George White is a Tax Notes contributing editor and retired national tax partner at EY. He is the author of several publications on consolidated returns and tax accounting and is an adjunct professor at the George Washington University School of Business, where he teaches graduate courses in tax accounting and corporate tax.
In this article, White discusses a how-to instructional by two leading authorities on changing accounting methods.
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At last fall's American Institute of Certified Public Accountants National Tax Conference in Washington, a full house was on hand for a how-to instructional on changing accounting methods. The panelists were two leading authorities: Jane Rohrs, a director in the accounting group of Deloitte's Washington National Tax office, and Leslie J. Schneider, a managing partner in Ivins, Phillips & Barker. Rohrs formerly served on the Joint Committee on Taxation staff. Schneider formerly served at Treasury, first as an accountant adviser and then as special assistant to the assistant secretary (tax).
Starting with the basics, the panelists noted that the practical significance of the definition of an accounting method lies in the fact that a taxpayer may not unilaterally change a method; IRS approval is required.1 Accordingly, the definition of an accounting method is critical. A method is more than the taxpayer's overall method of accounting -- that is, cash versus accrual. A method is more specific, covering an item or even a sub-item within the overall method. The panelists referred, for example, to a previously capitalized item that the taxpayer now wants to deduct instead.2 The regulations under section 446(a) provide generally that the timing of recognition of an income or expense item constitutes a method of accounting.3 This timing definition excludes an item that represents a permanent difference in the taxpayer's lifetime income -- for example, the treatment of an item as either a deductible or a personal expense.
One of the persistent issues in the accounting method area is whether the item being changed is a method (which requires IRS consent) or merely the taxpayer's facts (which does not require IRS approval). Schneider cited a change in the taxpayer's facts involving an increase in the taxpayer's gross receipts such that it no longer qualifies for the exception for the uniform capitalization inventory rules of section 263A -- that is, less than $10 million in average gross receipts.4 While clearly a change in the taxpayer's facts, it also involves a change in the taxpayer's inventory costing method that requires IRS consent. However, Schneider cited the example of a change in a taxpayer's bonus plan for employees. For instance, the elimination of a continued employment condition for qualification is a change in facts that does not require IRS consent.
Another troublesome question is whether correction of an error, for example, a mathematical or posting error, constitutes a change requiring IRS consent. In theory, the answer is clearly no, but the boundaries of a mathematical error are a matter of facts and circumstances and thus not always clear-cut.
Changing an accounting method creates a problem regarding the taxpayer's income involving possible duplication or omission of the item being changed. Take, for example, a taxpayer using an improper method for valuing inventories, a method that consistently undervalues ending inventory and thus understates taxable income. Changing to a proper inventory valuation means that in the year of change, opening inventory is higher than the prior year's ending inventory -- that is, additional basis. The higher basis will eventually flow through to, and reduce, taxable income. If the increase in basis is not accounted for, it will go untaxed.
Before enactment of the 1954 Code, the law in this area was unsettled because the statute did not prescribe any rules. Taxpayers could not change methods without securing IRS consent, and the IRS was free to impose conditions on its approval. However, taxpayers were not required to accept the IRS's conditions, because the IRS was not authorized to compel compliance.5 Section 481 was enacted as part of the 1954 Code; it requires making the necessary adjustments to effect a method change to avoid duplications and prevent omissions. Section 481 empowers the IRS to impose a change in the taxpayer's method of accounting, a so-called involuntary change.
Section 481 even gives the IRS authority to override the statute of limitations. Schneider gave the example of a taxpayer that over-allocates the acquisition price of a collection of business assets to depreciable property while under-allocating to non-depreciable land. Assume that the statute of limitations has run on the year of acquisition before the IRS notices the misallocation. Because the misallocation produces excessive depreciation in years following the year of acquisition, the IRS can apply section 481 to those open years, even though the effect is to override the statute of limitations. Otherwise, lacking that authority, the IRS would be unable to correct for the excessive depreciation amounts in the open years.
Section 481 was amended a few years after enactment to correct a huge windfall to taxpayers under the original statute.6 Before it was amended, section 481 in effect provided for vastly different outcomes depending on whether the change in method was initiated by the taxpayer or the IRS. If it was the former, the entire amount of the adjustment (positive adjustment) had to be taken into income in the year of change. For taxpayers that had been undervaluing ending inventory for years, for example, that was a major hit. On the other hand, if the IRS initiated the change, the required adjustment could not take into account undervaluations originating in tax years before enactment of the 1954 Code. This was popularly known as the "'54 Code dropout."
It didn't take a lot of head-scratching to see how taxpayers viewed the stakes. There was a huge premium on waiting to see whether the IRS noticed the taxpayer's improper inventory method and initiated the method change. If the IRS took the first step, taxpayers were off the hook for the pre-1954 years. In that environment, few taxpayers came forward to volunteer their bad methods. By the same token, the IRS was reluctant to initiate a change because it would lose the pre-1954 years from the required adjustment. The result was a stalemate.
