Method Changes Within the Nonaccrual Experience Method

By Kristy L. Rempalski, CPA, and Kristy R. Hasseltine, CPA, MBA, Nashville, TN

Editor: Frank J. O’Connell Jr., CPA, Esq.

A nonaccrual experience (NAE) method of accounting, as described in Sec. 448(d) (5), allows certain service providers to except from accrual the portion of revenue they have determined will not be collected, based on their own experience and through the use of formulas allowed under this section and the regulations. A taxpayer is eligible to use an NAE method of accounting if the taxpayer uses an accrual method of accounting with respect to amounts received for the performance of services by the taxpayer, and:

  • The services are in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting (Sec. 448(d)(2)(A) and Temp. Regs. Sec. 1.448-1T(e)(4)); or
  • The taxpayer has no more than $5 million annual gross receipts for all prior tax years (Sec. 448(c) and Temp. Regs. Sec. 1.448-1T(f)(2)).
A taxpayer, however, may not use an NAE method with respect to receivables for which interest is required to be paid or there is any other penalty for failure to timely pay the amount (Sec. 448(d)(5)(B)) or for amounts of receivables earned through a nonservice source, such as the sale of goods (Regs. Sec. 1.448-2(c)(1)(ii)(A)). In addition, amounts not billed or contractually not collectible should not be included in accounts receivable for the NAE calculation (Regs. Sec. 1.448-2(c)(1)(i)).

Methods and Sub-Methods

There are multiple methods and submethods within the NAE realm. A taxpayer may adopt or request the IRS’s consent to change to a formula that clearly reflects the taxpayer’s experience (Sec. 448(d)(5)(C)). This item focuses on the nuances surrounding the adoption of or change to the safe-harbor NAE methods described in Regs. Sec. 1.448-2(f). The intricacies of the respective methods, while fascinating, are beyond the scope of this item.

The regulations provide four safeharbor methods of calculating the uncollectible portion of ending accounts receivable as a reduction in income as well as allowing the taxpayer to develop its own safe-harbor method (the fifth method or alternative method) that must be tested against the other four safe harbors. The four safe-harbor methods are presumed to clearly reflect income while the taxpayer must specifically demonstrate the clear reflection of income to use the alternative method. Each safe harbor and the alternative calculation is a method of accounting, so a change to a different safe-harbor method or to the alternative method is subject to the provisions of Secs. 446 and 481.

Applicable period: The safe-harbor methods use data obtained from the taxpayer’s historical experience and require the selection of an “applicable period,” which is the number of tax years from which the data are gathered. The taxpayer may select a range of years within the following parameters:

  • The current year and at least two but no more than five of the immediately preceding consecutive tax years; or
  • At least three but no more than six of the immediately preceding consecutive tax years.
The selection of an applicable period is a method of accounting that requires the IRS’s permission to change, which is effected on a cutoff basis (Regs. Sec. 1.448- 2(c)(2)(i)).

New taxpayers: A newly formed taxpayer who has no prior tax years in the applicable period faces a challenge in initially adopting one of these safe-harbor NAE methods. In accordance with Regs. Sec. 1.448-2(d)(4), a new taxpayer may apply any of the five methods described in paragraphs (f)(1)–(f)(5) in its first year of existence by using the experience of the actual number of tax years available in the applicable period. Taxpayers adopting the (f)(1) or the (f)(3) safe-harbor method would compute the amount excludible from income using the initial tax year as the applicable period.

The regulations provide that a taxpayer wanting to use a method described in (f)(2), (f)(4), or (f)(5) in its initial year that does not have any accounts receivable upon formation may not exclude any portion of its year-end accounts receivable from income in its first tax year. The maintenance of books and records necessary to compute the adopted safe-harbor NAE method is sufficient for the first tax year without the requirement to affirmatively elect the method on its first federal tax return.

Practice tip: Taxpayers should consider including a statement outlining the taxpayer’s intent to adopt said safe-harbor NAE method with the initial federal tax return. This may alleviate later challenge by the IRS.

The taxpayer must begin to create its moving average in the second tax year by tracking the accounts receivable at the end of year 1 (i.e., beginning of the second year). The use of one of these NAE methods in the taxpayer’s second tax year is not a change in method of accounting.

Presumably, a new taxpayer may continue to add tax years to its applicable period as they become available without a method change as the taxpayer moves through its first, second, third, etc. tax year of existence. In other words, until the maximum number of years to be included in the applicable period—six years—is available, the taxpayer’s applicable period may be considered to be inclusive of all actual number of years available.

A new taxpayer transitioning year by year to arrive at its final applicable period will annually face a choice to limit its applicable period or continue to expand that period. Although there is little guidance, presumably once a given number of years has been included in the applicable period, it would be a change in method to use a lesser number of years for the taxpayer’s applicable period.

Example: N, an oncology imaging center, begins operations on January 1, 2007, and has no accounts receivable upon formation. All of N’s revenue is from the provision of oncology imaging services. N determines that it will use the NAE safe-harbor method described in Regs. Sec. 1.448-2(f)(2). Because N has no prior years’ experience, it does not exclude any portion of its end of year 1 accounts receivable from income. At the end of year 5, December 31, 2011, N uses an applicable period of the four immediately preceding consecutive tax years (2007–2010). On December 31, 2012, the end of year 6, N decides to use an applicable period of the four immediately preceding consecutive years (2008–2011) rather than the immediately preceding five years (2007–2011). By using a four-year applicable period for two consecutive years, N appears to have adopted this method.
Although N could have continued to transition into an applicable period of six years without filing Form 3115, Application for Change in Accounting Method, it presumably would have to file Form 3115 to request a change from a four-year applicable period to any other applicable period.

