The IRS has ruled in technical advice (TAM 200738014) that a service provider’s request for a change in accounting method for mixed service costs does not qualify for audit protection because the service provider received written notification, citing the treatment of mixed service costs as an issue under consideration.
The taxpayer used an overall accrual method and a calendar tax year. On September 11, 2003, the taxpayer submitted a Form 3115, Application for Change in Accounting Method, requesting permission to change its accounting method for self-constructed property under Sec. 263A. This Form 3115 was filed under the automatic consent procedures of Rev. Proc. 2002-9.
On the Form 3115, the taxpayer proposed to allocate mixed service costs under the simplified service cost method for all qualified property using the labor-based allocation ratio allowed by Regs. Sec. 1.263A-1(h)(4). The taxpayer included in its Form 3115 an explanation of the legal reasoning supporting the proposed change that discussed its qualification to use the simplified service cost method for its mixed service costs and its position on the issue of when assets are produced on a routine and repetitive basis. The taxpayer’s Form 3115 reflected a Sec. 481(a) adjustment that was reported on its 2003 federal income tax return.
On or about February 13, 2004, the taxpayer filed a superseding Form 3115 related to the same method of accounting for which the prior Form 3115 was filed. This change was filed under the advance consent procedures of Rev. Proc. 97-27.
In April 2005, the taxpayer was placed under examination. The examining team indicated that the taxpayer’s automatic accounting method change for self-constructed property would be audited and advised the taxpayer that the IRS was looking into the issue of self-constructed property under the uniform capitalization rules of Sec. 263A with other taxpayers throughout the country in services and related industries. The Service issued a number of information document requests (IDRs), which related to the automatic method change and three claimed adjustments (Affirmative Issues 1–3).
In August 2005, the Service issued Rev. Rul. 2005-53 (2005-2 CB 425), which clarified the types of property that qualify as eligible under Regs.Secs. 1.263A-1(h)(2)(i)(D) and 1.263A-2(b)(2)(i)(D) and how the terms “routine and repetitive” are interpreted for that purpose. The Service then issued final and temporary regulations (TD 9217) and, by cross reference, proposed regulations (REG-121584-05) on the capitalization of costs under the simplified service cost method and the simplified production method for self-constructed assets that are constructed on a routine and repetitive basis in the ordinary course of a taxpayer’s business.
At a meeting with the Service in August 2005, the taxpayer provided documentation for the Sec. 263A calculation, including a summary schedule detailing the computation. The documentation also contained an index and workpapers that supported the taxpayer’s computation of the Sec. 481(a) adjustment reflected on the first, automatic Form 3115, but it did not identify specific assets that were subject to the Sec. 263A computation. The IRS team coordinator orally asked the taxpayer to provide a description of the types of assets typically created and classified as self-constructed assets and to provide copies of the documentation for the Sec. 263A computation.
The taxpayer determined that it was required to change from the simplified service cost method effective for 2005 based on the guidance released in August 2005 involving self-constructed property under Sec. 263A. Accordingly, the taxpayer filed a third Form 3115 to change its accounting method to comply with Temp. Regs. Sec. 1.263A-1T(k). Under the regulations, this method change was filed under the automatic consent procedures of Rev. Proc. 2002-9.
After receiving this third Form 3115, the Service asked the taxpayer to explain its position that its accounting method for mixed service costs under Sec. 263A and the regulations thereunder was not an issue under consideration when the third Form 3115 was filed. This question was referred to the National Office for technical advice.
Under Section 3.09(1) of Rev. Proc. 2002-9, a taxpayer’s accounting method for an item is an issue under consideration for the tax years under examination if the taxpayer receives written notification from the examining agents specifically citing the item’s treatment as an issue under consideration.
The Service reviewed the IDRs sent by the examining team to the taxpayer. Even though three of the IDRs did not directly refer to the taxpayer’s mixed service costs, they did refer to Affirmative Issues 1–3, which were submitted to the examining team in May 2005. Those issues all related to the first Form 3115 filed in 2003 and the taxpayer’s accounting method for mixed service costs, which were expressly referred to and described in detail. The Service determined that Affirmative Issues 1–3 would be enough to place the taxpayer’s accounting method for mixed service costs under consideration if they had been issued by the examining agent instead of the taxpayer. Therefore, the IRS found that the IDRs also were sufficient to place the accounting method for mixed service costs under consideration because they expressly refer to Affirmative Issues 1–3.
The fourth IDR cites the taxpayer’s accounting method for determining the capitalizable portion of mixed service costs. The Service concluded that the IDR, on its face, satisfied the requirement of Section 3.09 of Rev. Proc. 2002-9 that the written notice specifically cite the item’s treatment. Thus, the taxpayer’s accounting method for mixed service costs was placed under consideration by the issuance of the fourth IDR.
The taxpayer argued that the primary IDR at issue lacked the requisite specificity because it did not indicate that there were questions about the taxpayer’s qualification to use the simplified service cost method or whether the taxpayer’s production was routine and repetitive. The Service found that the IDR did not lack specificity simply because it failed to refer to particular reasons why the taxpayer’s treatment of an item might be improper.
The taxpayer also asserted that the purpose of the primary IDR at issue was only to reconcile amounts and to verify the accuracy of the taxpayer’s Sec. 481(a) adjustment. The taxpayer contended that verifying the calculation of the Sec. 481(a) adjustment is a completely separate issue from examining the propriety of the old and new methods. The Service rejected this argument, noting that
[e]xamining a §481(a) adjustment requires determining the existence and nature of any duplications or omissions and verifying their amounts. This cannot be done without understanding the operation of the old and new methods of accounting. Thus, examining a §481(a) adjustment requires an examination of the old and new methods of accounting, and a written notice referencing a §481(a) adjustment places under consideration the item involved in the underlying change in method of accounting.
For these reasons, the Service ruled that the taxpayer’s accounting method for mixed service costs was an issue under consideration when the taxpayer filed the third Form 3115 in 2005. Therefore, the taxpayer did not have audit protection for its change in accounting method request made under Temp. Regs. Sec. 1.263A-1T(k)(1) on that Form 3115 for its mixed service costs.
David J. Kautter, CPA Ernst & Young LLP Washington, DC
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