Prop. Regs. Address Carryover of Accounting Methods Under Sec. 381

Editor: Lorin D. Luchs, CPA, J.D., LL.M.

Sec. 381 provides guidelines for the carryover of certain tax attributes, including accounting methods, in certain corporate reorganizations or liquidations. The current final regulations affect corporations that acquire the assets of other corporations in transactions described in Sec. 381(a). In order to resolve inconsistencies and confusion in the current regulations with respect to accounting and inventory methods to be used after such transactions, the IRS and Treasury issued proposed regulations in November 2007 (REG-151884-03).

Under the current regulations, after a Sec. 381(a) transaction, the accounting method or combination of methods used by the parties before the transaction will generally continue. However, if different methods are used by the parties on the transaction date, the acquiring corporation must determine which method is appropriate to follow after the transaction. The regulations refer to this method as the “principal method” (Regs. Sec. 1.381(c)(4)-1(c)). Where the combined corporations are afterward operated as a single trade or business, the current regulations apply various tests to determine the principal method, depending on whether the method under consideration is the overall accounting method, the method for a particular type of items for which the Code or regulations provide a special method, or an inventory method (Regs. Sec. 1.381(c)(4)-1(c)(2)). Under the current regulations, if there is no principal method under these tests or if the principal method is impermissible, the Service selects the appropriate method (Regs. Sec. 1.381(c)(4)-1(d)).

The IRS and Treasury have acknowledged that several areas of the current regulations are unclear or inconsistent. For example, there are inconsistencies in the guidelines for making adjustments for inventory (under Sec. 381(c)(5)) and adjustments for accounting method changes (under Sec. 381(c)(4)). In addition, there is confusion regarding when the accounting method is established for the newly combined company and the appropriate procedure for making accounting method changes required by the regulations. The Service has also admitted that the tests under the current regulations and the need for the IRS at times to select the appropriate method have led to confusion and conflicts between taxpayers and the IRS. The proposed regulations attempt to eliminate the confusion and address the inconsistencies existing under the current regulations.

In general, the accounting method to be used after a Sec. 381(a) transaction depends on whether (1) the businesses of the parties to the transaction are afterward combined and (2) the method is permissible. Similar to the current regulations, if the trades or businesses of the parties to the transaction are operated as separate trades or businesses afterward, then the acquiring corporation would use the same accounting method for each trade or business as was used previously as long as it is a permissible method (referred to as the “carryover method”) (Prop. Regs. Sec. 1.384(c)(4)-1(a)).

On the other hand, if the businesses will be operated as a single trade or business, then the acquiring corporation will be required to determine and use the principal method. The proposed regulations provide default guidelines for determining the principal method. In most cases, the principal method is the accounting method used by the acquiring corporation before the Sec. 381(a) transaction (Prop. Regs. Sec. 1.384(c)(4)-1(c)).

There are two exceptions to the default rule. First, if the acquiring corporation does not have an accounting method for a particular item or type of goods, the principal method would be the accounting method used by the distributor or transferor corporation before the transaction. Second, if the distributor or transferor corporation is larger than the acquiring corporation, the principal method for the overall accounting method and for the accounting method for a particular item or type of goods would be that used by the distributor or transferor corporation before the transaction. The principal method would continue to be determined separately for the overall accounting method and for any special accounting method (Prop. Regs. Sec. 1.384(c)(4)-1(c)).

The determination of the “larger” corporation under the proposed regulations is based on tests similar to those under the current regulations. For purposes of the overall and special accounting methods, the determination is based on total assets and gross receipts (the same test as under current Regs. Sec. 1.381(c)(4)-1). For purposes of inventory methods, the determination is based on the value of inventory (Prop. Regs. Sec. 1.384(c)(4)-1(c)(1)).

The proposed regulations affirm that the acquiring corporation would not be required to file a Form 3115, Application for Change in Accounting Method, to secure IRS consent to continue a carryover method or use the principal method. Any resulting Sec. 481(a) adjustment necessary to change to a principal method is computed as if the acquiring corporation had initiated an accounting method change as of the date of the transaction and is taken into account as an increase or decrease to its taxable income on the date of the transaction. The required adjustment is computed in the same manner for both accounting and inventory method changes, eliminating the previous inconsistency noted above (Prop. Regs. Sec. 1.384(c)(4)-1(d)(1)(A)).

However, if the principal method is an impermissible method or the acquiring corporation does not wish to use the principal method even though it is permissible, the acquiring corporation must secure IRS consent to change to a permissible accounting method. The proposed regulations make it clear that a taxpayer must request an accounting method change consistent with the manner in which accounting method changes are requested under Sec. 446(e)—that is, on a Form 3115 (Prop. Regs. Sec. 1.384(c)(4)-1(d)(2)). This proposed rule is intended to address the confusion in the current regulations as to whether the corporation may file a Form 3115 or must file a request for a private letter ruling in order to use another method. The proposed rules also clarify the appropriate timing for a taxpayer to request an accounting method change. The request must generally be filed on or before the later of (1) the last day of the tax year in which the transaction occurred or (2) the earlier of (a) the day that is 180 days after the transaction date or (b) the date on which the acquiring corporation files its tax return for the year in which the distribution or transfer occurs (Prop. Regs. Sec. 1.384(c)(4)-1(d)(2)).

The new rules are proposed to be effective for Sec. 381(a) transactions occurring on or after the regulations are finalized.

EditorNotes

Lorin D. Luchs, Partner, Washington National Tax Office BDO Seidman, LLP, Bethesda, MD.

Unless otherwise indicated, contributors are members of or associated with BDO Seidman, LLP.

If you would like additional information about these items, contact Mr. Luchs at (301) 634-0250 or lluchs@bdo.com.