New procedures for accounting method changes.

In general, a taxpayer seeking to change its method of accounting for a particular item may not do so without advance IRS approval. Earlier this year, the Service issued Rev. Proc. 92-20, which substantially modifies the procedures for requesting accounting method changes on or after Mar. 23, 1992. Under the new rules, different procedures apply depending on whether the taxpayer is changing from an improper method of accounting to an acceptable one or from one acceptable method to another acceptable method, and whether or not the taxpayer is under audit at the time of the request.

As under the previous procedures, a taxpayer must generally request a change in accounting method by filing Form 3115, Application for Change in Accounting Method, within 180 days after the beginning of the tax year in which the change will be implemented. If Form 3115 is filed after the 180th day of the tax year, the change will be effective for the following year, unless the taxpayer obtains permission to file a late application on a showing of good cause. (Note: IRS approval of late applications is generally difficult to obtain.)

The filing of Form 3115 by a taxpayer not currently under examination generally has the following benefits. * The Service may not adjust prior year returns for the particular tax issue that is the subject of the change. * Any increase or decrease in income that results from the change in the first year the new method is applied (i.e., the Sec. 481(a) adjustment) can generally be recognized ratably over a period of three to six years. * No interest or penalty is charged for failing to make the adjustment in an earlier tax year, even if an incorrect method was previously used.

Improper or "Designated A"

methods

Rev. Proc. 92-20 provides special rules for taxpayers that have been using an improper or "Category A" accounting method that is specifically identified by the IRS as a "Designated A" method. Although no "Designated A" methods have yet been identified by the IRS, these special rules are expected to apply to taxpayers who fail to adopt an accounting method that is required by a statutory change, or who continue to use a method after it has been specifically identified as improper by statute or regulation. The failure to apply required Sec. 263A inventory capitalization methods, and the failure to adopt the Sec. 460 percentage-of-completion method when required, are examples of methods that may eventually be identified as "Designated A" methods.

A taxpayer using a "Designated A" method has two options. The taxpayer may change to a proper method by amending its tax returns for all open years, and by taking any positive Sec. 481(a) income adjustment into account immediately in the earliest open year. This option does not require advance IRS approval. Alternatively, the taxpayer may request permission to make the change for the current tax year by filing Form 3115 under the normal procedures. However, any positive income adjustment must be taken into account immediately in the year of change, and an interest charge will be imposed that is designed to put the taxpayer in the same position it would have been in if it had amended its returns for prior open years.

Taxpayers currently under

audit

If a taxpayer is being audited by the Service, or has been contacted to schedule an examination, the taxpayer is generally prohibited from requesting an accounting method change unless it obtains the consent of the IRS district director. There are three exceptions to this general rule (not including a special transitional rule that expired Sept. 19, 1992).

The three permanent exceptions create "window" periods during which a taxpayer under audit can file a Form 3115 and still receive some of the benefits that normally apply to voluntary accounting method changes. 90-day window: A taxpayer that is notified that it is under examination may file Form 3115 within 90 days after the examination begins. Special rules determine the year of the change and the Sec. 481(a) adjustment period that are generally less favorable than the normal adjustment rules.

120-day window: A taxpayer may generally request a change under the normal procedures during the 120-day period following the date an examination ends, even if a subsequent examination has commenced.

30-day window., A taxpayer can request an accounting method change under the normal procedures during the first 30 days of any tax year if (1) it has been under IRS examination for 18 consecutive months and (2) it has not received written notification of proposed adjustments related to the accounting method being changed prior to filing Form 3115.

The special window periods do not apply if any of the taxpayer's returns are under consideration by an IRS appeals office, or are the subject of litigation before a Federal court, unless written permission is obtained from the appeals officer or IRS attorney handling the case.

Conclusion

Practitioners should carefully review their clients' accounting methods and consider the need to make appropriate changes, particularly for taxpayers that are contacted for audit by the Service. By adopting proper methods on a voluntary basis, a taxpayer can minimize its exposure to substantial audit adjustments and to the interest and penalty charges that might otherwise result.