The new rules for accounting method changes.
In Rev. Proc. 92-20, 1992-12 I.R.B. 10, the Internal Revenue Service issued new rules that taxpayers must follow in making requests to change accounting methods, supplanting the guidelines set forth in Rev. Proc. 84-74, 1984-2 C.B. 736. This article highlights important differences between the two procedures, including the expansion of the definition of a Category A method; the imposition of more stringent requirements with respect to certain Category A methods; the establishment of a new 90-day window for making method changes for taxpayers under examination; the development of specific rules for LIFO changes; and the elimination of the NOL/credit offset rule and the "67-percent rule" for Category B changes.
Under the new revenue procedure, special transition rules apply if the taxpayer is both (1) under IRS examination on March 23, 1992, and (2) not within either the 120-day or 30-day window period of Rev. Proc. 84-74 on that date. These rules - which are outlined in Exhibit I - apply only during the 180-day period from March 23, 1992, through September 18, 1992. Exhibit II summarizes the year-of-change rules and section 481(a) adjustment periods for different types of accounting method changes. As with the new rules discussed in the text, Exhibit II does not reflect all details and conditions of the complex new guidelines.
Expanded Definition of Category A Methods
Rev. Proc. 92-20 uses the same basic definition of a Category A method as Rev. Proc. 84-74 - i.e., one "that is specifically not permitted to be used by the taxpayer by the Code, regulations, or by a decision of the Supreme Court of the United States.' The new procedure, however, eliminates the requirement of Rev. Proc. 84-74 that "the Service may, or at the taxpayer's request will, treat the taxpayer's method of accounting as a Category A if the taxpayer's method is clearly erroneous."
Instead, Rev. Proc. 92-20 expands the Category A definition to include an accounting method that "differs from a method the taxpayer specifically is required to use under the Code, the regulations or a decision of the Supreme Court of the United States." This new language is intended to preclude taxpayer arguments that a method that is not "specifically not permitted" - even though another method is required - is a Category B method. (A Category B method is defined as any method not falling within the definition of a Category A method. Category B methods include both permissible methods as well as certain erroneous methods; a method held to be not proper in a Tax Court decision is an example of an erroneous B method.)
"Designated A" Methods
Rev. Proc. 92-20 carves out a new subset of Category A methods - the "Designated A" method. A Category A method becomes a Designated A method only if it is designated as such in a document published in the Internal Revenue Bulletin It is contemplated that Designated A's will be method changes required by tax law changes (e.g., the repeal of section 463 concerning accrual of vacation pay) but with respect to which the taxpayer does not comply with the law in a timely manner.
The terms and conditions associated with a Designated A method change are more demanding than those associated with a regular Category A method. In order to make a Designated A change, the taxpayer must either -
* file amended returns for all applicable open years,
with a section 481(a) adjustment in the earliest open
year (if needed), or
* adopt the change on a prospective basis, but also
include the entire section 481(a) adjustment in income
in the year of change.
In addition to including the entire section 481 adjustment in the year of change, taxpayers that follow the prospective approach must make a special payment calculated to approximate the time value of money and higher tax rates that would have been realized by the government had the change been made in accordance with the amended return procedure.
One possible advantage of following the prospective approach is that it may result in State tax savings. If amended federal returns are filed, amended State returns also will be needed. Under the prospective approach, however, no amended federal or State returns are required. The taxpayer thus saves the State interest expense associated with filing amended returns, since States currently do not have a similar "additional payment" mechanism like that incorporated in Rev. Proc. 92-20.
In counterpoint, a possible disadvantage of the prospective approach may accrue to taxpayers with net operating loss (NOL) or credit carryforwards, for it is unclear how NOL/credit carryforwards will enter into the computation to determine the additional required payment that approximates the lost time value of money. Depending on the resolution of this issue, taxpayers with NOL/credit carryforwards may obtain a more favorable result under the amended return approach.
