Taxpayers making automatic accounting method changes that affect capitalizable costs should consider the uniform capitalization rules of Sec. 263A and the related regulations (UNICAP rules). This item discusses how failing to consider the UNICAP rules might cause the IRS to reject the accounting method change.
On January 10, 2011, the IRS issued revised procedures for automatic accounting method changes. Rev. Proc. 2011-14 supersedes the prior guidance for automatic method changes in Rev. Proc. 2008-52 (as modified by Rev. Proc. 2009-39) and also modifies the advance consent method change procedures in Rev. Proc. 97-27 to conform certain procedural requirements. In general, Rev. Proc. 2011-14 is effective for automatic accounting method changes filed on or after January 10, 2011, for a year of change ending on or after April 30, 2010. Certain transition rules may apply to convert or amend previously filed applications. In the majority of cases, a Sec. 481(a) adjustment is imposed to prevent the duplication or omission of an item of income or deduction, and this adjustment reflects the cumulative impact of the proposed method versus the current method as of the end of the tax year immediately preceding the year of change (see Section 5.03 of Rev. Proc. 2011-14).
One provision in Rev. Proc. 2011-14 that taxpayers should consider is Section 2.05(1), which provides in relevant part that “[i]n computing the net §481(a) adjustment, a taxpayer must take into account all relevant accounts.” This language is not new but is of recent vintage; it was first included in Rev. Proc. 2009-39, which modified the comparable portion of Rev. Proc. 2008-52, which in turn was the predecessor to Rev. Proc. 2011-14. While the change was subtle and may simply memorialize otherwise applicable principles, taxpayers may not have fully grasped its effect. Although portions of the automatic procedures specifically require that the taxpayer must already properly capitalize the cost at issue or otherwise file a concurrent change (see, e.g., Section 6.01(1)(c)(ii) of the appendix to Rev. Proc. 2011-14, concerning certain changes in method of accounting for depreciation), the language in Section 2.05(1) ostensibly applies to all method changes.
The UNICAP Rules and Accounting Method Changes
Why does this issue merit attention? Interpretations of Section 2.05(1)’s implications are currently evolving and could have a significant effect on a taxpayer’s tax position; for example, is a taxpayer’s exposure the portion attributable to the UNICAP rules’ effect on the item being changed, or is it the entire change in method of accounting? Note that the UNICAP rules require the capitalization of a wide variety of costs to inventory and self-constructed fixed assets, so if a taxpayer changes its method of accounting with respect to a capitalizable cost, presumably the effect of the capitalization on the adjustment must be reflected.
First, note that eligible taxpayers making an accounting method change under Rev. Proc. 2011-14 are granted automatic consent under Sec. 446(e) and Regs. Sec. 1.446-1(e)(2)(i). However, consent is granted only if the taxpayer complies with the applicable provisions of the revenue procedure. (See Sections 6.01 and 6.06 of Rev. Proc. 2011-14.) Upon examination by the IRS, all accounting method changes are subject to review by the director, who can determine whether the changes were made in compliance with all applicable provisions, including whether the amount of the Sec. 481(a) adjustment was properly calculated. (See Section 9.01(2) of Rev. Proc. 2011-14; see also Section 1.01(3) of Rev. Proc. 2011-1, defining the term “director” for this purpose.) If the taxpayer did not comply with all the applicable provisions, the director has broad discretion under Section 9.02 of Rev. Proc. 2011-14 to:
- Deny the change and require the taxpayer to use the prior method of accounting;
- Deny the change and put the taxpayer on a proper method of accounting; or
- Make any necessary adjustments to bring the method change into compliance with the relevant procedures, including adjusting the Sec. 481(a) adjustment.
Assume that a taxpayer fails to reflect the effect of the UNICAP rules on a Sec. 481(a) adjustment, which in turn has been computed to reflect a change in method of accounting with respect to a capitalizable cost. Experience suggests that IRS examination teams generally take a reasonable approach and attempt to adjust the Sec. 481(a) adjustment as the remedy of first resort rather than simply disallowing the method change out of hand. A relevant example of this approach is evident in Technical Advice Memorandum (TAM) 200445026; in that case, the taxpayer failed to properly implement a change in accounting method to the retail inventory method. The IRS stated that “[w]hen a revenue agent determines under section 446(b) that a taxpayer has improperly applied a permissible method of accounting, the revenue agent generally will require the taxpayer to correct its application of the method for the year(s) under examination rather than require the taxpayer to change to some other permissible method.”
In the case at hand, the IRS ruled that because of an absence of adequate books and records permitting a proper computation, the ruling letter granting the taxpayer’s original request should be revoked. It is important to note that Sec. 6110(k)(3) prohibits the use or citation of a TAM as precedent. It can, however, provide useful information about how the IRS may view certain issues. Given the view expressed in TAM 200445026, while outright revocation of a method change is a potential risk, it would seem that when adequate books and records are available, the practical risk is most likely an adjustment to the Sec. 481(a) adjustment and to the prospective effect of the new method of accounting on, for example, the UNICAP computation.
Accordingly, when computing a Sec. 481(a) adjustment, taxpayers must be mindful of properly including the effect of all accounts, such as items capitalized to inventory under the UNICAP rules. Significantly, the interaction of the UNICAP rules and specific accounting method changes is addressed in several sections of the Rev. Proc. 2011-14 appendix (and prior guidance), thus creating additional potential risk for taxpayers who file method changes under those portions of the procedure. See, for example, appendix Section 6.01, mentioned above.
The interaction of Sec. 481(a) and the UNICAP rules may also have collateral effects on other issues. For example, one must evaluate whether a change in method of accounting is at the requisite level of authority and, if so, what portion is at that level; those method changes that are procedurally, computationally, or substantively defective because of a failure to reflect the effect of UNICAP rules could potentially result in the establishment of a reserve for financial reporting. In such cases, reporting on Schedule UTP may become relevant.
In conclusion, taxpayers should be careful to consider the influence of all accounts—including those costs capitalizable under the UNICAP rules—when preparing any current or future accounting method changes. In addition, all recent prior changes should be evaluated to determine whether there is any unidentified risk.
Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.
For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.