IRS Offers Another Mark-to-Market Valuation Safe Harbor

By David A. Thornton, CPA, New York, NY, and Brian P. McDonald, CPA, Oak Brook, IL

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

Gains & Losses

On April 6, 2011, the Large Business and International (LB&I) Division of the IRS released Industry Issue Directive LB&I-4-1110-033 instructing its examining agents to offer a safe-harbor election to certain taxpayers under examination regarding the market values used in their Sec. 475 calculations. This directive allows taxpayers who issue public financial statements to rely upon the fair market values (FMVs) of applicable securities as determined for financial reporting purposes in the mark-to-market calculations required under Sec. 475.

To qualify for the safe harbor, taxpayers must sign a certification statement with representations regarding the use of the financial statement values and provide it to the examining agent within 30 days of the agent’s request. Failure to elect or to qualify for the safe harbor simply reverts the taxpayer back to standard IRS audit procedures, which may enable a challenge of the values used in the Sec. 475 calculations (even if the financial statement values are used). While the directive is welcome news to taxpayers, the language of the certification statement will require some modification, as the current version would disqualify many taxpayers from making the safe-harbor election on examination.

Background

Sec. 475 requires the use of mark-to-market accounting for certain securities held by a taxpayer that meets the definition of a dealer in securities. Under the mark-to-market accounting method, inventoried securities are carried at fair market value, with fluctuations in value reported as a component of current taxable income. Unrealized gains and losses on noninventoried securities subject to the mark-to-market rules are recognized in current taxable income as if the securities were sold for their FMV on the last day of the tax year. Sec. 475 does not provide a definition of fair market value, nor does it provide any substantive guidance regarding how such value is to be determined. Consequently, the valuation of securities subject to Sec. 475 has been an area of potential disagreement between taxpayers and the IRS, particularly for complex financial instruments for which reliable market quotations are not available.

Taxpayers are required to value for purposes of preparing audited financial statements many of the securities requiring valuation under Sec. 475. While there is no statutory requirement that the IRS accept the values reported for financial reporting purposes, many taxpayers rely upon these values for purposes of compliance with Sec. 475 in order to avoid duplicative valuation efforts and associated costs. The IRS has not always agreed with the valuation methodologies employed by taxpayers for financial reporting purposes and has challenged the use of the financial statement values in the Sec. 475 calculations. However, in recent years the IRS has been trending toward allowing the use of financial statement values under limited circumstances.

Safe Harbor Under Regs. Sec. 1.475(a)-4

In an effort to reduce the level of disagreement between taxpayers and the IRS over appropriate valuation methods for securities under Sec. 475, Treasury issued Regs. Sec. 1.475(a)-4 in 2007. This regulation offers an elective safe harbor for taxpayers to use the values reported in the taxpayer’s financial statements for most securities subject to mark-to-market accounting under Sec. 475. However, the scope of this safe harbor is limited because the IRS does not automatically accept all financial statement values under the safe harbor.

While any taxpayer meeting the definition of a dealer in securities under Sec. 475(c)(1) is eligible to make the safe-harbor election under the regulation, the taxpayer must issue an applicable financial statement in order to qualify for the safe-harbor protection. The regulations define an applicable financial statement to include those filed with the Securities and Exchange Commission (SEC), those filed with the federal government or any of its agencies (other than the IRS), and certified audited financial statements prepared in accordance with U.S. GAAP and issued for a substantial nontax purpose (such as to creditors, shareholders, or potential investors). Taxpayers who do not issue an applicable financial statement cannot rely on the safe harbor for the values they report in any nonqualifying financial statement.

The regulation safe harbor does contain some limitations. First and foremost, the regulation does not simply accept without scrutiny all values reported by the taxpayer in its applicable financial statements. In order to qualify for the safe harbor, the taxpayer must use an eligible method with respect to the valuation of the securities, with particular requirements for valuing complex derivatives for which reliable market quotations are not available. If the taxpayer does not follow these methods in determining the values presented in its financial statements, the securities do not qualify for the safe-harbor election. In addition, the eligible method requires the effect of the mark-to-market adjustment to be recognized in financial statement income, which may not necessarily occur for all securities required to be marked to market for financial reporting purposes. Consequently, the regulation safe harbor is not comprehensive, as taxpayers may find that some of their securities do not qualify for the election.

The safe-harbor election under Regs. Sec. 1.475(a)-4 is made by attaching a statement to the tax return for the year in which the election is to become effective, and it is revocable only with IRS consent.

Industry Issue Directive LB&I-4-1110-033

Industry Issue Directive LB&I-4-1110-033 instructs LB&I examining agents not to challenge a taxpayer’s use of FMVs reported on the taxpayer’s qualified financial statement for purposes of computing the mark-to-market adjustments required under Sec. 475, provided the taxpayer submits a signed certification statement to the examining agent within 30 days of the agent’s request for the statement. The certification statement contains various representations regarding the taxpayer’s use of the financial statement market values in the calculation of taxable income. Compliance with the directive is voluntary, and taxpayers who fail to comply with the directive or who do not otherwise qualify under the directive will be subject to customary audit procedures in the Sec. 475 area, including potential challenges to the values used in the Sec. 475 calculations.

Based on the voluntary nature of the directive, it essentially amounts to an elective safe harbor that qualified taxpayers can use after the IRS has commenced an examination and has questioned the valuation methods under Sec. 475. The benefit of the election is that it protects the taxpayer’s use of the market values presented in the taxpayer’s qualified financial statement in computing the mark-to-market adjustments required under Sec. 475. Those taxpayers who do not wish to conform their tax and financial reporting valuation methods are not required to comply with the directive.

