Is the recharacterization of a sale or a lease a change in method of accounting?

One issue that is often overlooked by taxpayers trying to change the treatment of a sale or lease transaction, either on their own or as a result of an IRS exam, is whether this change involves a change in method of accounting. If an accounting method change is involved, there are various procedures under Sees. 446 and 481 that should be followed.

The Service has recently addressed this issue in Letter Ruling (TAM) 9237045. The taxpayer was engaged in the auto lease financing business and treated the leases as direct financing arrangements for book and financial reporting purposes. However, for tax purposes, the leases were treated as operating leases (true leases). The taxpayer argued that its method of accounting for tax purposes was improper because it did not conform to the method of accounting it used for its books and financial statements, as required by Sec. 446(a). The IRS disagreed with the taxpayer and concluded that an operating lease and a financing lease are not methods of accounting, because they do not involve the proper timing of income or deductions flowing from a transaction. Rather, they merely describe the transaction. Therefore, it was unnecessary for the book and tax treatments to conform. Thus, a recharacterization from an operating lease to a financing lease or vice versa would not be treated as a change in method of accounting. The Service also concluded that the auto leases were true leases for tax reporting purposes.

The courts have taken two different approaches on this issue. In Cubic Corp., DC Cal., 1974, the court held that because a taxpayer had chosen to treat lease revenues as rental income and had consistently done so for a period of years, this regular practice was clearly a method of accounting. As such, even if a taxpayer succeeded in recharacterizing the lease, a taxpayer would nevertheless have to obtain advance IRS consent to change its method of accounting.

However, in a subsequent case, Coulter Electronics, Inc., TC Memo 1990-186, the Tax Court ruled that whether revenues from a transaction are income from a sale of the property or income from a secured financing is not a question of the proper time for the inclusion of an item of income. Therefore, a recharacterization would not constitute a change in method of accounting. In Coulter, the taxpayer had transferred equipment leases to a bank in exchange for cash to expand its leasing business. The taxpayer initially treated the transfers as sales of leases to the bank, and included the full discounted value of the leases in income. However, during an IRS audit the taxpayer attempted to recharacterize the transfers as secured financings.

The Service argued that if Coulter were to succeed in recharacterizing the treatment of its transfers, it would be a change in the method of accounting for the transferred leases. The court ruled that there was no change in accounting method because the issue did not involve the proper time for the inclusion of income. Rather, the issue was the extent to which payments received by the taxpayer were taxable. The court held that the transactions were secured financings and not sales of the lease.

For Federal income tax purposes, a change in accounting method requires the filing of a Form 3115, requesting permission to change. However, in addition to the discretion to grant the request, the IRS has the authority to compute a Sec. 481 adjustment to the taxpayer's income (or deduction), which eliminates any duplication or omission created from accounting for income under the old method. In light of Letter Ruling 9237045 and Coulter, taxpayers and their advisers should assert that these rules for accounting method changes do not apply to lease versus sale recharacterizations. From Sandra H. Green, Esq., Washington, D.C.