IRS limits ability to adopt new accounting methods after a sec. 351 transfer.

For many years, clients wanting to adopt a new accounting method to which the IRS would not consent were advised to drop the business down to a new subsidiary in a Sec. 351 transaction and to adopt the desired accounting method in the new subsidiary. This approach worked because Sec. 381 (c) (4) does not apply to Sec. 351 transactions and, therefore, the new subsidiary did not have to use the transferor's accounting method. This technique was often used when a business wanted to adopt the cash method of accounting, when certain income deferral methods were desired (such as deferral of prepaid service revenue) or when certain inventory methods were used.

The Service, however, has now issued new regulations that will severely restrict the ability to use this approach in affiliated groups filing consolidated returns. New Regs. Sec. 1.1502-17(c) states that, if a member of a group acquires an activity with the principal purpose of giving the group an accounting method that would be unavailable (or unavailable without consent), the acquiring member must use the accounting method that would be used if Sec. 381 applied to the transaction or secure the IRS's consent to change the method. One example in the regulations specifically deals with a situation in which a corporation forms a new subsidiary with the purpose of using the cash method in the subsidiary and states that the new subsidiary must use the accrual method previously used by the parent.

These new regulations apply only in a consolidated return context and only if the principal purpose was to secure the new accounting method. Therefore, the Sec. 351 approach is still valid if either the new company will not be consolidated with the transferor or the principal purpose of the transaction is not to secure the new accounting method.

The new regulations are effective for tax years beginning after July 12, 1995.

From Glenn F. Mackles, Esq., Washington, D.C.