Comments on Notice 98-31, Service-initiated accounting method changes.
On May 15, 1998, the Internal Revenue Service released Notice 9831, which contains a draft of a proposed revenue procedure that, when promulgated, will govern changes in accounting methods initiated by the IRS under the authority of section 446(b) of the Internal Revenue Code.(1) The Notice describes the discretion the IRS may exercise in order to resolve issues involving accounting methods, as well as prescribing rules for resolving issues on a nonaccounting-method-change basis. The IRS invites comments on the proposed procedure and, accordingly, on behalf of Tax Executives Institute, I am pleased to submit the following comments.
TEI is the principal association of corporate tax executives in North America. Our nearly 5,000 members represent 2,800 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.
Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised in Notice 98-31, relating to proposed rules for changes in accounting method initiated by the IRS.
Overview Of Notice 98-31
In Notice 96-40, the IRS solicited comments from taxpayers and tax practitioners regarding the rules governing implementation of accounting method changes, including whether the rules set forth in Rev. Proc. 92-20 should be revised. Many of the public comments submitted in response to the 1996 notice were incorporated into Rev. Proc. 97-27, relating to taxpayer-initiated changes in accounting method. In Notice 98-31, the IRS has dropped the other shoe, prescribing the procedures the IRS is to employ, as well as the consequences to taxpayers, when adjustments involving "timing" issues and accounting method changes are made in connection with an IRS examination or settled at Appeals or in litigation (hereinafter a "Service-initiated" change).
In Notice 98-31, the IRS sets forth a proposed revenue procedure that, when promulgated, will set forth the procedures for implementing a Service-initiated change in method of accounting. Section 1.02 of the proposed procedure states that its purpose is to provide:
terms and conditions for Service-initiated
methods of accounting] that
are intended to encourage
taxpayers to voluntarily request
a change from an impermissible
method of accounting
prior to being contacted
for examination. Under
this approach, a taxpayer
that is contacted for examination
and required to
change its method of accounting
by the Service generally
receives less favorable
terms and conditions (for example,
an earlier year of
change and a shorter [sections]
481(a) adjustment period for
a positive adjustment) than
if the taxpayer had filed its
request to change before the
taxpayer was contacted for
The procedure mandates that the Examination Division (hereinafter "Exam") resolve all "timing" issue adjustments as accounting method changes, prescribes rigid guidelines for the resolution of method change issues by Exam, and otherwise circumscribes the authority of Exam to resolve accounting method issues.
The Notice professes that the proposed revenue procedure will not alter the authority of Appeals or government counsel to resolve or settle accounting method issues based on the hazards of litigation. Nonetheless, the Notice prescribes new rules governing the manner in which accounting method issues settled by Appeals or government counsel -- whether on an accounting-method-change basis or otherwise -- are to be finalized with, and subsequently implemented by, taxpayers.
The rules are propounded in elaborate detail, intimating that the procedure constitutes the exclusive means for resolving accounting method issues. Specifically, various new rules are prescribed concerning the form and content of closing agreements to implement any settlement resolving Service-initiated accounting method changes. These include the form and contents of notice to the taxpayer describing the new method of accounting, the year of change, the [sections] 481(a) adjustment amount, and the number of taxable years over which the [sections] 481(a) adjustment is to be taken into account (the "spread" or adjustment period). In addition, procedural rules are prescribed for resolution and settlement of disputes based on compromise terms and conditions for a change in method. Procedures for implementing nonaccounting-method change settlements, including "alternative timing" and time-value-of-money settlements, are also prescribed. Finally, default procedures are set forth and apply where the settlements or closing agreements fail to comply with specific rules contained in the procedure.
In many respects, issuing public guidance on involuntary, Service-initiated changes in accounting methods is navigating a course in uncharted waters. Hence, we commend the IRS for undertaking to provide rules in an area filled with uncertainty for taxpayers and IRS. As important, we commend the IRS for affording taxpayers and practitioners the opportunity to comment on the guidance before the rules are issued in final form. We believe that the thorny issues raised by Notice 98-31 will benefit from public scrutiny, and, as a result, we offer the following comments on specific issues raised by the Notice.
Rule Prohibiting Exam From Making Taxpayer-Favorable "Timing" Adjustments Contravenes the Authority and Mission of IRS
Section 2.04 of the proposed procedure provides in part:
Consistent with the policy of
encouraging prompt voluntary
compliance with proper
tax accounting principles,
the Service ordinarily will
not initiate an accounting
method change if the change
will place the taxpayer in a
position more favorable than
the taxpayer's position
would have been had the taxpayer
not been contacted for
TEI believes that it is improper for the IRS to refrain from initiating changes to a return simply because the change is favorable to the taxpayer. Such a policy is inconsistent with the authority and mission of the IRS and cannot be justified by the purported rationale. Indeed, the statement portends a policy of selective, even abusive, enforcement of the Code and Treasury regulations.
