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New procedure simplifies voluntary accounting method changes, but limits opportunities for taxpayers under examination.

Overview

The Internal Revenue Service issued a new revenue procedure on May 8, 1997, revising the general guidelines and applicable terms and conditions for requesting voluntary federal income tax accounting method changes. Rev. Proc. 97-27 makes significant changes to the five-year old rules provided in Rev. Proc. 92-20, including modifications of general filing requirements, window periods, rulers for taxpayers under examination, and terms and conditions -- most important, the elimination of the Category A and B distinction and the provision of a uniform four-year section 481(a) adjustment.(1)(*). The new procedure also provides further clarification of definitions such as "under examination" and "issues under consideration."

Generally, the new procedure increases the opportunity for taxpayers to make method changes, formalizes a number of existing IRS National Office polices, clarifies or eliminates many items that previously have been sources of disagreement, and attempts to encourage voluntary method changes. At the same time, it contains many provisions that limit a taxpayer's ability to make changes once they are contacted for examination and spawns a number of new issues that likely will be sources of future conflict.

Effective Date

The new procedure is generally effective for Forms 3115, Application for Change in Accounting Method, filed on or after May 15, 1997.(2) Transition rules are provided, however, that enable taxpayers to affirmatively choose to use most aspects of the terms and conditions of either Rev. Proc. 92-20 or Rev. Proc. 97-27 for certain pending Forms 3115 and new Forms 3115 filed before December 31, 1997.

Generally, the IRS National Office will apply the terms and conditions of Rev. Proc. 92-20 for a Form 3115 filed for a taxable year ending on or after May 15, 1997, and which is pending on or after May 15, 1997, unless the taxpayer requests in writing by the later of June 15, 1997, or the date the ruling letter is issued, to apply the terms and conditions of Rev. Proc. 97-27 (exclusive of the year of change).(3) For any Form 3115 filed after May 15, 1997, the National Office will apply the terms and conditions of Rev. Proc. 97-27. The taxpayer, however, may request the terms and conditions of Rev. Proc. 92-20 for applications filed on or before December 31, 1997, by attaching a statement to the Form 3115 requesting to apply the terms and conditions of Rev. Proc. 92-20 (exclusive of the year of change and application of window periods).(4) In addition, taxpayers in a window period provided under Rev. Proc. 92-20(5) on May 15, 1997, may file a Form 3115 during the remainder of that window period under the terms and conditions of Rev. Proc. 92-20.

Each procedure has advantages and disadvantages that taxpayers should consider with their particular factual situation to determine which procedure should be utilized under the transition rules. For example, taxpayers with a positive Category B section 481(a) adjustment with a six-year spread period or a negative Category A section 481(a) adjustment with a one-year spread period may prefer to utilize the provisions of Rev. Proc. 92-20.(6) Taxpayers with a negative Category B section 481(a) adjustment with a six-year spread period or positive Category A adjustment with a three-year spread period may prefer to utilize the provisions of Rev. Proc. 97-27 to obtain the uniform four-year spread provided under its terms.

Finally, for applications filed between May 15, 1997, and December 31, 1997, the IRS National Office has informally indicated that taxpayers will have the option to retract an election to have Rev. Proc. 92-20 apply only if there is no disagreement over the taxpayer's characterization of the method as Category A or Category B.

Anticipated Future Guidance

The IRS plans to issue a "mass automatic" change procedure "shortly" that will incorporate many of the existing automatic change procedures.(7) This procedure will likely include approximately a dozen new automatic method changes for requests that are routinely granted by the IRS. The terms and conditions in this mass automatic procedure presumably will conform to those provided in Rev. Proc. 97-27, including the four-year spread period. These automatic requests will probably be subject to IRS review and the Rev. Proc. 97-27 window periods discussed below. The goal of issuing additional automatic method changes is to allow the resources of both taxpayers and the IRS to be devoted to dealing with more substantive issues.

Owing to the likely conformity of terms and conditions to Rev. Proc. 97-27, taxpayers considering using the automatic change procedure should analyze the potential benefits and burdens of the different spread periods provided in current automatic procedures as compared with the four-year period expected to be provided in the new mass automatic procedure. For example, taxpayers wishing to utilize Rev. Proc. 96-31 for under-depreciated assets should consider filing Forms 3115 to obtain a one-year spread of the resulting negative section 481(a) adjustment prior to the effective date of the anticipated procedure.(8) Similarly, taxpayers considering a termination of their LIFO election and planning to file under Rev. Proc. 88-15 should consider taking steps to retain a six-year spread of any positive section 481(a) adjustment.(9)

The mass automatic change procedure may contain transition rules similar to Rev. Proc. 97-27. The transition rules may afford taxpayers the option to utilize current automatic change procedures or the terms and conditions of the new procedure. There is no guarantee, however, that such a provision will be included or which taxpayers, if any, will be able to utilize the transition rules.

The IRS plans to issue a third procedure before yearend that will provide guidance for involuntary method changes. Rev. Proc. 97-27 indicates that audit protection is not available if the method was adjusted as an involuntary method change.(10) The procedure, however, does not define when an involuntary method change has been made on examination. The involuntary change procedure should provide guidance on when an involuntary method change has occurred. This guidance likely will result in changes in how taxpayers and the IRS settle issues raised under examination. The potentially contentious nature of how the involuntary change procedures are applied to examination settlements may result in this procedure being issued in proposed form.

Methods of Accounting

Section 446(e) of the Code requires the taxpayer to obtain the Commissioner's consent before changing any method of accounting. If, however, a taxpayer has not adopted a method of accounting or the treatment does not result in a change in method of accounting, the taxpayer is not required to request the consent of the Commissioner. Therefore, before focusing on the details of requesting a change in method of accounting, it is important to ascertain whether the treatment of a particular item constitutes a method of accounting.

