Rule of 78's no longer acceptable.

Lenders have historically used the rule of 78's method of computing interest income on certain loans. This method calculates interest income by multiplying the total interest payable over the life of the debt by a fraction, the numerator of which is the number of periods remaining on such debt at the time the calculation is made and the denominator of which is the sum of the periods' digits for the term of the debt. The rule of 78's method generally front loads interest, in comparison to the constant-yield method provided for m Regs. Sec. 1.1272-1(c). Under the constant-yield method, interest is accrued by applying an effective rate of interest to the unpaid balance of a loan for a given period. No matter which method is employed, however, the total interest payments over the term of the loan are identical, assuming the loan is not prepaid before the scheduled maturity date.

Rev. Proc. 84-27 provided that the rule of 78's method for computing interest income was generally prohibited from being considered an acceptable accounting method; however, it also provided an exception for certain consumer loam. The IRS indicated that, as a matter of "administrative convenience" it would allow the rule of 78's for certain short-term consumer loans only when there was a self-amortizing loan that required level payments (at regular intervals at least annually) over a period not in excess of five years (with no balloon payment at the end of the loan term) and when the loan agreement between the borrower and the lender provided that interest was earned (or when the prepayment of the loan interest was treated as earned) in accordance with the rule of 78's method.

Recently, the Service issued Rev. Proc. 98-60, which provides automatic consent procedures available to taxpayers to change their methods of accounting for specific items. Rev. Proc. 98-60 prohibits use of the rule of 78's as an acceptable method of accounting for loans issued on or after the first day of the first tax year beginning after 1998. This procedure applies to taxpayers that will change their method for the first or second tax year beginning after 1997.

Taxpayers using the rule of 78's method for any of their loans must request a change to the constant-yield method. The change is made by filing Form 3115, Application for Change in Accounting Method, with the taxpayer's timely filed (including extensions) original Federal tax return for the first tax year beginning after 1997. A copy of Form 3115 must also be filed with the IRS National Office, no later than when the original is filed with the Federal income tax return for the change year.

The change is made using a cut-off method. It applies only to loans issued on or after the first day of the change year. For example, if a calendar-year taxpayer initiates the accounting change as of Jan. 1, 1999, all loans issued before 1999 would still be accounted for using the rule of 78's; all loans issued after 1998 would be accounted for using the constant-yield method. If the taxpayer uses the rule of 78's method on any loan issued after 1998, the taxpayer will be using an incorrect accounting method for Federal income tax purposes.

If the taxpayer makes the change for its first or second tax year beginning after 1997, the change can be initiated even if the taxpayer is under examination, before an Appeals office or before a Federal court. The taxpayer is required, however, to provide a copy of the application to the examining agent, Appeals officer or counsel for the government, as appropriate, at the same time it files the copy of the application with the IRS National Office.

As previously stated, the accounting change is made using a cut-off method. Thus, the taxpayer is not required to make any adjustments to prevent the duplication or omission of amounts taken into account under the taxpayer's previous accounting method (i.e., no Sec. 481(a) adjustment is necessary).

FROM BRETT E. LABELLE, CPA, MST, OAK BROOK, IL