Treas. Reg. [sections] 301.6201-1 provides that "the district director is authorized and required to make all inquiries necessary to the determination and assessment of all taxes imposed by the Internal Revenue Code.... The district director is further authorized and required...to make the determinations and the assessments of such taxes." In addition, section 7602 of the Code and Treas. Reg. [sections] 301.7602-1(a) authorize the IRS to examine any books, papers, records, or other data "for the purpose of ascertaining the correctness of any re turn." Moreover, IRS Policy Statement P-4-7 states that "it shall be a [Service representative's] duty to determine the correct amount of the tax, with strict impartiality as between the taxpayer and the Government." (Emphasis supplied.)
Any return that contains erroneous treatment of an item or reflects an impermissible method, regardless of whether the item or method operates to the disadvantage of the taxpayer, is an incorrect return.(2) TEI submits that, in accordance with the Code and regulations, the IRS should make all adjustments, including taxpayer-favorable adjustments, necessary to correct a taxpayer's return. The proposed policy contravenes the IRS's mandate and its professed objectives of fairness and impartiality as well as the thrust of the just-enacted IRS Restructuring and Reform Act. Moreover, it is questionable whether the courts will sustain the view enunciated in section 2.04.(3) Finally, the policy is inconsistent with the IRS's mission statement, i.e., "to collect the proper amount of tax revenues... in a manner that warrants the highest degree of public confidence in [the IRS's] integrity, efficiency and fairness."
Accordingly, TEI recommends that section 2.04 of the proposed procedure be revised to provide that where an incorrect item or method is discovered during the course of an examination, the IRS will correct the item or method regardless of whether the adjustment increases or decreases taxable income. Should the IRS adhere to the position set forth in the proposed procedure, it cannot help but foster taxpayer cynicism about the fairness of the system. Indeed, rather than encourage compliance with proper tax accounting methods, the lack of taxpayer-favorable adjustments for "timing" issues on examination may lead taxpayers to be even more aggressive when assessing their return positions. For example, if a taxpayer is weighing whether to deduct an expenditure in the current year or deduct it in a subsequent taxable year, the combined effect of the no-taxpayer-favorable-adjustments-on-examination rule and the likely prospective application of a [sections] 481(a) adjustment spread period will, in many cases, tip the balance in favor of a current deduction.(4) Hence, the rules may perversely influence taxpayers to take greater risks in the selection of accounting methods based on their assessment of whether the IRS will (1) discover the position, (2) prevail on the merits of an adjustment adverse to the taxpayer, and (3) assess penalties for the taxpayer's return position. Finally, as a matter of efficiency and conservation of IRS's resources, it would be more expedient for revenue agents to make the necessary adjustments than to compel the taxpayer to file a Form 3115 and have the National Office duplicate the review conducted by the field. Hence, we recommend that the IRS permit taxpayer-favorable adjustments in the earliest year open for examination (or to the year to which the adjustment relates, if later).
Improper Use of Revenue Procedure to Expand Definition of Change in Method of Accounting
Following the issuance of Rev. Proc. 97-27, TEI objected to the IRS's use of a revenue procedure to assert that a change in character of an item may be a change in accounting method. We explained that, by systematically citing Rev. Proc. 91-31 (relating to automatic consent procedures for changes in utility accounting methods to conform with the decision in Commissioner v. Indianapolis Power & Light Co.) as the source of authority for the position asserted in Rev. Proc. 97-27, the IRS will foster a misperception among agents and taxpayers that the position is a settled rule of law.
In Notice 98-31, the IRS has again asserted that a change in character of an item may constitute a change in accounting method. We will not repeat our comments on that issue here, except to note our continued objection to that position. More important, Notice 98-31 represents an expansion of the scope of IRS's effort to establish new or modify existing rules on accounting methods without adhering to the requirements of the Administrative Procedures Act. If the IRS concludes that the law governing changes in accounting methods should be modified, the proper course is to amend the Treasury regulations (pursuant to the notice and comment procedures of the Administrative Procedures Act) or by proposing legislative amendments to section 446.
Section 5.02 of the proposed procedure states that an "examining agent proposing an adjustment with respect to a timing issue will treat the issue as a change in method of accounting." Section 3.01 defines a "timing issue" as "any issue regarding the propriety of a taxpayer's method of accounting for an item." The two sections seemingly create circular, interdependent definitions. The tautology is mitigated somewhat by referring to section 2.01, which defines a method of accounting as involving "the proper time for the inclusion of the item in income or the taking of the item as a deduction." To determine whether a taxpayer's practice involves "timing," section 2.01 provides:
generally the relevant question
is whether the practice
permanently changes the
amount of the taxpayer's lifetime
income. If the practice
does not permanently affect
the taxpayer's lifetime income,
but does or could
change the taxable year in
which income is reported, it
involves timing and is therefore
a method of accounting.
Even apart from the circularity of the definitions, we believe that sections 3.01 and 5.02 are wrong as a matter of law in intimating that a change in method of accounting is simply any adjustment that affects "timing." There are numerous cases and rulings that state that a change in method of accounting does not occur even though the taxpayer's practice may affect the proper time for inclusion in, or deduction from, income. For example, a change in method of accounting does not exist where (1) the proper accounting flows automatically from the characterization of an item;(5) (2) the taxpayer made an inadvertent error;(6) (3)the accounting is inconsistent with the taxpayer's chosen method of accounting;(7) (4) the change is to an estimating formula;(8) or (5) a correction is made in the first year the improper method was used.(9) Finally, section 2.01(4) of the proposed procedure is itself an incomplete and, hence, misleading summary of Treas. Reg. [sections] 1.446-1(e)(2)(ii)(b) from which it is drawn. Specifically, the regulation identifies adjustments that do not involve changes in method of accounting, the most notable of which is that a change in accounting treatment arising from a change in facts is not a change in accounting method.