Whether a particular treatment is a method of accounting is also important because of the broad discretion granted to the IRS to change a taxpayer's method of accounting in order to clearly reflect income.(11) Further, a change in a taxpayer's method of accounting generally results in an adjustment to prevent amounts from being duplicated or omitted in determining taxable income when the taxpayer uses a different accounting method from the method used in the preceding year.(12) To encourage voluntary compliance, taxpayers are allowed to recognize the resulting section 481(a) adjustment ratably over a four-year period under Rev. Proc. 97-27.(13) For involuntary changes, the IRS can include the entire section 481(a) adjustment in income for the earliest open year under examination.(14)

Method of Accounting Defined. Rev. Proc.97-27 provides a definition of an accounting method change generally consistent with the definition in Rev. Proc. 92-20.(15) A change in method of accounting includes a change in the overall plan of accounting for gross income or deductions, or a change in the treatment of a material item. A material item is defined to be any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.(16) Thus, in determining whether the treatment of an item involves timing, the relevant question is whether the practice permanently affects the amount of taxable income recognized over the taxpayer's lifetime. If the practice does not permanently affect the taxpayer's lifetime income, but rather does or could change the taxable year in which income is reported, it involves timing and is therefore a method of accounting.(17)

Although a method of accounting may exist under this definition without a pattern of consistent treatment, in most instances a method of accounting is not adopted without consistent treatment. The treatment of a material item in the same way in two or more consecutively filed tax returns represents consistent treatment.(18) If a taxpayer treats an item properly in the first return that reflects the item, however, it is deemed to have adopted a method of accounting.(19) Once a taxpayer has adopted a method of accounting, the taxpayer may not change its method by filing amended tax returns, but must request permission of the IRS National Office by filing a Form 3115.(20)

There are a number of common situations that do not give rise to a change in accounting method. A change in method of accounting does not include the correction of mathematical or posting errors, errors in the computation of tax, a change that does not involve the proper time for inclusion of the item in income or the taking of a deduction, or a change in treatment resulting from a change in underlying facts.(21)

Item Characterization 1e a Method of Accounting.

Rev. Proc.97-27 includes the following new provision, which potentially treats item characterization as a method of accounting:

A change in the characterization of an item may

also constitute a change in method of accounting if

the change has the effect of shifting income from

one period to another. For example, a change from

treating an item as income to treating the item as

a deposit is a change in method of accounting. See

Rev. Proc. 91-31.(22)

Whether a change in the characterization of an item constitutes a change in accounting method has been a matter of much debate over the years. In Diebold, Inc. u United States,(23) the taxpayer treated a pool of replacement parts as inventory and later filed amended returns claiming depreciation and investment tax credit with respect to the parts. The Claims Court and the Federal Circuit held that Diebold could not change accounting methods from inventory treatment to depreciable property without the Commissioner's consent. The IRS quickly adopted the Diebold decision as proof that a taxpayer can adopt a method of accounting through the characterization of a transaction.

In Coulter Electronics, Inc. u. Commissioner,(24) the Tax Court held that "[a]lthough there is a timing consequence to the outcome of the characterization, it is automatically determined by the characterization and no change of accounting within the meaning of section 446 is involved." The Tax Court thus agreed that the taxpayer, a medical equipment manufacturer, could change the characterization of certain transactions as equipment sales to equipment leases by notification of the examining agent.

The Supreme Court in Commissioner v. Indianapolis Power & Light Co.(25) held that utility customer deposits should not be characterized as income when received but as nontaxable security deposits. Although the Supreme Court addressed the substantive issue only with no discussion of any change in accounting method by the taxpayer the IRS quickly published Rev. Proc. 91-31(26) which treated the change in characterization from prepaid income to nontaxable deposits as a change in accounting method. The IRS held that taxpayers could not follow the Supreme Court decision unless the automatic procedure set forth in Rev. Proc. 91-31 or the general method change procedure was followed.

When new regulations were issued under section 446(e) in 1970 a decision was made by Treasury and the IRS to drop an example in the extant proposed regulations (section 1.446-1(e)(2)(ii)(b)) that referred to a change from lease treatment to sale treatment as a change in method of accounting.(27) The specific inclusion in Rev. Proc. 97-27 of the change in characterization of an item that has the effect of shifting income from one period to another as a situation that "may" constitute a change in method of accounting signals heightened IRS interest in treating recharacterizations as accounting method changes. Taxpayers will likely face additional challenges during examination to characterization changes made without obtaining Commissioner consent.

Modifications to General Accounting Method Change Procedures

Upon concluding that a particular item is an accounting method, taxpayers are required to request the consent of the Commissioner to effect any change in their method.(28) Rev. Proc. 97-27 is the most recent revision of the general rules and guidelines to follow when requesting consent to make voluntary accounting method changes.(29) The revised decision process in determining whether a taxpayer can request a change in method of accounting is illustrated in Diagram 1 on the next page. The new procedure is generally effective for requests filed on or after May 15, 1997.(30)

[Diagram 1 ILLUSTRATION OMITTED]

Rev. Proc. 97-27 embodies significant modifications of the structure of Rev. Proc. 92-20.(31) Many provisions are contained in both procedures but are located in entirely different sections. The reorganization of the format of the general method change procedure is an attempt to enhance taxpayer access to the applicable guidance. To best understand the potential effect of Rev. Proc. 97-27 on taxpayers, the significant changes from Rev. Proc. 92-20 are highlighted.

General Filing Requirements. Rev. Proc. 97-27 allows taxpayers that are not under examination to file Forms 3115 any time during the year of change.(32) Therefore, a calendar-year taxpayer can file a Form 3115 anytime on or before December 31, 1997, for a change that is effective for its 1997 taxable year. The requirement in Rev. Proc. 92-20 that Forms 3115 be filed within 180 days of the beginning of the requested year of change has been eliminated.(33)

In order to provide adequate time for the IRS to respond prior to the original due date of the taxpayer's return for the year of change, the request should be filed as early in the taxable year as possible.(34) Further, owing to the elimination of the previously available 90-day window period after contact for examination(35) (which is discussed below), taxpayers should not procrastinate in filing any contemplated method change requests.