To break the logjam, the IRS published Rev. Proc. 64-16, 1964-1 C.B. 677. The revenue procedure was commonly considered a tacit admission that IRS agents were unable to find what, at the time, was perceived to be widespread undervaluation of inventories. It offered a compromise to taxpayers seeking a method change: The required adjustment could be spread over several years. The length of the required adjustment periods has been through several iterations. The latest guidance is Rev. Proc. 2015-13, 2015-5 IRB 1 , which provides various spread periods depending on the taxpayer's circumstance. Rev. Proc. 2015-13 updates the procedural guidance for all method change requests, both automatic and advance consent.7
If the IRS consents to the change, the taxpayer gains audit protection -- that is, the IRS will not raise the bad-method issue for prior years. Looking to future years, IRS approval amounts to ruling protection for the new method -- that is, the IRS will not challenge the previously approved method.
Some method changes have become so routine that IRS approval is presumed (so-called automatic changes). In Rev. Proc. 2015-14, 2015-5 IRB 1 , the IRS recently updated the list of automatic method changes. For automatic changes, the IRS simply requires notification by the taxpayer of the change. The IRS's objective is to conserve its resources for method changes requiring scrutiny.
Although both automatic and advance consent method changes are filed with the IRS on Form 3115, the panelists noted the significant differences between them. First, the filing fee for requesting IRS advance consent is $8,000,8 while there is no fee attached to filing under the automatic change rules. Also, the IRS does not explicitly issue a ruling on the automatic changes, whereas it issues an approval letter on successful applications for advance consent. The filing deadlines for the two types of changes are also different. For advance consent requests, the deadline is generally the end of the year of the proposed change.9 For automatic changes, the deadline is the filing date of the taxpayer's return for the year of purposed change.10
Given the need for certainty on some method changes, the taxpayer might opt for an advance consent request, even if the proposed change might be covered by the automatic provisions. The IRS may deny the application for advance consent on grounds that the change is really one covered by the automatic change rules. In that circumstance, the panelists advised requesting a letter from the IRS to that effect.
Generally, a taxpayer is eligible to file for a proposed change at any time as long as it is not under examination. (Separate rules apply to taxpayers under examination. Those rules are covered in Rev. Proc. 2015-13 and provide for "window" periods for taxpayers that are under examination or have just concluded an examination.11)
An examination begins when the taxpayer receives written or oral notice from the IRS to that effect. Rohrs referred to an instance in which the IRS's written notice was received in the taxpayer's mailroom at 10 a.m. but the taxpayer's tax director did not receive it until after he filed Form 3115 later that same day. Too late, the IRS decided, because the mailroom's date stamp on the notice was determinative.
The panelists spent considerable time discussing the strategies involved in requesting advance consent. Some taxpayers favor a bare-bones approach to describing their old and new methods, preferring to let the IRS ask for more detail if it wants it. Schneider said he has seen a Form 3115 involving a billion-dollar section 481(a) adjustment that described the new method in a single sentence. A bare-bones approach, even if successful at the IRS National Office level, may simply mean that the taxpayer may face a challenge upon examination. Schneider sees risks in a bare-bones strategy; he favors greater disclosure upfront. His reasoning is that if there is to be a dispute about a method change, he prefers to have that discussion with the experts in the national office rather than a field agent. Further, Schneider favors an explanation on Form 3115 of the application of the new method. While the IRS will not explicitly rule on the application questions, it's always helpful, in Schneider's view, to be able to tell the agents that the Form 3115 laid out the details of the new method and that the IRS did not raise questions during its consideration of it.
Schneider added an anecdote to support his preference for full disclosure on Form 3115. He once had a situation in which it was clear that the client's inventory valuation method involved ignoring some pages of inventory items, with its equally clear impact on reducing the client's taxable income. Rather than obfuscate the matter with a convoluted explanation of the client's method, Schneider decided to take an upfront approach: He described the client's method as the "leave it out" method. (More cynical tax practitioners sometimes refer to these methods as UFM for "uniform fraud method.") Schneider's client was rewarded for its candor with a straightforward IRS approval letter.
1 Section 446(e).
2 The panelists also noted that currently the IRS does not consider a change in identification of an expenditure as research and experimentation under section 174 to be a method change.
5 Stephen F. Gertzman, Federal Tax Accounting, section 8.04 (1993).
6 Technical Amendments Act of 1958, P.L. 85-866.
7 For commentary on the latest guidance, see Andrew Velarde, "Accounting Method Change Rules Provide More Clarity," Tax Notes, Jan. 26, 2015, p. 474 .
8 Rev. Proc. 2015-1, 2015-1 IRB 1 , Appendix A, "Schedule of User Fees."
9 Rev. Proc. 2015-13, section 6.03(2).
10 Id. at section 6.03(1).
11 Id. at section 8.02.
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