The authorities demonstrate that the proposed procedure vastly oversimplifies the process of determining whether or when an adjustment for a "timing" issue implicates an accounting method. Moreover, because of the requirement that revenue agents link the purported "timing" adjustment with a change in accounting method and [section] 481(a) adjustment, the proposed procedure will increase the number of adjustments that are erroneously treated as changes in methods of accounting and permit Appeals and government counsel to extract concessions from taxpayers in order to settle frivolous "accounting method" issues. Such a result may enrich the fisc but it does not further the IRS's mission of collecting the proper amount of tax. TEI urges the IRS to delete the definition of a "timing" issue or modify it substantially to conform to the nuances of the applicable authorities. As important, we reiterate our earlier recommendation that the IRS reconsider the requirement that adjustments for "timing issues" (however that term is defined) always be linked with a Service-initiated change in accounting method.
Proposed Procedure Is Cumbersome, Burdensome, and Antithetical to Resolving Issues at the Lowest (or Any) Level
TEI believes that the Notice introduces a number of over-restrictive procedures that will not only handcuff Exam's ability to reach agreements with taxpayers, but will also indirectly limit settlement options at Appeals. The result will be an inefficient use of IRS resources at Exam and Appeals, as well as a proliferation of litigation.
1. Examination Authority. Section 5.01 of the proposed procedure states that "except as otherwise provided in published guidance (for example, Delegation Order No. 236), the discretion of an examining agent to resolve timing issues is set forth in sections 5.02 through 5.05 of this procedure." Section 5.02 states that "an examining agent proposing an adjustment with respect to a timing issue will treat the issue as a change in method of accounting." Section 5.04 states that "an examining agent changing a taxpayer's method of accounting will impose a [sections] 481(a) adjustment." Finally, pursuant to section 5.05, the examining agent "will effect the change in the earliest taxable year under examination... with a one:year [sections] 481(a) adjustment period."
Since the authority granted in Delegation Orders 236 and 247 (i.e., the only published guidance currently available) is limited in scope, section 5 of the proposed procedure seemingly requires that examining agents treat every adjustment for a timing issue as a change in method of accounting with a one-year [sections] 481(a) adjustment spread period in the earliest taxable year under examination. There is no alternative. There is no discretion. There is no acknowledgment that the law can be complex, the facts ambiguous, and the application of the law to the facts uncertain. As a result, there is no flexibility to apply the law to the facts developed on examination in order to fashion a pragmatic resolution of the issue.
a. Agent Discretion to Apply the Law to the Facts Should Be Acknowledged. Section 2.02 of the procedure recites a litany of black-letter law intended to emphasize the Commissioner's broad discretion to initiate changes in a taxpayer's method of accounting where the method does not clearly reflect income. Section 5, however, significantly circumscribes the ability and authority of the Commissioner's "eyes and ears" -- Exam -- to exercise professional judgment in applying the complex rules relating to accounting methods and, as discussed more fully below, "timing" issues. Specifically, section 5.02 provides that a proposed adjustment related to any "timing issue" is to be treated as a change in method of accounting. Section 5.03 of the proposed procedure provides:
An examining agent changing
a taxpayer's method of
accounting will properly apply
the law to the facts without
taking into account the
hazards of litigation when
determining the new method
Section 5.03 is premised on two faulty assumptions: (1) the law is always clear and (2) factual and legal issues can be compartmentalized. Moreover, examining agents may be encouraged by such statements to view issues in black-and-white terms rather than distinguishing among the various shades of gray that permeate the tax law. The complex legal provisions that taxpayers and agents are required to apply to myriad factual circumstances can engender substantial differences of opinion and interpretation. The proposed procedure blithely ignores the complexity and states that when examining agents are applying the law to the taxpayer's facts they may only find "x" or "y," but nothing in between "x" or "y." Moreover, should the agent find "x" there will presumably be no adjustment, but if he or she finds "y," an adjustment will be made and a [sections] 481(a) adjustment will be imposed. Section 5.03 removes all discretion and actually sanctions as standard operating procedure the practice of some agents to aggressively propose adjustments that increase taxable income.
