office or before a Federal court, it must still provide a copy of the application to the examining agents, Appeals officer or counsel for the government at the same time that it files a copy of the application with the National Office. The application must contain the name and telephone number of the examining agent, Appeals officer or counsel for the government.

Generally, Rev. Proc. 98-60 applies to tax years ending on or after Dec. 21, 1998. However, Section 13.03(2) of Rev. Proc. 98-60 states that the procedure is effective for a taxpayer's first tax year ending after July 22, 1998 for changes made under Section 10A of the appendix. A taxpayer does not receive audit protection in connection with this accounting method change.

FROM GEORGE A. MANOUSOS, CPA, WASHINGTON, DC