IRS Provides Safe Harbor for Nonaccrual-Experience Accounting Method Taxpayers

By Jack Donovan, J.D., LL.M., Washington, DC

Editor: Michael Dell, CPA

Tax Accounting

The IRS issued guidance (Rev. Proc. 2011-46) providing a book safe-harbor accounting method for taxpayers that use the nonaccrual-experience (NAE) accounting method under Sec. 448(d)(5) and Regs. Sec. 1.448-2. The revenue procedure also contains procedures for obtaining automatic consent to change to the NAE book safe-harbor method and to make certain changes within the NAE book safe-harbor method. Rev. Proc. 2011-46 is effective for tax years ending on or after September 28, 2011.

Background

Under Sec. 448(d)(5), taxpayers may use the NAE method to account for amounts they will receive from performing services. Taxpayers using the method are not required to accrue any portion of amounts that, based on their experience, will not be collected. Taxpayers may use the NAE method only if (1) they use the accrual method of accounting and (2) they provide services in a field described in Sec. 448(d)(2)(A) (health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting) or meet the $5 million annual gross receipts test of Sec. 448(c). Taxpayers may not use the NAE method for amounts for which they charge interest or penalties for failure to timely pay.

NAE Book Safe Harbor

Rev. Proc. 2011-46 allows a taxpayer to compute its uncollectible amount under the NAE book safe-harbor method by multiplying the portion of the year-end allowance for doubtful accounts on the taxpayer’s applicable financial statement that is attributable to current-year NAE-eligible accounts receivable by 95%. Taxpayers using this safe harbor are subject to the rules in Regs. Sec. 1.448-2. However, the NAE book safe harbor is not subject to the self-testing requirements of Regs. Sec. 1.448-2(e).

Rev. Proc. 2011-46 defines “allowance for doubtful accounts” as “the amount of outstanding accounts receivable the taxpayer anticipates it will not collect.” Thus, an allowance that is calculated to maximize the deferral of taxable income under Rev. Proc. 2011-46 and does not represent the amount of outstanding accounts receivable the taxpayer anticipates it will not collect in the future does not qualify under this revenue procedure.

The revenue procedure defines “current year NAE-eligible accounts receivable” as accounts receivable described in Regs. Sec. 1.448-2(c)(1)(i) that a taxpayer earns during the current tax year. Accounts receivable for which a taxpayer is prohibited from using the NAE method (e.g., amounts not earned through the performance of services) are not included in current-year NAE-eligible accounts receivable.

Rev. Proc. 2011-46 allows a taxpayer to use any reasonable method to determine the amount of the taxpayer’s financial statement allowance for doubtful accounts that is attributable to current-year NAE-eligible accounts receivable. A method will not be considered reasonable if it fails to consider relevant information that is readily available to the taxpayer that would produce a result that differs materially from the method employed by the taxpayer.

Rev. Proc. 2011-46 lists, in descending priority, applicable financial statements:

  1. A financial statement required to be filed with the Securities and Exchange Commission (i.e., Form 10-K or annual statement to shareholders);
  2. A certified audited financial statement that is accompanied by the report of an independent CPA (or, for foreign corporations, the report of a similarly qualified independent professional) that is used for:
    • Credit purposes;
    • Reporting to shareholders; or
    • Any other substantial nontax purpose; or
  3. A financial statement (other than a tax return) required to be provided to the federal or a state government or any federal or state agency (other than the SEC or IRS).
Change to the NAE Book Safe Harbor

A change in a taxpayer’s accounting method to the NAE book safe-harbor method is a change in accounting method to which Secs. 446 and 481 apply. A taxpayer within the scope of the revenue procedure is granted the IRS’s consent to change to the NAE book safe-harbor method if the taxpayer complies with the applicable provisions of Rev. Procs. 2006-56 and 2011-14 (or any successor).