To remedy this situation, we recommend that the IRS modify section 5.03 to acknowledge that the application of the law to the facts during an examination is one of the most critical judgments exercised by revenue agents. Whether the law or facts requires an adjustment at all is the first determination. Assuming an adjustment to the taxpayer's income is proper, the determination of whether an accounting method change should be proposed should not follow automatically. Agents should be permitted -indeed encouraged -- to exercise professional judgment about whether a change in method of accounting is warranted based on all the facts and circumstances.
b. Flexibility to Resolve Issues at the Lowest Level Should Be Restored. Even where the amounts involved in respect of an issue are de minimis in the years under examination, the requirement that agents impose an accounting method change for "timing issue" adjustments and that the taxpayer treat subsequent years in accord with the new "accounting method" limits both Exam's and the taxpayer's flexibility to resolve cases. The lack of flexibility on both sides will significantly increase the scope and number of controversies referred to Appeals or to litigation, even as the amounts involved in particular issues may diminish. As important, when the inflexibility of section 5 is combined with the no-taxpayer-favorable-adjustments-for-timing-issues rule of section 2.04, the proposed procedure may provoke gridlock at the examination level.(10)
TEI believes that the straitjacket that the procedure imposes on Exam will vitiate many of the initiatives undertaken to improve the currency of tax years under examination. Moreover, the most punitive terms and conditions for Service-initiated changes in accounting method from Rev. Proc. 92-20 have effectively been incorporated in section 5. Specifically, the mandatory imposition of a [sections] 481(a) adjustment in the earliest year under examination with a one-year spread (but only for positive adjustments to taxable income) imposes the worst possible terms and conditions on the taxpayer. Accordingly, taxpayers will have nothing to lose by protesting these issues to Appeals, and may obtain a better resolution. By eliminating Exam's discretion to resolve accounting methods issues in a flexible manner, these rules will likely produce a net increase in workload for the IRS, especially for appeals officers and government counsel. Indeed, the ability of Exam to reach even partial agreements will be severely curtailed. Hence, we anticipate that the number of cases and issues referred to Appeals will increase dramatically. We recommend that the IRS modify section 5 to permit Exam to effect adjustments to a taxpayer's taxable income for "timing issues" in any manner consistent with the applicable law. Resolving issues at the lowest level of authority will encourage the most efficient use of IRS and taxpayer resources.
c. Permit Cut-Off Method for Adjustments by Exam. Under section 5.04, an examining agent must impose a [sections] 481(a) adjustment. "Only in rare and unusual circumstances" will a cut-off method be permitted in lieu of a [sections] 481(a) adjustment. Section 6.02(2)(c) imposes no similar limitation on the use of the cut-off method by Appeals and government counsel. Computing the [sections] 481(a) adjustment itself, however, can be a time-consuming and contentious exercise. In order to achieve resolution of accounting method issues, TEI believes that examining agents should be permitted to employ the cut-off method. We see no policy or administrative reason to limit examining agents' discretion to employ the cut-off method in order to effect a change in a taxpayer's method of accounting.
2. Appeals Authority. Section 1.03 of the proposed procedure avers that "the proposed procedure does not alter the authority of Appeals and counsel for the government to resolve or settle issues." Nonetheless, section 6 may limit the options appeals officers consider in resolving cases. Specifically, section 6.02 states that an appeals officer or government counsel may resolve a timing issue by (1) changing the taxpayer's method of accounting using compromise terms; (2) using an alternative timing resolution; or (3) using a time-value-of-money resolution. The latter two methods are referred to as "non-accounting-method-change" settlements. TEI believes that Appeals and government counsel must retain the authority to resolve timing issues and accounting method issues in a flexible manner.
a. Procedure Should Not Constitute Exclusive Means of Settlement. While the three methods are not per se objectionable (indeed, they may be beneficially employed to resolve cases), the costs of settling on any one of the three bases may, after weighing the hazards of litigation, be excessive under the circumstances and, hence, impede agreements. In other words, the language of section 6 implies that the dispute resolution procedures set forth in the procedure are the exclusive means through which to effect settlements with appeals officers and government counsel. Hence, these individuals may be inhibited from developing -- or considering -- alternative means of crafting settlements with taxpayers. If Appeals lacks authority to resolve issues on some basis other than the three prescribed methods, there will certainly be an increase in litigation, and the number and types of issues that government counsel must resolve in litigation will expand substantially.
TEI recommends that the IRS modify section 6 to clarify that the three methods for settlement of cases are illustrative mechanisms for resolving cases and are not intended be the exclusive means of settling cases.
b. Punitive Nature of Time-Value-of-Money Settlement Diminishes its Utility as a Settlement Option. Under section 6.02(4), appeals officers and government counsel may use the time-value-of-money option to resolve an accounting method issue on a nonaccounting-method-change basis. Under this option, the taxpayer's method of accounting is unchanged, but the taxpayer agrees to pay the government a non-deductible, noncapitalizable "specified amount" that approximates the time-value-of-money benefit the taxpayer has received by using its method of accounting for the years under consideration by Appeals or government counsel. The "specified amount" is reduced by an "appropriate factor" to reflect hazards of litigation. An illustration of the manner of computing the "specified amount" is provided in section 6.02(4)(b).
Regrettably, the use of the "specified amount" payment as a means of resolving timing issues on a non-accounting-method basis seemingly resurrects the procedures and attendant problems of changes of "Designated A" methods under Rev. Proc. 92-20. The "specified amount" in the proposed procedure (as in Rev. Proc. 9220) is punitive because it constitutes a permanent difference to the taxpayer that may neither be deducted nor capitalized.