The directive safe harbor is available only to those taxpayers who file public financial statements with the SEC under Rules 17a-5 and/or 17a-12 of the Securities Exchange Act of 1934 (qualified financial statements). Furthermore, if the directive is applied, the taxpayer must demonstrate that all the securities marked to market under Sec. 475 were valued using the FMVs presented in the taxpayer’s financial statements. As noted above, in order to effect the safe harbor, eligible taxpayers must file an applicable certification statement with the examining agent within 30 days of the agent’s request for the statement. The statement requires the taxpayer to make numerous representations regarding the conformity of the tax and financial statement values used for applicable securities (see below for further explanation of the required disclosures).

The protection granted under the directive is broader than the protection under the safe-harbor election of Regs. Sec. 1.475(a)-4 because, unlike the regulation, the directive imposes no limitations on the methodologies used to value the taxpayer’s securities. Thus, regardless of whether the taxpayer uses an eligible method as defined under Regs. Sec. 1.475(a)-4(d), the IRS will accept the financial statement values. The directive also offers taxpayers who did not use the financial statement values an opportunity to retroactively apply these values, either as an adjustment to the examination year or as an advance consent accounting method change for the current year (vesting the discretion as to which method is used with the examining agent).

A taxpayer who elected the regulation safe harbor can supplement that safe harbor with the directive for those securities ineligible for the regulation safe harbor (i.e., because of the use of an ineligible valuation method) if the use of financial statement values is desired. For qualified taxpayers that issue public financial statements with the SEC, the comparatively expansive nature of the directive protections would appear to render the regulation safe harbor meaningless. However, as noted below, qualification for the directive safe harbor may be restrictive, based on the representations that are required as part of the certification statement. In addition, taxpayers who issue audited financial statements but do not meet the SEC filing requirement imposed for qualification under the directive will continue to use the regulation safe harbor.

The LB&I clearly states that the objective behind the directive is to eliminate the time and effort spent independently valuing securities for tax purposes that are already required to be valued for financial reporting purposes. The directive expressly states that the valuation methods used for financial reporting and tax valuation purposes are substantially similar, and independent valuation for tax purposes imposes a significant administrative burden on both taxpayers and the IRS and requires the commitment of substantial IRS audit resources. Based on this reasoning, the IRS clearly intended a broad application of the directive to taxpayers who issue public financial statements. However, for the reasons discussed below, unless it is changed, the language of the required certification statement may prohibit many such taxpayers from participating in the directive.

The certification statement must be signed by an authorized officer and must contain the following representations made under penalties of perjury:

  • The mark-to-market values reported on the financial statement are consistent with those used in the calculation of taxable income for securities required to be marked to market under Sec. 475;

  • No Schedule M adjustments (i.e., book-tax reconciliations) were made regarding the mark-to-market values (which assumes the marks are included in financial statement net income); and

  • No deferred taxes (indicating a book-tax basis difference) were recorded with respect to the mark-to-market values.

The certification statement appears to have been written under the assumption that all securities required to be marked to market for tax purposes under Sec. 475 are also required to be marked to market for financial reporting purposes. In addition, the certification statement assumes that all adjustments to mark the appropriate securities to market for financial reporting purposes are recorded through the income statement. For many taxpayers, these assumptions are not correct; consequently, these taxpayers cannot make the representations required under the certification statement. This would prohibit such taxpayers from qualification under the directive.

For example, the opportunity to mark securities to market under Sec. 475 is potentially more expansive than the list of securities that are required to be marked to market in the taxpayer’s financial statement. If the taxpayer has securities that are subject to mark-to-market accounting for tax purposes but not for financial reporting purposes, the taxpayer cannot qualify under the directive (because it would have Schedule M adjustments and deferred tax items related to Sec. 475 market value adjustments for these securities and could therefore not issue the certification statement). In addition, many taxpayers mark their securities to market through a component of shareholders’ equity (other comprehensive income) on the balance sheet, rather than recording these adjustments into net income. Apparently, if such securities are marked to market for tax purposes, this treatment would prohibit the taxpayer from qualification under the directive (because it would have Schedule M adjustments related to Sec. 475 market value adjustments for these securities and could therefore not issue the certification statement).

Until these issues are addressed, few taxpayers will qualify for the elective safe harbor under the directive. This is because most public companies are likely to experience some of the discrepancies discussed above and will therefore be unable to issue the required certification statement. KPMG LLP issued a letter addressed to the LB&I on May 17, 2011, addressing these concerns and the need for additional clarification under these circumstances.

Conclusion

The mark-to-market safe harbor offered under the directive is welcome news for many taxpayers struggling to calculate different tax and financial reporting FMVs for securities. However, unless the language of the required certification statement disclosures is modified, many taxpayers will not qualify to take advantage of the elective safe harbor. Given the stated objective to eliminate the administrative burden of justifying disparate financial reporting and tax values for mark-to-market calculations and the need to free up IRS audit resources for other purposes, the IRS clearly did not intend for the required certification statement disclosures to result in an exceedingly restrictive application of the directive. Several modifications and clarifications to the language in the certification statement representations are necessary to make the directive workable. Once these issues are addressed, the directive will undoubtedly eliminate much of the controversy in this area, as many taxpayers will likely seek to rely on financial statement valuations to support their tax mark-to-market adjustments under Sec. 475.

EditorNotes

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

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

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

Newsletter Articles

TAX ACCOUNTING

Should Small Businesses File Form 3115?

Small business taxpayers should be aware of the implications of adopting the tangible property regulations through the small business exception and, especially, that any change to this treatment must be made very soon.

PRACTICE MANAGEMENT

2015 Tax Software Survey

See how nearly 5,000 paid CPA tax preparers rated the strengths and weakness of major tax preparation software products they used in 2015.