Changes in Book Recognition of Advance Payments May Require Changes in Tax Accounting Method

By Betty Hong, CPA, Costa Mesa, CA

Editor: Kevin D. Anderson, CPA, J.D.

Tax Accounting

The Sec. 446 regulations have long established that a taxpayer that changes its book method of accounting must secure the IRS’s consent before applying its new book method of accounting for tax purposes. In cases where a taxpayer accounts for certain items for tax purposes by using the same methods of accounting as for financial reporting (book), this principle could be easily overlooked. Unless the taxpayer takes steps to change its method of accounting for tax purposes, the taxpayer must generally continue to use the previous method for tax purposes and record a book-tax difference on its federal income tax return.

Based on Chief Counsel Advice (CCA) 201011009, issued in 2010, taxpayers using the one-year deferral method under Rev. Proc. 2004-34 to recognize advance payments must be mindful of any changes in the underlying revenue recognition method used for book purposes. For taxpayers in such situations, Rev. Proc. 2011-14, which provides the exclusive procedures for obtaining automatic consent for a change in method of accounting, recently introduced a new automatic consent method change for taxpayers wishing to use the new book method of recognizing advance payments in revenues for purposes of determining the extent to which advance payments are included in gross income under Rev. Proc. 2004-34.

General Rules and Analysis

The question raised in CCA 201011009 is whether a taxpayer that previously elected to defer advance payments under Rev. Proc. 2004-34 is required to obtain consent under Sec. 446(e) if the taxpayer subsequently changes its applicable financial statements for deferred advance payments. Sec. 446(e) generally requires a taxpayer that changes the method of accounting on the basis of which it regularly keeps its books to secure the consent of the IRS before computing taxable income under the new method. Similarly, Regs. Sec. 1.446-1(e)(2)(i) provides as follows: “[A] taxpayer who changes the method of accounting employed in keeping his books shall, before computing his income upon such new method for purposes of taxation, secure the consent of the Commissioner.” As discussed below, the facts and rationale of CCA 201011009 demonstrate how this regulation may pose a trap for the unwary.

In the CCA, an accrual-method taxpayer was engaged in the business of providing services to clients and received advance payments from its customers for services that the taxpayer would provide over a 15-month period. For book purposes, the taxpayer recognized advance payments in revenues ratably over the first 10 months of the 15-month period. In year 1, the taxpayer properly filed a Form 3115, Application for Change in Accounting Method, and received consent to change its method of accounting for advance payments from the full inclusion method to the deferral method prescribed by Rev. Proc. 2004-34. Under the deferral method, among other things, the taxpayer must include advance payments in gross income for the tax year of receipt to the extent recognized in revenues in its applicable financial statement (AFS) for that tax year. The remaining amount of the advance payment must be included in income in the next succeeding tax year.

Two years later (year 3), the taxpayer changed its book method of accounting to recognize the advance payments ratably over the entire 15-month period and restated its prior financial statements. Beginning in that same year, the taxpayer reported advance payments using the deferral method of Rev. Proc. 2004-34 in its federal income tax return consistent with the new book method, but failed to file a Form 3115 to request consent to change its method of accounting for advance payments.

The IRS National Office concluded based on these facts that a change in a taxpayer’s manner of computing deferral of advance payments under Rev. Proc. 2004-34 to conform to a change in financial accounting constitutes an accounting method change for which the taxpayer is required to obtain consent under Sec. 446(e) and the regulations thereunder. In so concluding, the IRS rejected the taxpayer’s assertion that a change in the underlying book method for advance payments is not a change in method of accounting because the taxpayer had already received consent to change to the deferral method under Rev. Proc. 2004-34.

According to the CCA, the taxpayer in year 1 adopted a tax method of accounting for inclusion of advance payments pursuant to which it included the payments in income on a pro-rata basis over the first 10 months of the 15-month contractual period. This method of including advance payments in income conformed to the taxpayer’s method of recognizing the payments in revenues for financial purposes, as required by Rev. Proc. 2004-34. In year 3, in conjunction with changing its method of recognizing revenues for financial purposes, the taxpayer began including advance payments in income for tax purposes on a pro-rata basis over 15 months. Thus, the taxpayer changed the timing of including an item in income from the timing of including that item in the previous two years. As a result, the change in the timing of inclusion of the advance payments constitutes a change in method of accounting, which requires filing Form 3115 to obtain the IRS’s consent.

New Method Change Procedures

Taxpayers that used the one-year deferral method under Rev. Proc. 2004-34 to recognize advance payments and experience a change in the manner of recognizing the underlying advance payments for book purposes may automatically change their method of accounting to use their new book method. In August 2009, Rev. Proc. 2009-39 modified Rev. Proc. 2008-52 (the predecessor to Rev. Proc. 2011-14) to permit a taxpayer to file an automatic method change request to use its new method of recognizing advance payments in revenues in its AFS for purposes of determining the extent to which advance payments are included in gross income under Rev. Proc. 2004-34. This modification was made to Section 15.07 of the appendix to Rev. Proc. 2008-52 (automatic change 84), the automatic change procedure for changing to the deferral method of Rev. Proc. 2004-34.

On January 10, 2011, Rev. Proc. 2011-14 introduced a new automatic change for changes in advance payment resulting from a change in AFS. Section 15.11 of the appendix to Rev. Proc. 2011-14 permits a taxpayer to file a statement, in lieu of the Form 3115, to obtain the IRS’s consent. The statement, which must be attached to the taxpayer’s original return for the year of change, must provide, among other things, the designated automatic method change number (automatic change 153), a description of each type of item affected by the change in revenue recognition and the line number (or schedule) where the affected item is reflected on the federal return for the year of change, and a description of the basis used for deferral (i.e., the method the taxpayer uses in its AFS or how the taxpayer determines amounts earned, as applicable) both before and after the change in the revenue recognition policy for the AFS.

The taxpayer makes this automatic change on a cutoff basis (i.e., no Sec. 481(a) adjustment), and it applies only to advance payments received on or after the beginning of the year of change. There are also special transition rules for previously filed Form 3115 applications. Rev. Proc. 2011-14 is effective for automatic consent applications filed on or after January 10, 2011, for a year of change ending on or after April 30, 2010.


EditorNotes

Kevin Anderson is a partner, National Tax Services, with BDO USA, LLP, in Bethesda, MD.

For additional information about these items, contact Mr. Anderson at (301) 634-0222 or kdanderson@bdo.com.

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