The "specified amount" is punitive in other respects as well. For example, the hypothetical under- or overpayment isolates the effect of the hypothetical change in method of accounting from other taxpayer items or tax attributes (such as net operating losses or foreign tax credits) that can significantly diminish the monetary effect of the timing adjustment on the determination of the taxpayer's taxable income or tax liability. In addition, the applicable tax rate applied to the hypothetical under- or overpayment is the highest marginal income tax rate in effect for corporations, which will unduly penalize taxpayers subject to lower tax rates.
We believe that the punitive aspects of the time-value-of-money settlement option substantially diminishes its utility as a means of resolving accounting method issues, notwithstanding the ameliorative effect of the interest-credit mechanism provided under section 8.02(6)(f). Hence, while the option should be retained (since some taxpayers may embrace it), the option should be improved. For example, if Appeals and government counsel are afforded broad discretion and flexibility to consider the tax attributes of the taxpayer or to negotiate the deductibility of the payment, the punitive nature of the option would be mitigated.
c. Filing of Amended Tax Returns as a Condition for Closing Agreements. Under sections 7.02(2)(1) and 7.03(2), as well as sections 8.02(5)(e) and 8.03(1)(b), where an accounting method issue is resolved either as a Service-initiated accounting method change or pursuant to the alternative-timing procedures, the proposed procedure would require the taxpayer to file amended tax returns, if appropriate, as a condition of, or a prerequisite to, obtaining a closing agreement governing the change in method or alternative-timing resolution. The amended tax returns would be required to be filed for any affected taxable years for which a tax return has been filed as of the date of the closing agreement.
The Code does not require a taxpayer to file amended returns under any circumstance. To impose such a term as a condition to implement an "agreed" resolution of a timing issue as a change in accounting method is, we believe, beyond the scope of the IRS's authority. As important, a requirement to file amended returns for all intervening years imposes undue administrative burdens on the taxpayer. Filing amended returns is premature in situations where a final determination of the taxpayer's federal income tax liability has not been made. This may occur, for example, where the taxpayer and Appeals reach agreement in respect of one "timing" issue involving an accounting method change, but fail to agree on another and litigation ensues on the other issue.
Moreover, for taxpayers subject to continuous examination under the Coordinated Examination Program (CEP) (whether as part of the National or "district-level" CEP), this is a burdensome, indeed, make-work requirement, not only in respect of additional federal income tax returns for which the liability remains subject to examination, but also because of the substantial state income or franchise tax filing burden engendered. Specifically, the filing of amended federal tax returns generally triggers a requirement that a taxpayer file state income tax returns for the same periods. In the case of taxpayers with large numbers of companies within an affiliated group -- each of which may file multiple state income or franchise tax returns -- the requirement to file amended federal tax returns for the interim years between the years under examination (or under consideration at Appeals or in the federal courts) imposes a tremendous administrative burden. Moreover, for CEP taxpayers, the "amended returns" remain subject to examination (and change) by the IRS.
We believe that the IRS may have recognized this burden in the last sentence of sections 7.03 and 8.03(1)(b), which both state that if the IRS does not require amended returns to be filed in connection with the closing agreement and the taxpayer does not file amended returns, the IRS "will make the adjustments necessary to reflect the change for the affected taxable years when it examines those returns." We believe the IRS can clarify the purpose of this language by incorporating a reference to Rev. Proc. 94-69.(11) Specifically, we recommend that CEP taxpayers be permitted to accumulate all collateral adjustments necessary to implement accounting method changes (i.e., the amounts necessary to prevent omissions or duplications from income) and provide them to the IRS in accordance with the procedures specified in Rev. Proc. 94-69, relating to disclosures that must be made in order to avoid the section 6662 accuracy-related penalty. Hence, we recommend that the procedure be modified to state that the closing agreement will address whether the taxpayer is to file amended returns in connection with effecting the closing agreement.
3. Procedures. Section 7.01 of the proposed procedure states that any "examining agent, appeals officer, or counsel for the government changing a taxpayer's method of accounting will provide notice that a timing issue is being treated as an accounting method change." In order to finalize a Service-initiated method change "the taxpayer and the IRS must execute a closing agreement." The requirement that notice be given to taxpayers whenever the IRS initiates an accounting method change is welcome. Since the Notice adopts an overbroad view of when changes in accounting method are to be imposed, however, there will likely be a significant increase in the number of closing agreements that must be executed. TEI believes that the expansion of the number of cases requiring closing agreements to resolve cases is administratively burdensome and cumbersome for both taxpayers and the IRS.
Under current practice, there are a number of forms of settlement documents that Exam (or Appeals) and taxpayers may employ to conclude an examination. Closing agreements are executed in relatively few cases. In our members' experience, the IRS generally eschews closing agreements, presumably because the time-consuming nature of the review and approval process -- especially for CEP taxpayers -- is a significant drain on IRS resources. For example, even though the National Office has delegated authority to execute closing agreements, a request still must pass through several layers of review, and closing agreements themselves (especially for CEP taxpayers) must generally be approved by high-ranking officials such as the Deputy Chief Counsel and Assistant Commissioner (Examination).(12) It would be impractical for every "timing" issue of every taxpayer to be reviewed and approved by such officials.