Taxpayers that were contacted for examination during the first 180 days of their taxable year often became subject to the superseded 90-day window period requirements because of their delay in completing their request applications. Under Rev. Proc. 97-27, taxpayers that procrastinate and are contacted for examination prior to filing their Forms 3115 may be prohibited from making a voluntary change in accounting method.(36)

Since taxpayers can file a request at any time during the taxable year, the new procedure eliminates the ability of taxpayers to file early applications before the beginning of the year of change as provided in Rev. Proc. 92-20.(37) Taxpayers often filed early applications under Rev. Proc. 92-20 in order to obtain audit protection or to postpone the year of change. For similar reasons, requests for late-filing relief under Treas. Reg. [sections] 301.9100, which were routinely granted for applications filed within 90 days of the due date, will now only be granted in "unusual and compelling circumstances."(38)

Elimination of Category A and B Methods. Rev. Proc. 97-27 eliminates the classification between Category A, Category B, Designated A, and Designated B method changes by providing the same terms and conditions for all taxpayer-initiated changes. Taxpayers under examination that can utilize an available window or secure district director consent obtain identical terms and conditions as taxpayers not under examination.(39) The year of change for all taxpayer-initiated changes is the taxable year in which the Form 3115 is filed.(40) Further, a standard four-year spread of the section 481(a) adjustment will apply for method changes that generate either a positive and negative section 481(a) adjustment.(41) Changes within the LIFO inventory method generally will continue to be made on a cut-off basis.(42)

Under Rev. Proc. 92-20, the year of change varied depending on the day in the taxpayer's year that the request was filed, whether the taxpayer was under examination, and the category of the method change request. For example, taxpayers changing from Category A methods in a 90-day window after being contacted for examination were required to effect the change in the earliest year under examination.(43)

Further, the spread period for section 481(a) adjustments also varied depending on the category of method change requested. The section 481(a) adjustment for Category A methods (methods differing from those specifically required to be used or methods not permitted to be used by the Code, the regulations, or a decision of the Supreme Court)(44) and Designated B methods (Category B methods that the IRS specifically identified to be treated as Category A methods in certain situations)(45) were generally spread over three-years for a positive and one-year for a negative adjustment.(46) Category B methods (all other methods that were not a Category A or Designated A or B method)(47) were generally provided a six-year spread of the section 481(a) adjustment for both positive and negative changes.(48)

As evidenced by the IRS's 1995 modification of regulations under section 446,(49) the IRS believes it has the authority to require taxpayers seeking voluntary method changes for Category A methods of accounting with a negative section 481(a) adjustment to utilize a four-year spread period rather than a one-year spread. Taxpayers, however, may be able to challenge the IRS's ability to prevent them from utilizing a one-year spread in these situations.

In Rev. Proc. 97-27, the IRS reserved the authority to provide special terms and conditions for certain method changes in the interest of sound tax administration.(50) For example, the only Designated A method-relating to notional principal contracts-retains the special terms and conditions provided in Rev. Proc. 93-48.(51)

Shortened or Accelerated AdJustment Period. The new procedure eliminates most of the previous events that resulted in shortened spread periods for the section 481(a) adjustment. For example, the one-year spread period when 90 percent of the adjustment was attributable to the year preceding the year of change and the reduction in the spread period to reflect the number of years the taxpayer used the method being changed have been eliminated.(52)

Generally, the only remaining acceleration of the spread period provided in Rev. Proc. 97-27 applies when the taxpayer ceases to engage in the trade or business to which the change in method of accounting relates.(53) The definition of when a taxpayer ceases to engage in the trade or business that gave rise to the adjustment remains unchanged.(54)

The acceleration of section 481(a) adjustment spreads related to inventory method changes or the reduction in inventory value has been eliminated.(55) Also eliminated was the section 481(a) acceleration for inventory method changes that occurred as a result of a reduction of inventory value.(56) The IRS concluded this acceleration provision was too limited in scope since it only applied to inventory method changes.

The IRS is studying under what circumstances, if any, the section 481(a) adjustment spread period should be accelerated. The IRS is concerned that taxpayers may abuse the four-year spread period provided through planning in certain circumstances. Limiting the spread period to only four years, however, reduces the incentive for taxpayer abuse. The IRS may issue guidance in the future that modifies Rev. Proc. 97-27 to require acceleration of the section 481(a) adjustment in certain situations.

Window Periods for Taxpayers Under Examination. Taxpayers under examination previously had an assortment of window periods to consider in determining their eligibility to request a voluntary method change. The new procedure greatly simplifies the complexity by limiting the number of available windows. The price for this simplification, however, is reduced taxpayer opportunity to obtain voluntary method changes for taxpayers contacted for examination.

Rev. Proc. 97-27 provides three methods by which a taxpayer under examination may file a method change -- the 90-day window period, the 120-day window period, and district director consent.(57) The IRS did not adopt the common request to allow taxpayers to file method change requests any time prior to having an issue under consideration since this provision would have resulted in a large number of disputes regarding when an issue came under consideration.

Similar to the 30-day window provided in Rev. Proc. 92-20, the new 90-day window allows taxpayers that have been under continuous examination for 12 months as of the beginning of the year of change to request a change in method of accounting for an issue not under consideration or in suspense during the first 90 days of any taxable year.(58) To afford Coordinated Examination Program (CEP), large case, and other taxpayers undergoing extended examinations greater flexibility to file method change requests, the existing 30-day window was expanded to 90 days at the start of the taxable year and the continuous examination requirement was reduced from 18 to 12 months. The reduction in the continuous examination period should be helpful to some taxpayers. The benefit of the expansion of this window period from 30 to 90 days, however, is questionable since most taxpayers filed as early as possible in the window period in order to request a change before the issue is raised on examination.

The IRS decreased the period from 18 months to 12 months to allow taxpayers. under continuous examination additional opportunities to change their methods of accounting voluntarily without significantly increasing the potential for disputes regarding when an issue has come under consideration. Reducing the continuous examination requirement to a period of less than 12 months would have greatly increased the number of taxpayers eligible to utilize this window.