As a general rule, taxpayers with a method that is likely to be classified as a Designated A method should file the request to change as soon as possible (i.e., prior to designation) in order to receive more favorable treatment. It is unlikely that taxpayers will have any warning before a Category A method becomes a Designated A.
New 90-Day Window for Taxpayers
Rev. Proc. 92-20 provides a new window period, pursuant to which taxpayers under examination may file accounting method changes other than Designated A's during the first 90 days of the examination. This window period is in addition to the 30-day and 120-day windows for Category A methods provided in Rev. Proc. 84-74, which are retained in the new revenue procedure.
The new window allows a taxpayer to file a Category A method change (except for a Designated A) at the start of the audit. Taxpayers were precluded from doing so under Rev. Proc. 84-74. The new window, however, is more restrictive for Category B method changes than the rules under Rev. Proc. 84-74. Under Rev. Proc. 84-74, a taxpayer could file a change while under examination, including after the issue was raised by the IRS. Under Rev. Proc. 92-20, in order to file a Category B method change (even from one proper method to another proper method) while under examination and after the 90-day window, the taxpayer first must obtain advance permission from the district director (DD) before filing the request. Taxpayers should exercise caution in seeking the DD's permission in that the DD may desire to make the item an examination change or may seek to extract a "price" for this "favor" that the IRS is granting.
For a positive Category A change, the year of change under this window is the earliest year under audit. For a negative Category A change and for a Category B change, the year of change is the year the Form 3115 is considered timely filed as if the taxpayer were not under examination - i.e., either the current tax year or the following tax year. Exhibit II details the applicable spread periods in respect of these changes.
Given the not-so-generous terms and conditions for changing during this window, taxpayers may conclude that they would be better off waiting until they are in a 120-day or 30-day window period or are not under examination. The risk of waiting, however, is that if the taxpayer is using an erroneous method, the IRS may make the adjustment on examination. And if the IRS makes the adjustment, the terms may be even less favorable and penalties may be assessed.
New Application of 30-Day
and 120-Day Windows
Under Rev. Proc. 84-74, taxpayers under examination were precluded from filing a Category A method change unless they were in either the 30-day or 120-day window periods. The 30-day window occurred during the first 30 days of the taxable year if the taxpayer was under examination for at least 18 consecutive months before the start of the year and if the item to be changed had not been raised during the audit. A taxpayer was in the 120-day window following the date the examination ended (even though a subsequent examination had commenced) so long as the item to be changed was not an examination issue.
Rev. Proc. 92-20 continues the windows described in its predecessor. Now, however, the windows have broader applications as a result of other rule changes. Thus, taxpayers under audit who did not file a Category B method change during the first 90 days of the examination must now either obtain permission from the DD before filing or wait until one of these window periods occur. (Under Rev. Proc. 84-74, a Category B method change could generally be filed at any point in time.)
New Rules Relating to LIFO
1. Submethod Changes. Rev. Proc. 92-20 enunciates for the first time in a published document the IRS National Office's longstanding position that changes from one LIFO submethod to another generally are to be accomplished on a cut-off basis with no section 481 adjustment.
There are several exceptions to this general rule. One exception is that the IRS may publish a list of LIFO changes that require a section 481(a) adjustment. Currently, only changes relative to the definition of an item acquired in a bulk bargain purchase of inventory in order to comply with the Tax Court's decision in Hamilton Industries are included in this list.
Another exception is for taxpayers that make a change during the 90-day window period. In such a case, the taxpayer must compute a modified section 481(a) adjustment by revaluing the inventory activity during the 10 taxable years preceding the earliest year under examination. If the taxpayer does not change during the 90-day window and the IRS makes the change on examination, the IRS may require that the adjustment be computed from the year LIFO was adopted. A change in method of accounting for inventory for a LIFO taxpayer will not be implemented on a cut-off approach if such change would have been implemented if the taxpayer was on FIFO) (e.g., a section 263A adjustment).