As a result, we recommend that the IRS reconsider the requirement in section 7.02 that every Service-initiated accounting method change be finalized in a closing agreement. At a minimum, TEI recommends that the closing agreement procedures be simplified and, further, appeals officers and government counsel in CEP cases be given authority to execute closing agreements without further review (as is the current practice in respect of smaller taxpayers).
Method of Resolving Accounting Method Issues Requires Clarification
1. Service-Initiated Method Change Should Be Binding. Under section 7.04, "a Service-initiated change that is final establishes a new method of accounting" that the taxpayer is required to use beginning with the year of change and for all subsequent years, unless the taxpayer obtains the Commissioner's consent to change from the new method or the IRS changes the taxpayer from the new method on subsequent examination. In other words, except as provided in section 7.04(3), the IRS is "not precluded from changing the taxpayer from the new method of accounting if the Service determines that the new method does not clearly reflect the taxpayer's income." Under section 7.04(3), a taxpayer receives audit protection for the new method of accounting for taxable years for which a return has been filed as of the date of the closing agreement.
TEI believes that the finalization of a change in method of accounting should be binding on the IRS and the taxpayer until (1) there is a change in material fact, (2) there is a change in law, or (3) the taxpayer initiates and obtains the Commissioner's consent to change its method of accounting. The one-sided nature of a closing "agreement" to effect a change in accounting method in the proposed procedure invites revenue agents to challenge the propriety of the taxpayer's method of accounting in subsequent taxable years. These provisions would embolden revenue agents that disagree with the resolution reached by Appeals or government counsel to undermine the agreement by challenging the taxpayer's method in subsequent years. We believe that this provision will encourage recurring disputes between revenue agents and taxpayers and undermine the IRS's dispute resolution initiatives.
Under section 7.04(3)(b), the IRS may require the taxpayer to change or modify the new method of accounting "in the earliest open taxable year in which the applicable law has changed." Under Notice 98-31, a change in applicable law includes (i) the enactment of legislation; (ii) a decision of the United States Supreme Court; (iii) the issuance of temporary or final regulations; or (iv) the issuance of a revenue ruling, revenue procedure, notice, or other guidance published in the Internal Revenue Bulletin. This statement is confusing, overbroad, and -- to the extent the IRS believes that rulings, notices, or other pronouncements in the Internal Revenue Bulletin are equivalent in status and effect with final or temporary regulations, legislation, or Supreme Court decisions -- overreaching and wrong.(13) Moreover, in the absence of a demonstrated need to prevent an abuse, final and temporary regulations are generally not applied on a retroactive basis.
The final revenue procedure should permit the IRS to impose "retroactive" changes in methods of accounting only in very limited circumstances. In accordance with [sections] 446 and the applicable regulations, a change in method of accounting agreed upon between the taxpayer and the IRS should remain in effect until (1) there is a change in material fact or law (as determined by the effective date of the change in law) or (2) the taxpayer obtains the Commissioner's consent for a self-initiated change in accounting method.
Finally, when the taxpayer agrees to a Service-initiated change in method of accounting, the agreement should afford the taxpayer audit protection not only for taxable years for which an income tax return has been filed, but also for future taxable years assuming no change in material facts or law. Such a provision would provide certainty to taxpayers, is an efficient and effective use of IRS and taxpayer resources, and is easy to administer. The taxpayer should, of course, retain its right to request consent of the Commissioner to effect a change in its method of accounting.
2. Additional Factual Development by Exam Requires Appeals Oversight. Under section 7.05 of the proposed procedure, an appeals officer or government counsel may resolve an accounting method issue by deferring the change in method to a taxable year under examination (i.e., not a taxable year before Appeals or a federal court). Although Appeals or government counsel is required by the proposed procedure to "coordinate the resolution with Examination.... approval of the resolution by Examination is not required."
This section of the proposed procedure should be retained. It clearly delineates authority between the IRS functions, facilitates issue resolution, and removes taxpayers from turf battles that can prevent or delay resolution of issues -- often for many years. This provision would be improved by requiring that the taxpayer and either Appeals or government counsel reach agreement in respect of the audit plan where a case is to be referred to Exam for additional fact-finding on an accounting method issue. Specifically, the audit plan should be in writing and be specific concerning the scope of the procedures to be employed and also include deadlines by which the review is to be finished. If TEI's recommendation is adopted, taxpayers and the government will be assured that issues referred to Exam for additional development will be undertaken as quickly and efficiently as possible for resolution by Appeals or government counsel.
3. Effect of Intervening Closed Tax Years Requires Clarification. Under section 8.03(1), the IRS will make the necessary adjustments to taxable income to effect an alternative-timing resolution to an accounting method issue for the years before Exam, Appeals, or a federal court. In addition, the IRS will make the appropriate adjustments on examination if amended returns are not filed. The procedure, however, is unclear about the result where one or more of the intervening years between the years under IRS control and the current taxable year is closed under the statute of limitations. We recommend that the IRS clarify this section to state that adjustments to taxable income are not required to the intervening years as a result of an alternative-timing resolution. Moreover, since the alternative-timing procedure resolves accounting method change issues on a non-accounting-method-change basis, this section of the proposed procedure should be clarified to state that, pursuant to the closing agreement, Exam is precluded from proposing a [sections] 481(a) adjustment in later audit cycles for the same issue. In subsequent audit cycles, Exam should independently evaluate the propriety of the taxpayer's method of accounting before proposing any [sections] 481(a) adjustment.