The 120-day window period allows taxpayers to request a method change for issues not under consideration or placed in suspense at the time the request is filed during the 120-day period following the date an examination ends, regardless of whether a subsequent examination has commenced.(59) Although this window period is similar to the 120-day window provided in Rev. Proc. 92-20,(60) two significant changes in Rev. Proc. 97-27 will affect its application. First, the procedure clarifies that the 120-day window period is available even if a subsequent examination has not commenced. This is a reversal of the IRS's previous position that taxpayers needed to be under continuous examination to be eligible for the 120-day window. With the elimination of any window period after initial contact for examination, this change guarantees a window period that otherwise could have been eliminated through a contact for examination shortly after the conclusion of the previous examination. Second, the new definition of "under examination" indicates that an examination ends for partially agreed or unagreed cases,-among other ways, not upon the request for Appeals consideration as previously provided in Rev. Proc. 92-20,(61) but rather upon notification from Appeals that it has received the referred case.(62) This modification may prevent a taxpayer from filing a method change if the item comes under consideration before notification from Appeals. Since the IRS controls the notification of when a case has been referred to Appeals, examining agents will have additional opportunities to place issues under consideration before taxpayers are eligible for the 120-day window.

In addition, there is no formal IRS procedure requiring Appeals to notify the taxpayer within a specified time period that it has received the referred case. Consequently, taxpayers may have to wait months after filing a protest before the opening of the 120-day window. Since this interregnum will provide examination agents additional opportunities to raise issues under consideration, the new provision effectively eliminates taxpayers' ability to utilize the 120-day window. Unless that was the intent of the IRS National Office, the IRS should amend Rev. Proc. 97-27 to reinstate the request-for-Appeals-consideration standard as one of the definitions of when an examination has concluded.

For both of these windows, the taxpayer must attach a separate signed statement certifying that, to the best of the taxpayer's knowledge, the requested method change is not an issue under consideration or an issue placed in suspense by the Examination function.(63)

Similar to the provisions in Rev. Proc. 92-20, taxpayers may request to change an accounting method if the district director consents to the filing.(64) The new procedure modifies the criteria for when district directors will consent to a requested change by limiting their review to whether the item would ordinarily be included as an item of adjustment to just the years under examination. The ability to consider "years to which the examination could be extended"(65) has been eliminated. This change should reduce potential disputes for issues developing in years not under examination. Guidance also has been provided for when the district director will consent through two examples involving a change from a clearly permissible method of accounting and a change from an impermissible method where the impermissible method was adopted subsequent to the years under examination.(66)

Windows That Were Eliminated. A significant change made by Rev. Proc. 97-27 is the elimination of the 90-day window after a taxpayer is contacted for examination.(67) Many taxpayers used this initial contact window period to identify potential issues and make voluntary changes or to file method change requests planned before being contacted for examination in order to avoid potential penalties. Elimination of this 90-day window period may reduce disputes over when a taxpayer was actually contacted for examination. Once contacted for examination, however, taxpayers may need to wait as long as 23 months (if contacted during the first month of the taxpayer's year) to request an accounting method change without district director consent. Therefore, taxpayers should not procrastinate with the filing of any known method changes. Allowing taxpayers to file a request any time during the taxable year combined with the elimination of this initial contact window period likely will find many taxpayers unable to file a planned request. This window period was eliminated since the IRS believed that some taxpayers were waiting until being contacted for examination prior to filing a method change request. This perceived abuse by taxpayers did not support the goal of seeking voluntary taxpayer compliance.

The second window eliminated was the 90-day window period provided for a new affiliate in a consolidated group.(68) The elimination of this window is ameliorated by a change in the definition of "under examination" to provide that only consolidated group members for years under examination will be considered as being under examination.(69) Therefore, joining a consolidated group currently under examination will not prevent a newly affiliated subsidiary from filing a method change request, unless the subsidiary itself is already under examination. Previously under Rev. Proc. 92-20, if a consolidated group was being examined, each member of the consolidated group was considered under examination regardless of the taxable year under examination.(70)

Taxpayer Before Appeals or Federal Court. For taxpayers that are before Appeals or a federal court, the new procedure requires them to provide the Appeals officer or government counsel with a copy of the Form 3115. In addition, taxpayers must provide a separate signed statement that the requested change is not an issue under consideration by Appeals or a federal court. The IRS National Office likely will contact Appeals or counsel to confirm the taxpayer's representation since the request must include the names and telephone numbers of the pertinent individuals.(71) The often time-consuming process of obtaining written confirmation that Appeals or government counsel does not object to the change has been eliminated.(72) Since taxpayers rarely sought method changes for items under consideration by Appeals or a federal court, this simplified approach should save both taxpayer and IRS resources.

Issue Under Consideration. Taxpayers may not file method changes for issues under consideration or placed in suspense. Rev. Proc. 97-27 leaves unchanged the definition of an issue under consideration as "written notification (for example, by examination plan, information document request (IDR), or notification of proposed adjustment or income tax examination changes) from the examining agent(s) specifically citing the treatment of an item as an issue under consideration."(73) The procedure clarifies this definition by providing examples for the first time. In one example, a taxpayer's method of pooling under dollar-value LIFO is not an issue under consideration as a result of an examination plan that identifies LIFO inventories, but is an issue under consideration as a result of a plan that identifies LIFO pooling as a matter to be examined.(74) While instructive, these examples do not provide a bright-line test for determinating the scope of the item under consideration. Accordingly, disputes are likely to arise.

