IRS concedes accounting method issue in Eighth Circuit.

In an unprecedented move, the IRS announced in Notice 95-57 that it will allow cash method banks located in the Eighth Circuit to change back to the cash method of accounting for interest income on short-term loans.

The Service maintains that Sec. 1281 applies to these loans, and thus generally requires banks to accrue interest on them. But in 1992, the Tax Court ruled against the IRS on this issue, and in 1993, the Eighth Circuit affirmed the Tax Court's decision. The Service did not acquiesce in this decision, and intends to litigate the issue in other circuits. But because of the Eighth Circuit precedent, the IRS will grant accounting method change requests and refund claims filed by banks in the Eighth Circuit (Arkansas, Iowa, Missouri, Minnesota, Nebraska, North Dakota and South Dakota). At the same time, the Service says it will deny such applications and claims for refund filed by banks outside the Eighth Circuit.

Notice 95-57 provides guidance relating to change of accounting method requests and claims for refund filed as a result of the decision in Security Bank Minnesota, 994 F2d 432 (8th Cir. 1993), aff'g 98 TC 33 (1992).

Security Bank Minnesota involved Sec. 1281, which requires certain holders of short-term obligations to include interest income on the short-term obligation as it accrues, regardless of the overall accounting method used by the holder of the instrument. Since this provision was added in 1986, its application to banks using the overall cash method of accounting has been disputed. (Note. Total annual receipts of a bank must be less than $5 million to use the cash method.)

The Eighth Circuit held in Security Bank Minnesota that Sec. 1281 did not require a cash method bank to include in gross income stated interest on short-term loans made in th course of business as the stated interest accrued. The IRS disagrees with the Eighth Circuit's interpretation of Sec. 1281 and plans on pursuing the issue in other circuits. In the interim period, the Service has decided that cash method banks in the Eighth Circuit will be granted permission to change to the cash method for stated interest on short-term loans made in the ordinary course of business.

According to Notice 95-57, cash method banks in the Eighth Circuit will be considered to have obtained IRS consent to make that change if the accounting method change is made in accordance with the notice after Nov. 6, 1995; the Service will not seek to deny the use of the cash method if the change in method was made on or before Nov. 6, 1995. It is important to note that the IRS has stated that cash method banks in the Eighth Circuit may be required to apply Sec. 1281 to short-term loans for any tax year not barred by the statute of limitations if the Service is later successful in litigating this issue in other circuits, or if there is a law change.

Accounting Method Change Under Notice 95-57

Notice 95-57 allows cash method banks in the Eighth Circuit to change to the cash method of accounting for stated interest on short-term loans made in the ordinary course of business according to the following guidelines:

* This change may be made in the bank's current tax year or in the bank's earliest open tax year after which there is no closed tax year.

* If the tax return for the year of change has not been filed, a current Form 3115, Application for Change in Accounting Method, must be attached to the timely filed income tax return for the year of change.

* If the tax return for the year of change has already been filed, a current Form 3115 must be attached to an amended return for the year of change on or before June 30,1996. In addition, amended returns must be filed at that time for all subsequent affected tax years.

* A copy of the Form 3115 must be filed with the IRS National Office no later than the date when the original Form 3115 is filed with the income tax return for the year of change.

The Sec. 481 (a) adjustment associated with this accounting method change must be taken into account in the year of change.

Banks Not Located in the Eighth Circuit

The Service will deny any request for a change in accounting method or any claim for refund based on Security Bank Minnesota filed by a bank outside of the Eighth Circuit.

The banking industry had hoped that after the IRS lost the test case it would concede the issue. Fighting the Service is an expensive proposition given the size of the institutions involved. The IRS strategy undoubtedly will force many banks to accept the Service's position, rather than undergo costly litigation (i.e., the IRS may win even though the case was lost).