Section 3 of the proposed procedure employs the phrase "impermissible method of accounting" without defining the term. We recommend that the term "impermissible method of accounting" be defined, but without resort to the categories of accounting methods set forth in Rev. Proc. 92-20. Specifically, we believe "impermissible method of accounting" refers to methods of accounting that are contrary to a statute, regulation, or Supreme Court decision. TEI believes that the term should not include methods that are contrary to methods set forth in IRS Notices, Announcements, or private rulings.
Statute of Limitations
Section 10 of Notice 98-31 sets forth an elaborate illustration of the operating rules of the proposed procedure. Section 10 also asserts, without reasoned justification or legal support, that the IRS may ignore the statute of limitations in respect of improperly deducted capital expenditures (or any other "timing" item adjustment) relating to noninventory property in any prior year merely by proposing a [sections] 481(a) adjustment in the earliest open tax year under examination.(14) We believe that the assertion in section 10 is questionable, contravenes the public policy evinced by the statute of limitations to quell controversy, and encourages revenue agents to take multiple "bites at the apple." That is, an agent can examine multiple years of a taxpayer's return, decline to make any adjustments, permit the statute of limitations to expire, and then propose massive, retroactive adjustments under the purported authority of a [sections] 481(a) adjustment. Indeed, even without the slightest color of authority that the proposed procedure would provide, revenue agents have reportedly proposed [sections] 481(a) adjustments for repairs on long-lived assets in tax years closed by the statute of limitations. Whatever merit there may be in correcting the improperly deducted item, the statute of limitations should not be open to one-way IRS adjustments. We recommend that section 10 be revised to eliminate any reference to the IRS making [sections] 481(a) adjustments for "timing" amounts involving noninventory property in years for which the statute has closed. At an absolute minimum, the IRS should clarify the example to demonstrate how correlative adjustments (for depreciation expense in the example) affect the [sections] 481(a) adjustment amounts and amortization period.
Section 12 states that the proposed procedure will apply to examiner's reports issued 90 days after its promulgation. In addition, the new rules will apply to Forms 870AD and closing agreements executed on or after 90 days following publication of the procedure. As a transition rule, taxpayers and the IRS may agree to abide by the terms and conditions of the final procedure upon its publication. TEI agrees that taxpayers and IRS personnel will need time to study and take account of the final procedure's requirements and effect on pending cases. Hence, we support the 90-day transition period. We also believe that taxpayers and IRS should be accorded the flexibility to apply the terms of the procedure at an earlier date. Hence, we recommend that the IRS retain both the 90-day transition period and the transition rule in the final procedure.
The preamble to the proposed procedure describes a number of items for which future guidance will be issued. We have the following recommendations concerning items that should be released soon or contemporaneously with the final procedure.
a. Expand Scope of Multiple-Year Dispute Resolution Processes. Since the proposed procedure will likely lead to a substantial increase in the number of issues that Exam "sets up" as accounting method changes, examinations will become even more contentious and adversarial than currently. Hence, the scope of IRS's dispute settlement mechanisms likely must be expanded and the procedures streamlined. The preamble to the proposed procedure notes, for example, that the IRS intends to publish guidance making the process for early referral of cases to Appeals under Rev. Proc. 96-9 available to non-CEP taxpayers. We concur that all taxpayers should be permitted to obtain expedited resolution of accounting method (and other) issues, and recommend that IRS expand the availability of the procedures in Rev. Proc. 96-9 to non-CEP taxpayers.
The preamble also notes that guidance concerning the resolution of accounting method issues for taxable years beyond those under Exam, before Appeals, or before a federal court will be issued. While it is unclear what form that guidance might take, a procedure comparable in effect to the accelerated issue resolution (AIR) procedure of Rev. Proc. 94-67 or to Delegation Order 236 (or some combination of the two procedures) should be considered in order to provide "linkage" between the resolution of an issue in the earliest open years under examination (before Appeals, etc.,) and the most recent tax year for which the taxpayer has filed its return. Contrary to the statement in the preamble, however, we recommend that such guidance afford the taxpayer "audit protection" for the intervening years. The purpose of the contemplated guidance should be to enhance resolution of disputes rather than defer resolution of issues to another day.
Finally, guidance reflecting the model closing agreement for Service-initiated accounting methods changes should be issued soon.
b. Year of Change. The preamble to the proposed procedure states that the IRS intends to publish guidance permitting the IRS and taxpayers to resolve accounting method issues for taxable years beyond the years under examination, before Appeals, or before a federal court. In order to make that future guidance mesh with this proposed procedure, we recommend that the IRS eliminate the prohibition against the "year of change" being in a year later than the year in which an agreement is reached. Indeed, we recommend that the IRS publish guidance concerning the circumstances under which the "year of change" may be a taxable year that is not currently before Exam, Appeals, or a federal court, but is prior to the taxable year that includes the date the agreement to the accounting method change is finalized (i.e., an intervening or "gap year").