Except as provided in other published guidance, a new taxpayer must request advance consent from the IRS to adopt a method other than one of the safe-harbor NAE methods to ensure that the method clearly reflects income and experience (Regs. Sec. 1.448-2(b)).

The preamble to the regulations (T.D. 9285) provides additional clarity that a newly formed or acquired taxpayer through a Sec. 351(a) or Sec. 721(a) transaction should include the predecessor’s experience in the NAE method. Regs. Sec. 1.448-2(d)(3) also provides guidance for computing an NAE method upon disposition of a major portion of the taxpayer’s trade or business.

A taxpayer may follow the procedures for requesting a letter ruling at least 30 days before the close of the tax year to ask that certain tax years be excluded from the applicable period. The IRS is likely to approve such a request upon demonstration that there is a change in a substantial portion of the outstanding accounts receivable such that the risk of loss is substantially increased (Regs. Sec. 1.448-2(d) (6)).

It should be noted that the regulations give the Service authority to change the taxpayer’s method of accounting on examination if the recordkeeping requirements of Regs. Sec. 1.448-2(d)(8) are not met.

Recoveries: The taxpayer must consider recoveries when using the NAE method. If in a subsequent tax year a taxpayer recovers an amount previously charged off or excluded from income under an NAE method, the taxpayer must include the recovered amount in income (Regs. Sec. 1.448-2(d) (5)). The regulations require taxpayers to trace recoveries to their corresponding charge-offs if they are able to do so without undue burden (Regs. Sec. 1.448-2(f) (2)(iii)(B)). However, if the taxpayer would incur undue burden, it can use any reasonable method to determine the amount of recoveries to be traced to each tax year’s bad debts. The taxpayer may allocate those or all recoveries between charge-offs in the relevant beginning accounts receivable balances. A method will be considered reasonable if there is a cause-and-effect relationship between the allocation base or ratio and the recoveries (Regs. Sec. 1.448-2(f)(2) (iii)(C)).

Determination date: A determination date is used as a cutoff for determining all known data to be taken into account in the computation of the tax year’s uncollectible amount. The determination date may not be later than the extended due date or the date on which the taxpayer timely files for that tax year, whichever is earlier. A change in determination date is not a change in accounting method, although once a determination date is selected and used for a particular tax year, it may not be changed (Regs. Sec. 1.448- 2(c)(5)).

Method Changes

Automatic changes: In Rev. Procs. 2006-56 and 2008-52, the IRS provides guidance on obtaining automatic consent to make accounting method changes to, out of, or within nonaccrual experience methods. The guidance under Rev. Proc. 2008-52 applies to changes within the scope of Rev. Proc. 2006-56, §§3.01(1)– 3.01(5). These sections generally apply to taxpayers who want to:

  • Change to one of the five safe-harbor NAE methods provided in Regs. Secs. 1.448-2(f)(1)–(5);
  • Change to a periodic system;
  • Change from an NAE method to a specific charge-off method;
  • Change from one permitted applicable period to another permitted applicable period, other than a change to exclude tax years from an applicable period; or
  • Change from a sub-method of tracing recoveries to another sub-method of tracing recoveries.
The designated automatic accounting method change number for these changes is no. 35 (Rev. Proc. 2006-56, §4.01(1)). Changes within Rev. Proc. 2006-56, §§3.01(1)–3.01(3) and 3.01(5), should be made with a Sec. 481(a) adjustment. A change from one permitted applicable period to another permitted applicable period under Rev. Proc. 2006-56, §3.01(4), is made on a cutoff basis (Rev. Proc. 2008- 52, §14.04(3)).

Advance consent: Changes in method of accounting under Rev. Proc. 2006-56, §§3.01(6)–3.01(8), seek to:

  • Change a sub-method unrelated to the applicable period or to the tracing of recoveries for a taxpayer currently using an NAE method provided in Regs. Sec. 1.448-2(f);
  • Change to an NAE method other than a safe-harbor method provided in Regs. Secs. 1.448-2(f)(1)–(5); or
  • Adopt an NAE method other than a safe-harbor method provided in Regs. Secs. 1.448-2(f)(1)–(5).
A tax payer wanting to adopt or make a change under §§3.01(6)–3.01(8) must follow the advance consent change method of accounting procedures under Rev. Proc. 97-27 (Rev. Proc. 2006-56, §§4.02 and 4.03).

Concurrent changes: A taxpayer that wants to make a change to an NAE method and either is required under Sec. 448 to change to an overall accrual method (automatic accounting method change no. 34) or wants to change to an overall accrual method must file a single Form 3115 and complete all applicable sections, including those that apply to the change to an overall method and the change to the NAE method. If the taxpayer is required to file Form 3115 and follow the change of method in accounting procedures under Rev. Proc. 97-27 (for concurrent changes within the scope of §§3.01(6) or (7) of Rev. Proc. 2006-56), only one user fee is required (Rev. Proc. 2006-56, §§4.01 and 4.02).

As exemplified in this item, there is much complexity to the multiple methods and sub-methods within the NAE domain. Practitioners should carefully study the regulations to ensure that the most appropriate method is selected and properly elected.


Frank O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.

Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.

For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or

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