Is a Change in Characterization an Accounting-Method Change?

Editor: Annette B. Smith, CPA

Taxpayers periodically assess the validity of their tax positions. Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes, has made this assessment even more detailed, and the questions have become more probing. This increased awareness has many companies in a quandary as to how to address uncertain tax positions. While the issue is not new, taxpayers still are asking: Is a change in characterization an accounting-method change?

Effect of Classification

Whether the treatment of an item is classified as an accounting method is pivotal, because such classification dictates how changes in the method can be made. If the treatment is deemed an accounting method, the taxpayer must seek IRS permission before computing taxable income under a new method; see Sec. 446(e). The Service automatically grants consent for certain method changes, but Form 3115, Application for Change in Accounting Method, generally still must be filed to request the change; see Rev. Proc. 2002-9. 

In determining whether to file Form 3115, a taxpayer should consider the likelihood that the request will be approved. Also, taxpayers under audit might, depending on the circumstances, be restricted by the rules applicable to method changes while under audit. Another issue is whether the company can take a financial statement benefit for a position. There are many strategic issues to consider; at the forefront is whether a method change exists.

The uncertainty as to whether treatment of an item is an accounting method is particularly problematic if the treatment is erroneous. If the treatment is an accounting method, the taxpayer, by filing Form 3115 at the appropriate time, can secure audit protection with a current year of change and a spread of the unfavorable Sec. 481(a) adjustment; see Rev. Proc. 2002-9. However, if a taxpayer files Form 3115 and the IRS determines that the treatment is not an accounting method, it generally will adjust taxable income in prior open years. In light of this risk, the taxpayer needs to undertake prudent analysis and consideration of the potential positions.

What Is an Accounting Method?

Accounting methods often are thought of as the overall method of accounting employed (e.g., the overall accrual accounting method). But an accounting method can be any method that affects the timing of income or deductions. Strictly speaking, a change in accounting method includes a change in the treatment of any material item used in the overall plan of accounting for gross income or deductions. A material item is any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.

The courts have concluded that if the treatment of an item does not affect a company’s  lifetime income, the treatment of the item is a timing issue and is classified as an accounting method; see, e.g., Wayne Bolt & Nut Co., 93 TC 500 (1989). Conversely, the treatment of an item that does affect a company’s lifetime income has been held not to be an accounting method; see, e.g., Schuster’s Express, Inc., 66 TC 588 (1976). One broad class of items affecting a company’s lifetime income is a change in characterization, such as a change from treating an item as taxable income to treating it as excluded income with a basis reduction.

The characterization issue has triggered significant disagreement between tax practitioners and the government. The Service disagrees with the assertion that a change of characterization is not a change of accounting method, arguing that such a position would allow many taxpayers to change how they treat material items without requesting IRS permission. Case law is divided on whether a change in character is a method change requiring approval; compare Florida Progress Corp., 156 FSupp2d 1265 (MD FL 1999), Underhill, 45 TC 489 (1966), and Coulter Electronics, Inc., TC Memo 1990-186, with Johnson, 108 TC 448 (1997), and Firetag, TC Memo 1999-355. One particularly controversial change affects basis adjustments.

Saline Sewer: In Saline Sewer Co., TC Memo 1992-236, the Tax Court considered whether changing the treatment of fees received from nontaxable Sec. 118 contributions to capital, to taxable customer connection fees, was an accounting-method change. The court concluded it was not a method change, stating that the depreciation and income issues had to be analyzed separately and not collapsed into one event when deciding whether timing was affected. The court separated the issue into distinct items and did not consider the effect of the characterization of the contributions on depreciation.

The taxpayer in Saline Sewer previously had been treating fees received as nontaxable Sec. 118 contributions to capital and had reduced the assets’ bases by the fees. Because of this treatment, the taxpayer was forgoing the opportunity to depreciate the basis it had reduced. Subsequently, the Service changed the taxpayer’s treatment, requiring that the fees be included in taxable income when earned, rather than reducing basis. Under this treatment, the taxpayer had a higher basis in the property that was depreciated over the property’s depreciable life.

The Tax Court determined that the restoration of the depreciable basis was not a timing issue, stating that “when the depreciable basis of assets is decreased, a corresponding amount of depreciation expense is permanently forfeited.” With that approach, the court refused to combine the two effects of the change (i.e., inclusion of fees in income and increase in depreciable basis of property purchased with the money).

The court concluded that neither the income nor the depreciation issues, when looked at independently, involved timing. Specifically, it stated that the failure to report the contributions as income did not involve a timing issue, because the excluded income would never be reflected in the taxpayer’s lifetime income. Accordingly, the court concluded the change was a change in characterization, not an accounting-method change.

IRS Guidance

While Saline Sewer is not a new development, reliance on the conclusions set forth therein continues to be a contentious position. The Service informally has stated that it would like to issue guidance on the subject, but it is uncertain when it may be published.

In Rev. Proc. 91-31, the IRS determined that a change in treatment of customer deposits, from treating them as taxable when received to treating them as nontaxable until applied against a future invoice, was an accounting-method change. Utility companies often receive deposits from customers to protect them from the risk of nonpayment. Before 1990, some companies treated these deposits as taxable income. The Supreme Court, in Indianapolis Power & Light Co., 493 US 203 (1990), held that such amounts were nontaxable deposits. As a result, companies that had been including customer deposits in income needed to change their treatment of the deposits to stop reporting such amounts in income when received.

Rev. Proc. 91-31 took the position that such change in treatment is an accounting-method change and prescribed an automatic procedure for implementing it. While Saline Sewer involved an exclusion resulting in a basis reduction, no basis reduction was involved in Rev. Proc. 91-31 and, thus, no depreciation was forgone.

Rev. Proc. 97-27 originally contained the following language:

A change in the characterization of an item may also constitute a change in method of accounting if the change has the effect of shifting income from one period to another. For example, a change from treating an item as income to treating the item as a deposit is a change in method of accounting. See Rev. Proc. 91-31.  (Emphasis in original.)

After criticism from commentators, this section was later deleted from the procedure. The Service indicated that it agreed to delete this statement because it was not directly relevant to the content of Rev. Proc. 97-27. While the IRS backed off from the issue by removing the statement, it did not concede the issue, and future guidance could be published.

Observations

Several cases have held that a change in characterization of a transaction is not an accounting-method change, while other cases have held to the contrary. In light of this potential conflict, it is very important to analyze carefully the precise change of characterization at issue, and the surrounding context, before deciding how to proceed in a particular situation.

EditorsNotes

Annette B. Smith, CPA, Washington National Tax Services PricewaterhouseCoopers LLP, Washington, DC.

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

If you would like additional information about these items, contact Ms. Smith at (202) 414–1048 or annette.smith@us.pwc.com.