Significant new guidance for changing an accounting method.
The publication of this new guidance is significant and, with respect to the voluntary change procedures, presents planning opportunities for taxpayers. It also presents an opportune time to review the types of accounting practices that constitute a method of accounting for tax purposes, the general procedures by which a taxpayer may initiate a change in accounting method, certain benefits or consequences of initiating or not initiating a change, and a brief discussion of the new voluntary-method-change guidance.
A method of accounting includes a taxpayer's overall plan of accounting (e.g., cash versus accrual) and the accounting treatment of any item of income or deduction. In general, an accounting method affects the timing for reporting income or deductions. If an accounting practice does not permanently change the amount of the taxpayer's lifetime income, but does or could change the tax year in which income is reported, it involves timing. An accounting method that is used for two or more tax years is generally considered "adopted" and may only be changed with the consent of the IRS, even if the method was erroneous.
An accounting-method change occurs when the taxpayer computes its taxable income for a particular year using an accounting method that is different from the method it used for the preceding tax year. The taxpayer makes voluntary method changes on a prospective basis. On the other hand, an involuntary change imposed by the IRS during the course of an examination is made in the earliest tax year under examination or, if later, the first tax year in which the IRS considers the method impermissible.
An accounting-method change does not include a correction of mathematical or posting errors, or of errors in the computation of a tax liability. It also does not include the adjustment of any item of income or deduction not involving the proper timing for the inclusion or deduction. For open years, the taxpayer may typically file amended returns to correct these types of errors. In general, however, taxpayers cannot use amended returns to change or correct an accounting method that has been adopted. The IRS does not consider a change in an item's treatment due to a change in underlying facts as an accounting-method change. The taxpayer can generally incorporate such a change on the return for the year the underlying facts change.
When a taxpayer changes an accounting method, Sec. 481(a) ordinarily requires the taxpayer to adjust taxable income to prevent amounts from being duplicated or omitted under the new method. While some method changes must be made on a cut-off basis (which does not require an adjustment to taxable income), most method changes result in a Sec. 481(a) adjustment, which can be either positive (resulting in an increase in taxable income) or negative (resulting in a decrease in taxable income). In essence, the Sec. 481(a) adjustment is the cumulative difference in taxable income for years prior to the change year, as computed under the old and new methods.
The period for including the change's effect in income varies, and depends on whether the change is voluntary or involuntary and on the nature of the change. For voluntary changes, the taxpayer usually includes a positive Sec. 481(a) adjustment in income ratably over four years. Although the same rule had previously applied to negative adjustments, Rev. Proc. 2002-19 modified the spread period. As a result, the taxpayer can now deduct a negative Sec. 481(a) adjustment entirely in the change year. For an involuntary change, the taxpayer ordinarily takes the Sec. 481(a) adjustment into account entirely in the change year, whether positive or negative.
A taxpayer may want to change an accounting method for various reasons, such as to correct an impermissible or erroneous method or to take advantage of a more beneficial method. When the taxpayer has been using an impermissible method to its advantage (and thus to the government's disadvantage), voluntarily correcting the method often provides audit protection. This might allow the taxpayer to avoid penalties and interest that the IRS could otherwise assess on discovering the error during an examination, and would allow the taxpayer to spread a positive Sec. 481(a) adjustment over four years. Conversely, the same adjustment involuntarily imposed on audit would likely result in no spread of the Sec. 481(a) adjustment in prior open years, but could result in deficiency interest and penalties.
A taxpayer may also initiate a method change to claim allowable deductions that it neglected to claim on prior returns because it was using an erroneous method. For example, the taxpayer may have incorrectly classified depreciable property placed in service in prior years, resulting in under-depreciation of the assets. By filing for a change to correct the erroneous method, the taxpayer can obtain a favorable Sec. 481(a) adjustment in the change year for the entire amount of the under-depreciation.