2. Readoption. Under Rev. Proc. 92-20, taxpayers who have changed from LIFO to another method must wait five years before readopting LIFO unless extraordinary circumstances can be shown. In contrast, Rev. Proc. 84-74 required a 10-year waiting period. Furthermore, even after the five-year period has elapsed, the taxpayer still must obtain the advance permission of the National Office by filing a Form 3115 to make the change back to LIFO.
Category B Modifications
1. NOL/credit Offset Rule. Under Rev. Proc. 84-74, the IRS conditioned the approval of a positive Category B change on the portion of the section 481(a) adjustment allocable to the year of change not being offset by NOL and credit carryforwards. Rev. Proc. 92-20 eliminates this condition. This condition stih is present in various automatic change procedures (e.g., Rev. Proc. 88-15 dealing with certain LIFO to FIFO changes), so taxpayers should exercise caution until these special procedures are updated. The IRS National Office has established a policy to waive the NOIJ credit offset rule for requests pending at the National Office under the rules of Rev. Proc. 84-74. In order to obtain this waiver, the taxpayer must first request it.
2. "67-Percent Rule." Under Rev. Proc. 84-74, a special rule applied in determining the manner in which the section 481(a) adjustment for a Category B method was spread. Specifically if 67 percent or more of the adjustment was attributable to either the one-, two-, or three-year period prior to the year of change, then the highest percentage from any of those years was spread pro rata during the first three years, with the remaining balance spread over the next three years.
This rule, along with the 75-percent rule for methods used no more than four years, has been eliminated. Hence, under Rev. Proc. 92-20, if 90 percent or more of the section 481(a) adjustment is attributable to the year preceding the year of change, then the entire adjustment is included in the year of change.
Special Consolidated Group Rules
1. New Members. If a subsidiary not under examination joins a consolidated group that is under examination, then during the 90-day period after affiliation, the parent may request permission to change a method of a subsidiary. The year of change is the taxable year that includes the first day of the 90-day post-affiliation period.
2. Section 351 Transfers. One of the general conditions of spreading the section 481(a) adjustment is that if the taxpayer ceases to engage in a trade or business, the section 481(a) adjustment is accelerated. A taxpayer is treated as ceasing to engage in a trade or business if substantially all of the assets of the trade or business are transferred to another taxpayer in a section 351 transaction. Under Rev. Proc. 92-20, this rule does not apply if the transfer is made to another member of the consolidated group pursuant to a section 351 exchange and the transferee member uses the same accounting method and agrees to follow the terms and conditions agreed to by transferor with the IRS.
IRS Audit Protection
Rev. Proc. 92-20 makes clear that if the taxpayer timely files a Form 3115 under the procedure, the IRS may not change the same method of accounting for a year prior to the year of change prescribed by Rev. Proc. 92-20. In addition, any substantial understatement penalties and preparer penalties will not be assessed with respect to the item changed.
More Latitude at Appeals
Rev. Proc. 84-74 permitted an Appeals Officer to change an accounting method to settle a case when it was in the best interest of the government to do so. The terms and conditions, however, were to be generally no more favorable than those prescribed by Rev. Proc. 84-74. Under the new procedure, an Appeals Officer is still permitted to change a method in order to settle a case, but he may do so on terms and conditions that differ from those in Rev. Proc. 92-20. This change in language appears to empower the Appeals Officer to settle on more favorable terms when previously he was precluded from doing so under Rev. Proc. 84-74.
It is apparent that the method change rules are very complex in nature and should be thoroughly evaluated by a corporate tax department to determine their effect. Taxpayers under examination should pay particular attention to the transition rules since these special rules generally contain the best of both Rev. Proc. 84-74 and Rev. Proc. 92-20. The time invested in this area by the corporate tax department should produce large rewards as well as enable it to avoid potential traps.
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|Author:||Gallagher, Everett E., Jr.|
|Date:||May 1, 1992|
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