The combination of a number of changes in the general method change request provisions incorporated in Rev. Proc. 97-27 provides examining agents with increased opportunities to place an issue under consideration. By placing an item under consideration, the agent reserves the issue for potential examination adjustment. In conjunction with enhanced examining agent control over when method changes can be made, it is anticipated that agents will provide more specific and exhaustive plans and IDRs to prevent taxpayers from being eligible to change their methods of accounting. Indeed, this behavioral change is already occurring. For example, taxpayers facing a certain industry issue have received detailed letters, drafted by the industry specialist, identifying certain issues that will be examined. These letters, which arrive in the mail after contact for examination but before the initial examination planning meeting with the taxpayer, include the affirmative statement that all the enumerated issues are "under consideration." Consequently, the taxpayer is prohibited from requesting an accounting method change in respect of the issues.

The IRS National Office has confirmed that this practice of providing detailed lists of items to be considered under examination (e.g., various submethods of LIFO to be specifically considered) before the initial examination conference does, in its opinion, preclude taxpayers from filing method changes. For significant industry issues, taxpayers should expect that this type of practice will occur more frequently in order to prevent them from changing under the window periods.

Partnerships and S Corporations. Rev. Proc. 97-27 provides for the first time definitions of "under examination" and "issue under consideration" for partnerships and S corporations. For an entity treated as a partnership or an S corporation for federal income tax purposes that is subject to the TEFRA unified audit provisions, an examination begins on the date of the notice of the beginning of an administrative proceeding sent to the Tax Matters Partner/Person (TMP). An examination ends (1) in a-no change case, on the date of the "no adjustments" letter; (2) in an agreed case, when all the partners, members or shareholders execute a Form 870-P, 870-L, or 870-S; or (3) in an unagreed case, the earlier of when the TMP is notified by Appeals that the case has been referred or the date the TMP requests judicial review.(75)

An issue is under consideration for an entity treated as a partnership or an S corporation if the method is an issue under consideration in an examination, by Appeals, or in a federal court with respect to a partner, member, or shareholder's federal income tax return.(76)

Audit Protection. To encourage voluntary compliance, the new procedure still provides audit protection for changes in accounting methods that are initiated by the taxpayer.(77) Hence, when a taxpayer timely files a Form 3115 pursuant to Rev. Proc. 97-27, the IRS on examination will not require the taxpayer to change its accounting method for the same item prior to the year of change.(78) Taxpayers required to change their method of accounting by the IRS generally will be required to change their method in the earliest open year with no spread period and may be subject to penalties.(79) In negotiating examination agreements, taxpayers should remember that discretion is provided to allow the IRS to provide for differing terms and conditions to settle a matter in the best interest of the government.(80)

A significant addition to the exceptions to audit protection for timely filed requests allows the IRS to make adjustments for taxable years prior to the requested year of change for the same item to reflect a prior year "IRS-initiated" change,(81) which is not defined in Rev. Proc. 97-27. The IRS is concerned about situations where the examining agents believe a taxpayer's method of accounting has been adjusted on examination, the taxpayer disagrees with this characterization of the settlement agreement, and therefore the taxpayer requests a prospective accounting method change and audit protection for years after the close of the last examination.

For example, assume costs capitalized under section 263A and expenses eligible for the research tax credit under section 41 are both issues raised on examination. As part of an Examination or Appeals settlement, the taxpayer agrees to the section 263A adjustment in order to retain the claimed R&D credit or the IRS and taxpayer agree to a partial settlement of the proposed section 263A adjustment. In both of these situations, the taxpayer may feel that the agreed adjustments were the basis for reaching a settlement with the IRS and not a change in method of accounting. The IRS may view any settlement as a change of the taxpayer's method of accounting for costs under section 263A.

If the taxpayer tries to change its method from the pre-examination method to the post-examination method through the filing of a Form 3115, this new provision indicates that audit protection may not be available. In other words, the requested section 481(a) adjustment may be reduced or eliminated by reflecting this income in earlier years during the next examination cycle.

The IRS is planning on issuing an involuntary change procedure that should define when an involuntary method change has occurred under examination. It is not known whether the revenue procedure will have prospective effect. Nevertheless, this exception to audit protection is likely to be a source of examination controversy. It also should result in a change in examination settlement procedures for both taxpayers and the IRS. Consequently, taxpayers should consider clarifying the consequences of any settlement to the taxpayer's method of accounting for the agreed adjustments.

Effect of Consent. Rev. Proc. 97-27 specifies when method changes granted pursuant to the procedure may be required to be changed or modified. Events that can result in a change or modification of the new method include the enactment of legislation; a decision of the Supreme Court; the issuance of temporary or final regulations; the issuance of a revenue ruling, revenue procedure, notice, or other statement published in the Internal Revenue Bulletin, the issuance of written notice to the taxpayer that the change in method of accounting was granted in error or is not in accord with the current views of the IRS; or a change in the material facts on which the consent was based.(82)

Any modification or required change will not be applied retroactively as long as the taxpayer complied with all the applicable provisions of the consent agreement and Rev. Proc.97-27; there were no misstatements or omissions of material facts; there was no change in the material facts on which the consent was based; there was no change in the applicable law; the taxpayer acted in good faith in relying on the consent; and applying the change or modification retroactively would be to the taxpayer's detriment.(83)

In addition, the role of the district director is emphasized by allowing any examination review to determine whether the representations on which the consent was based reflect an accurate statement of the material facts; the amount of the section 481(a) adjustment is accurate; whether the change was implemented in accordance with the terms and conditions; whether there has been a change in material facts; and whether there has been any change in the applicable law.(84)

The district director must apply the consent letter in determining the taxpayer's tax liability unless the district director recommends that the ruling should be modified or revoked. The district director needs to forward the matter to the IRS National Office for consideration if there is a recommendation that the ruling, other than the amount of the section 481(a) adjustment, should be modified or revoked.(85)

These provisions emphasize that taxpayers must disclose all material facts in requesting method changes. Further, taxpayers cannot rely on previous accounting method changes if there has been a material change in facts or law underlying the change granted. Since a change in material facts can result in retroactive change or modification of the consent granted, there is the potential for additional disputes under examination.