Nonautomatic vs. Automatic Voluntary Method Changes
Sec. 446(e) requires taxpayers that change an accounting method used for Federal income tax purposes to obtain advance consent from the Service. The IRS might require a taxpayer that changed an accounting method without consent to revert to its former method, even if the former method was erroneous. Depending on the type of change, the Service must expressly grant advance consent through a letter ruling, or alternatively, consent may be deemed granted, in which case it would not issue a letter ruling. The types of accounting-method changes requiring a letter ruling are frequently referred to as "nonautomatic" changes, while method changes eligible for deemed consent are referred to as "automatic" changes. An accounting-method change generally requires express IRS permission, unless published IRS guidance specifies that the method change is eligible for automatic consent.
Nonautomatic changes. For nonautomatic changes, a taxpayer obtains advance consent by filing Form 3115, Application for Change in Accounting Method, with the IRS National Office pursuant to Rev. Proc. 97-27, as modified by Rev. Proc 2002-19. Under Rev. Proc. 97-27, the taxpayer must file Form 3115 within the change year. The IRS then issues a letter ruling either granting or denying the requested change. Approval of a method depends primarily on whether the new method is valid and clearly reflects income, in the IRS's view. This determination is somewhat subjective and injects a degree of uncertainty into the taxpayer's application, pending receipt of the ruling letter.
Because the IRS has limited resources, the time between filing a request and receiving a ruling may be long. This delay can leave a taxpayer that timely requests to use a new method for the change year still waiting for a ruling on the filing deadline for its change-year return, which creates uncertainty about whether it should use the old or a new method on the return.
Automatic changes. Filing for an automatic accounting-method change offers taxpayers several advantages over a nonautomatic filing. A taxpayer seeking to change an eligible accounting method must still file Form 3115, notifying the IRS of the change. However, the taxpayer will be deemed to have obtained the IRS's consent, providing the taxpayer adhered to the terms and conditions governing the change request. No letter ruling is issued for an automatic change request, thus eliminating the uncertainty associated with a ruling letter. In addition, the taxpayer has additional time to file for an automatic change, as the Form 3115 is not due until the change-year return's extended due date. As an added bonus, a nominal user fee required with nonautomatic change filings is waived for automatic changes.
The specific accounting-method changes eligible for automatic approval and the terms and conditions for which the IRS grants consent are detailed in Rev. Proc. 2002-9, which supersedes Rev. Proc. 99-49. Rev. Proc. 2002-9 retains more than 30 automatic method changes previously allowed and eliminates three. It also adds 13 automatic method changes, published subsequent to Rev. Proc. 99-49's release and allows 12 new accounting methods not previously permitted. The Appendix of the revenue procedure includes a list of most method changes eligible for automatic consent.
Taxpayers considering an accounting-method change must first determine the appropriate revenue procedure under which they should file the proposed change. This is, in essence, a process of elimination: Taxpayers should first review the Rev. Proc. 2002-9 appendix, to determine whether the proposed change is potentially eligible for automatic approval. If not, the taxpayer should then search IRS publications released subsequent to Rev. Proc. 2002-9, to determine whether the proposed change has been added to the list of approved automatic changes. This step is necessary as the IRS expects to continue to add to the list of method changes eligible for automatic consent, to free up internal resources. If the method change is not eligible for automatic consent, the taxpayer must file the change request under Rev. Proc. 97-27's nonautomatic procedures.
Regardless of which procedure a method change is filed under, the taxpayer must consider and adhere to all terms and conditions specified in the procedure, as well as any applicable modifications made by IRS releases subsequent to publication of the relevant procedure (including possible scope limits). An incorrect or incomplete application may result in a rejection and a loss of audit protection. On the other hand, a taxpayer can use a properly filed accounting-method change as both a tax planning and compliance tool. Corporate calendar-year filers have until Sept. 16, 2002 to take advantage of the benefits of an automatic method change on their 2001 returns, so they do not let this opportunity slip away.
FROM MICHAEL T. SMALLEY, CPA, WASHINGTON DC
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|Author:||Smalley, Michael T.|
|Publication:||The Tax Adviser|
|Date:||Jun 1, 2002|
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