Tax Executives Institute appreciates this opportunity to present its views on Notice 98-31. If you should have any questions about the Institute's position or if we can be of any assistance, please do not hesitate to contact either David L. Klausman, chair of TEI's Federal Tax Committee, at (408) 765-6592 or Jeffery P. Rasmussen of the Institute's legal staff at (202) 638-5601.
(1) 1998-22 I.R.B. 10.
(2) Concededly, where there are two (or more) permissible methods of accounting for an item, and in connection with an examination the taxpayer discovers that it is employing a suboptimal method, the IRS might properly decline to exercise its authority to initiate a change in method in the tax years under examination.
(3) See SoRelle v. Commissioner, 22 T.C. 459, 469 (1954) (acq.) (discretion under statutory predecessor of 446(a) cannot be exercised to compel a taxpayer to remain on an improper accounting basis).
(4) Regrettably, the interaction of the Notice with Rev. Proc. 97-27 may deprive taxpayers under continuous examination of the opportunity to change an unfavorable method. The proposed procedure would deny Exam the authority to make a taxpayer-favorable change in method. Section 6.01(2)(a) of Rev. Proc. 97-27, on the other hand, deprives taxpayers of an unqualified right to a change in method under either the 90-day or 120-day windows where an accounting method "issue" is "under consideration" by Exam. Moreover, while a taxpayer may apply for a change in method with the consent of the district director under section 6.01(4) of Rev. Proc. 97-27, the district director may withhold consent if the method to be changed "would ordinarily be included as an item of adjustment in the years under examination." The combined effect of the two procedures may be to permit the taxpayer's request to languish indefinitely.
(5) See, e.g., Underhill v. Commissioner, 45 T.C. 489 (1966); Technical Advice Memorandum 9307002.
(6) See, e.g., North Carolina Granite Corp. v. Commissioner, 43 T.C. 149 (1964); Buddy Schoelkopf Products, Inc. v. Commissioner, 65 T.C. 640 (1970).
(7) See, e.g., Gimbel Brothers, Inc. v. United States, 535 F.2d 14 (Ct. Cl. 1976); Standard Oil Co. (Indiana) v. Commissioner, 77 T.C. 349 (1989).
(8) See, e.g., Baltimore & Ohio Railroad Co.0 v. United States, 221 Ct. Cl. 16 (1979); EXCO Corp. v. United States, 750 F.2d 1466 (9th Cir. 1985). For example, where a taxpayer improperly deducts a one-time expenditure that should be capitalized, e.g., a repair, there is a correction of an error rather than an adjustment involving a method of accounting.
(9) See, e.g., Silver Queen Motel v. Commissioner, 55 T.C. 1101 (1971).
(10) Section 5.05 requires the 481(a) adjustment to be made in the earliest taxable year under examination with a one-year 481(a) adjustment period for positive adjustments to taxable income. By contrast, under section 2.04, the IRS will not initiate an accounting method change where the change will place the taxpayer in a more favorable position than if the taxpayer had not been contacted for examination. In other words, where the change in method will result in a negative adjustment to taxable income (i.e., where it is taxpayer favorable), section 2.04 states that the change can only be effected on a prospective basis with the year of change being the current year and any 481(a) adjustment taken into account in subsequent years rather than in the years under examination.
(11) 1994-2 C.B. 804.
(12) Delegation Order 97 (Rev. 34), 1997-41 I.R.B. 14.
(13) Revenue rulings, revenue procedures, notices, and "other guidance" generally represent only the IRS's interpretation of the law and, hence, are not equivalent to statutes, regulations, or decisions of the Supreme Court.
(14) Under section 481(a)(2), the IRS is authorized to make "those adjustments which are determined to be necessary solely by reason of the change [in accounting method] in order to prevent amounts from being duplicated or omitted.... "Where, as in the facts of section 10.01 of the proposed procedure, the IRS is proposing an adjustment for improperly deducted capital expenditures for noninventory property (i.e., repairs made to a building or other similarly long-lived asset), it is difficult to see how there is any "method" of accounting to be changed. There is either a repair, for which section 162 prescribes a deduction, or there is a capital expenditure for which section 263 prescribes capitalization. Hence, there is either a correct or incorrect treatment of each year's expenditure as a repair or capital expenditure. There is no basis for the IRS to assert that correction of an erroneously deducted capital expenditure in an open year (1995 on the facts of section 10.01) permits it to make adjustments in years closed by the statute of limitations (1994) under the guise of a fictive accounting "method" change. Assuming the taxpayer is consistent in its treatment of the improperly deducted repair (i.e., does not claim additional depreciation expense or basis for computing gain or loss on sale), there is no "item that will be duplicated or omitted from income" as a result of the taxpayer's error in a previous year. Hence, it is highly questionable, under section 481(a)(2), whether the IRS has the authority to make the [sections] 481(a) adjustment.
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|Title Annotation:||IRS Notice 98-31|
|Date:||Jul 1, 1998|
|Previous Article:||The Internal Revenue Service Restructuring and Reform Act of 1998.|
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