Many of the conditions enumerated in Rev. Proc. 97-27 were incorporated as standard conditions in consent letters granted to taxpayers. The IRS National Office, however, was concerned that examining agents often did not utilize the review authority contained in the consent letters. Placing these terms as part of Rev. Proc. 97-27 reemphasizes the district director's role in reviewing granted requests. The inclusion of these two new sections regarding potential modifications or revocation of the consent granted may reflect an increasing practice of examining agent review of accounting method issues -- or an effort to spur such increased activity.

Technical Advice Requests. Although IRS practice has allowed for technical advice requests in the past, for the first time there are three specific provisions in Rev. Proc. 97-27 detailing when requests for technical advice from the IRS National Office can be sought. Technical advice from the IRS National Office can be requested if a question arises regarding whether a method of accounting is an issue under consideration(86) or whether district director consent should be granted for taxpayers under examination.(87) Further, the district director is required to request technical advice any time a determination is made that a previously granted method change should be modified before any further action is taken.(88)

Submission of Additional Information. The time period for taxpayers to submit responses to additional information requests has been shortened from 45 to 21 days from the date of notification (the possibility of an additional 15-days upon written request remains unchanged).(89) This change is designed to accelerate the approval process, but may increase taxpayer burden to meet this short response period. Delays in receiving the request for additional information, availability of appropriate staffing at the time of request receipt, and amount of additional information requested can result in significant taxpayer burden to accurately complete a timely response.

Completed Contract Method Changes. As part of the unification of the terms and conditions for accounting method changes, the IRS superseded Q&A number 13 of Notice 89-15.(90) Under Notice 89-15, taxpayers not in conformity with the long-term contract method of accounting under section 460 were forced to effect the required method change in the earliest open year, even for voluntary requests.(91) These method changes now receive the same terms and conditions as all other method changes.

The IRS is in the process of updating the regulations under section 460, including the definition of what is a "unique item."(92) If the IRS successfully incorporates its recent examination position utilizing a broad definition of what is a unique item, many manufacturers may find that they are required to utilize the percentage of completion method.(93) The elimination of the procedure to adopt the percentage of completion method under Notice 89-15 will be of significant benefit to taxpayers that should have been on the percentage of completion method in the past.

Changes Under the LIFO Method. The Rev. Proc. 92-20 provision requiring a section 481(a) adjustment for LIFO changes made outside the scope of the procedure (e.g., changes made under examination) has been eliminated.(94) Similarly, the provision allowing use of reasonable estimation procedures to compute a section 481(a) adjustment has been eliminated.(95) The deletion of these provisions likely results from simplification and not from a change in IRS position, since a section 481(a) adjustment is generally required for all method changes made under examination.(96)

The special provisions regarding the procedures for discontinuance of the LIFO method and their coordination with the automatic change provisions of Rev. Proc. 88-15(97) have also been eliminated.(98) It is anticipated that LIFO discontinuance procedures will be contained entirely in the pending mass automatic change procedure.

Criminal Investigation. Taxpayers subject to a pending criminal investigation or proceeding were generally prohibited from making accounting method changes under Rev. Proc. 92-20.(99) Rev. Proc. 97-27 allows taxpayers subject to criminal investigations or proceedings to request a change in accounting method under normal terms; however, the portion of any net operating loss attributable to a negative section 481(a) adjustment may not be carried back to a criminal investigation or proceeding year and audit protection is not provided.(100)

Miscellaneous Items of Note. If the taxpayer changed its method of accounting for the same item within the last four years, the taxpayer must include all applicable information regarding the earlier change with its application.(101) Similarly, if a prior application was withdrawn, not perfected, or denied during the previous four years (a reduction from six years), all applicable information, including an explanation, regarding the earlier application must be provided with the request.(102)

The requirement that the taxpayers provide a separate statement in their request indicating that they agree to all the terms and conditions of the procedure has been eliminated.(103)

The IRS is in the process of updating Form 3115 to conform to the provisions of Rev. Proc. 97-27. The IRS anticipates issuing an electronic version of the revised Form 3115 during July 1997 with a hard-copy version available in August 1997. Taxpayers are being encouraged to utilize the current Form 3115 to file their requests as early as possible with no requirement to wait until the revised form is issued.

Summary

Owing to the significant modifications made to Rev. Proc. 92-20, taxpayers should be aware of the potential benefits and pitfalls included in Rev. Proc. 97-27. The primary improvements in Rev. Proc. 97-27 include the ability to file any time during the year for taxpayers not under examination, the elimination of the various Category A and B method change rules, a uniform four-year spread of the section 481(a) adjustment, the expansion of the previous 30-day window for taxpayers under continuous examination to 90 days, and the notification (rather than consent) provision for taxpayers before Appeals or a federal court.

The revised procedure, however, also has its disadvantages. The main drawbacks of Rev. Proc. 97-27 include the elimination of the 90-day window after contact for exam, the change to the definition of when an examination ends, treatment of a change in characterization as a method change, the reduction in the response time from 45 to 21 days, the increased potential for examination adjustments to approved method changes, and, in the case of certain section 481(a) adjustments, the provision of a uniform four-year spread period.

Thus, taxpayers should consider whether method changes should be made under the terms and conditions of Rev. Proc. 92-20 under the applicable transition rules. Most importantly, taxpayers should not wait until the last minute to file voluntary method changes and risk being contacted for examination. The elimination of the 90-day window after contact for examination will prevent filing method changes requests (without district director consent) until a window period is available.

Notes

(1) All section references are to the Internal Revenue Code of 1986, as amended, unless otherwise stated.

(2) Rev. Proc. 97-27, [sections] 13.01.

(3) Rev. Proc. 97-27, [sections] 13.02(1).

(4) Rev. Proc. 97-27, [sections] 13.02(2).

(5) Rev. Proc. 92-20, 1992-1 C.B. 685.

(6) Rev. Proc. 97-27, [sections] 13.02(3).

(7) A listing of these procedures is contained in Rev. Proc. 97-1, [sections] 9.03.

(8) Rev. Proc. 96-31, 1996-1 C.B. 714.