The scope limitations of Rev. Proc. 2011-14 (or any successor) do not apply for a taxpayer’s first tax year ending on or after September 28, 2011. However, if a taxpayer files Form 3115, Application for Change in Accounting Method, for that year, and the taxpayer’s NAE method is an issue under consideration for a tax year under examination, then the audit protection of Section 7 of Rev. Proc. 2011-14 (or any successor) will not apply. The NAE accounting method is an issue under consideration for the tax years under examination if the taxpayer receives written notification from the examining agent specifically citing the treatment of the NAE accounting method as an issue under consideration.

Change in Allowance for Doubtful Accounts

A change to a taxpayer’s method for determining its allowance for doubtful accounts for its applicable financial statements is a change in accounting method to which Sec. 446 applies. Under Rev. Proc. 2011-46, a taxpayer is granted the IRS’s consent to change its method, provided the taxpayer complies with the procedures in Rev. Procs. 2011-14 (or any successor) and 2011-46. An adjustment to a taxpayer’s estimates in determining its allowance for doubtful accounts that does not change the base or formula is not a change in the method of determining the allowance for doubtful accounts. Additionally, a restatement of its applicable financial statements will not invalidate a taxpayer’s accounting method or change its uncollectible amount determined under the NAE book safe harbor in earlier tax years.

To change its accounting method for its allowance for doubtful accounts, a taxpayer must attach a statement to its original return for the tax year of change (or an amended return if under the limited relief for a late application provided in Section 6.02 of Rev. Proc. 2011-14 or any successor). Rev. Proc. 2011-46 does not require the taxpayer to file a Form 3115 or file a copy of the statement with the IRS National Office. The statement filed with the return must include:

  • The taxpayer’s name and the taxpayer identification number for each applicant;
  • The beginning and ending dates of the year of change;
  • For each applicant, the type of applicable financial statement the taxpayer uses;
  • A description of the method the taxpayer uses to determine its allowance for doubtful accounts on its applicable financial statements before and after the change; and
  • The designated automatic accounting method change number (35—see Rev. Proc. 2006-56).

This accounting method change applies only to accounts receivable earned on or after the first day of the tax year of change. A taxpayer must continue to apply its former method to accounts receivable earned before the tax year of change. Therefore, a Sec. 481(a) adjustment is not required.

Like the change to the NAE book safe-harbor method, the scope limitations of Rev. Proc. 2011-14 do not apply, but audit protection will not be granted if the taxpayer is otherwise ineligible to file an automatic accounting method change because it is under examination for any income tax issue.

Change in Method of Determining the NAE-Eligible Amount

A change in a taxpayer’s method for determining the portion of the taxpayer’s applicable financial statement allowance for doubtful accounts that is attributable to current-year NAE-eligible accounts receivable is an accounting method change to which Sec. 446 applies. A taxpayer makes this accounting method change by attaching a statement to its original return for the tax year of change (or an amended return if under the limited relief for a late application provided in Rev. Proc. 2011-14 or any successor). The statement must include the same information as for a change in allowance for doubtful accounts for applicable financial statements, except the taxpayer is not required to include the type of financial statement it uses for each applicant.

Because this accounting method change applies only to accounts receivable earned on or after the first day of the tax year of change, a taxpayer must continue to use its former method for accounts receivable earned before the tax year of change. Thus, a Sec. 481(a) adjustment is not required. The scope limitation of Rev. Proc. 2011-14 (or any successor) does not apply to a change in method of determining the NAE-eligible amount.

Implications

The book safe-harbor NAE method will provide a beneficial option for most taxpayers using the NAE method. Previously available safe harbors would produce results approximating 65% of the book allowance for doubtful accounts. In addition to providing the benefit of a greater income exclusion, the book safe harbor will generally be easier to apply than the other safe harbors. Safe harbor 2, previously and currently available, was the most beneficial safe harbor but was somewhat difficult to apply (see Regs. Sec. 1.448-2(f)(2)). In sum, the book safe-harbor method will likely be well received by companies using the NAE method.

EditorNotes

Michael Dell is a partner at Ernst & Young LLP in Washington, DC.

For additional information about these items, contact Mr. Dell at (202) 327-8788 or michael.dell@ey.com.

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.

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