(9) Rev. Proc. 88-15, 1988-1 C.B. 683.

(10) Rev. Proc. 97-27, [sections] 9.02(3).

(11) I.R.C. [sections] 446(b) and Treas. Reg. [sections] 1.446-1(b)(1).

(12) I.R.C [sections] 481(a)

(13) Rev. Proc. 97-27, [sections] 1.02(1).

(14) Treas. Reg. [sections] 1.481-1(c)(3) and Rev. Proc. 97-27, [sections] 10.02.

(15) Rev. Proc. 97-27, [sections] 2.01 and Rev. Proc. 92-20, [sections] 2.01.

(16) Treas. Reg. [sections] 1.446-1(e)(2)(ii)(a).

(17) Rev. Proc. 91-31, [sections] 3.02, 1991-1 C.B. 566.

(18) Treas. Reg. [sections] 1.446-1(e)(2)(ii)(a).

(19) Rev. Rul. 90-38, 1990-1 C.B. 57.

(20) I.R.C. [sections] 446(e) and Treas. Reg. [sections] 1.446-1(e)(3)(i).

(21) Treas. Reg. [sections] 1.446-1(e)(2)(ii)(b).

(22) Rev. Proc. 97-27, [sections] 2.01(3) (emphasis added).

(23) 16 Cl. Ct. 1993, aff'd, 891 F.2d 1579 (Fed. Cir.), cert. denied, 498 U.S. 823 (1989).

(24) 59 T.C.M. 350, 365 (1990), aff'd in unpublished opinion, 943 E2d 1318 (11th Cir. 1991), citing Underhill v. Commissioner, 45 T.C. 489 (1966); Standard Oil Co. (Indiana) u. Commissioner, 77 T.C. 349 (1981). See also PLR 9307002 (Oct. 5, 1992).

(25) 493 U.S. 203 (1990).

(26) Rev. Proc. 91-31, 1991-1 C.B. 566.

(27) T.D. 7073, 1970-2 C.B. 98.

(28) I.R.C. [sections] 446(e).

(29) In addition to the general procedures provided in Rev. Proc. 97-27, the IRS has published several automatic procedures in which consent is deemed granted. Currently, a listing of these procedures may be obtained in Rev. Proc. 97-1, [sections] 9.03. As previously noted, however, many of these procedures are likely to be combined in one "mass automatic" change procedure.

(30) Rev. Proc. 97-27, [sections] 13.01.

(31) Rev. Proc. 92-20, 1992-1 C.B. 685.

(32) Rev. Proc. 97-27, [sections] 5 01(1)

(33) Rev. Proc. 92-20, [sections] 5.01(1)

(34) Rev. Proc. 97-27, [sections] 5.01(1)(b).

(35) Rev. Proc. 92-20, [sections] 6.02.

(36) Rev. Proc. 97-27, [sections] 6.01(1).

(37) Rev. Proc. 92-20, [sections] 5.01(3).

(38) Rev. Proc.97-27, [sections] 5.01(2). Subsequent to the release of Rev. Proc. 97-27 the IRS issued temporary regulations modifying Treas. Reg. [subsections] 1.446 and 301.9100 to conform to the provisions of Rev. Proc. 97-27. T.D. 8719, 1997-1 I.R.B. 4. A detailed discussion of section 9100 relief is beyond the scope of this article.

(39) Rev. Proc. 97-27, [sections] 6.04.

(40) Rev. Proc. 97-27, [subsections] 5.02(2) and 6.04.

(41) Rev. Proc. 97-27, [subsections] 5.02(3) and 6.04.

(42) Rev. Proc. 97-27, [sections] 5.02(3)(b).

(43) Rev. Proc. 92-20, [sections] 6.02(2)(a).

(44) Rev. Proc. 92-20, [sections] 3.06.

(45) Rev. Proc. 92-20, [sections] 3.09.

(46) Rev Proc. 92-20, [sections] 5.03.

(47) Rev. Proc. 92-20, [sections] 3.08.

(48) Rev., Proc. 92-20, [sections] 5.03

(49) T.D. 8608, 1995-2 C.B. 67.

(50) Rev. Proc. 97-27, [sections] 8.02.

(51) Rev. Proc. 97-27, [sections] 14.02.

(52) Rev. Proc. 92-20, [sections] 8 and Rev. Proc. 97-27, [sections] 7.03.

(53) Rev. Proc. 97-27, [sections] 7.03(3).

(54) Id.

(55) Proc. 92-20, [sections] 8.03(3).

(56) Rev. Proc. 92-20, [sections] 8.03(1).

(57) Rev. Proc. 97-27, [sections] 6.01(1).

(58) Rev. Proc. 97-27, [sections] 6.01(2).

(59) Rev. Proc. 97-27, [sections] 6.01(3).

(60) Rev. Proc. 92-20, [sections] 6.03.

(61) Rev. Proc. 92-20, [sections] 3.02(4).

(62) Rev. Proc. 97-27, [sections] 3.07(1)(a)(iii).

(63) Rev. Proc. 97-27, [subsections] 6.01(2)(b) and 6.01(3)(b).

(64) Rev. Proc. 97-27, [sections] 6.01(4).

(65) Rev. Proc. 92-20, [sections] 6.06.

(66) Rev. Proc. 97-27, [sections] 6.01(4).

(67) Rev. Proc. 92-20, [sections] 6.02.

(68) Rev. Proc. 92-20, [sections] 6.05.

(69) Rev. Proc. 97-27, [sections] 4.02(5).

(70) Rev. Proc. 92-20, [sections] 3.02.

(71) Rev. Proc. 97-27, [subsections] 6.02 and 6.03.

(72) Rev. Proc. 92-20, [subsections] 4.02 and 4.03.

(73) Rev. Proc. 97-27, [sections] 3.08.

(74) Rev. Proc. 97-27, [sections] 3.08.

(75) Rev. Proc. 97-27, [sections] 3.07(2). Beginning after December 31, 1996, S corporations are not subject to the TEFRA unified audit provisions. Small Business Job Protection Act of 1996, Pub. L. No. 104-188, [sections] 1317(a), 110 Stat. 1755, 1787 (1996).

(76) Rev. Proc. 97-27, [sections] 4.02(6)

(77) Rev Proc. 97-27, [sections] 9.01

(78) Id.

(79) Rev. Proc. 97-27, [sections] 2.10.

(80) Rev. Proc. 97-27, [sections] 8.15

(81) Rev. Proc. 97-27, [sections] 9.02(3).

(82) Rev Proc. 97-27, [sections] 10.01.

(83) Rev. Proc. 97-27, [sections] 10.02.

(84) Rev. Proc. 97-27, [sections] 11.01.

(85) Id.

(86) Rev. Proc. 97-27, [sections] 3.08(1).

(87) Rev. Proc. 97-27, [sections] 6.01(4).

(88) Rev. Proc. 97-27, [sections] 11.02.

(89) Rev. Proc. 97-27, [sections] 8.09.

(90) Rev. Proc. 97-27, [sections] 14.03.

(91) Notice 89-15, 1989-1 C.B. 634.

(92) Treasury and IRS 1997 Guidance Priorities (Notice issued Feb. 28, 1997).

(93) I.R.C. [sections] 460(f)(2)(A).

(94) Rev. Proc. 92-20, [sections] 9.01.

(95) Rev. Proc. 92-20, [sections] 9.02.

(96) Rev. Proc. 97-27, [sections] 2.10.

(97) Rev. Proc. 88-15, 1988-1 C.B. 683.

(98) Rev. Proc. 92-20, [subsections] 9.03(1) and (2).

(99) Rev. Proc. 92-20, [sections] 4.04.

(100) Rev. Proc. 97-27, [subsections] 5.02(4) and 9.02(4).

(101) Rev. Proc. 97-27, [sections] 8.05(1)(a).

(102) Rev. Proc. 97-27, [sections] 8.05(2) and Rev. Proc. 92-20, [sections] 10.03.

(103) Rev. Proc. 92-20, [sections] 10.05.

RELATED ARTICLE: Important CPE/CLE Accreditation Information

Boards of Accountancy. TEI is registered with the National Association of State Boards of Accountancy (Sponsor No. 91-00116-97, Exp. 12/31/96). TEI is also registered with the following Boards of Accountancy: Illinois (#1D8-000651. Exp. 1/98): Indiana (#CE92000119, Exp. 12/99); New Jersey (#160. Exp. 6130197); New York (E93-253. 911193-8131196): Ohio (P0087); Pennsylvania (PX613L); and Texas (#3S12).

Continuing Legal Education. The Institute is registered in the following states as a sponsor of continuing legal education programs: California: Approved Provider status from September 1, 1996, to August 31, 1998 -- provider number 2080; Iowa; Kentucky: 1996 46th Midyear Conference -- 24.5 credit hours [Ethics credits are included]. 1996 51st Annual Conference -- 22.75 credit hours [Program Number 36198]); Minnesota: 1996 46th Midyear Conference 20.5 credit hours, 1996 51st Annual Conference -- 19.0 credit hours; Ohio: 1996 46th Midyear Conference -- 26.25 credit hours, 1996 51st Annual Conference -- 21.5 credit hours, International Tax Course -- Level I (11/18-22/96) -- 30.0 credit hours,1996 International Tax Seminar: Section 482 Compliance (2122-23196) -- 11.5 credit hours. IRS Audits and Appeals Seminar (4/18-19/96) -- 12.25 credit hours. 1996 Federal Tax Course -- Level I (4/28-5/3/96 -- 30.0 credit hours [including 0.0 for ethics and 0.0 for substance abuse], State and Local Tax Course (7/14-19/96 [is greater than] 28.75 credit hours [including 2.5 for ethics and 0.0 for substance abuse]), State and Local Tax Seminar: Advanced Planning for the State Tax Executive (4/17-18/97) -- 12.50 credit hours; Oklahoma: 1996 46th Midyear Conference -- 31.5 credit hours, 1996 51st Annual Conference -- 28.0 credit hours; Pennsylvania: 1996 51st Annual Conference -- 22.5 substantive, Federal Tax Course -- Level II (6/16-21/96) -- 31 credit hours, State and Local Tax Course (7/14-19/96) -- 28.0 credit hours [including 1.5 for ethics] ); Wisconsin: 1996 46th Midyear Conference -- 26.0 hours; 1996 51st Annual Conference -- 25.0 credit hours. The Institute is also an accredited sponsor of educational programs for enrolled agents.

Note: Several states, such as Wisconsin and Georgia, require the individual to submit conference materials directly to the CLE board. TEI provides a continuing professional education form for each registrant at its conferences. courses, and seminars, which should be completed at the end conclusion of the program and returned to the TEI Registration Desk for verification and signature. A copy of the form is retained and filed at TEI headquarters.

Tax Executives Institute and TEI Education Fund accord to participants of any race, color, creed, sex, or national ethnic origin all the rights, privileges, programs, and activities generally accorded or made available to participants at their programs, courses, and other activities.

Please note: TEI and TEI Education Fund programs are presented for the benefit of TEI members and others who work in corporate tax departments; private practitioners may not register for the programs listed above.

DANIEL T. MORGAN is a principal consultant in the Federal Tax Services Group of Price Waterhouse LLP's Washington National Tax Services office. He received his J.D., LL.M. in Taxation, and M.B.A. degrees from Washington University and his B.S. in finance from St. Louis University. He is a member of the Missouri Society of Certified Public Accountants, the Missouri Bar Association, and the American Bar Association's Section of Taxation.

CRISTY M. BAYLES is a principal consultant in the Federal Tax Services Group of Price Waterhouse LLP's Washington National Tax Services office. She received her B.B.A. in accounting from Baylor University and is currently pursuing a Masters of Science degree in taxation from American University. She is a member of the American Institute of Certified Public Accountants and the Texas Society of CPAs.
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