Taxpayers often want to change either their overall method of accounting (e.g., cash versus accrual) or their method of accounting for a specific item (e.g., inventory). There are varied reasons a taxpayer may request a change. However, as demonstrated by the Tax Court decision discussed below, it is critical that a taxpayer follow all the required procedures to ensure the IRS will grant approval for the change.
What Is an Accounting Method?
An accounting method is the consistent application of a rule to determine when a taxpayer recognizes items of income or deduction. Sec. 446(a) provides that “[t]axable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.” If the taxpayer’s method of accounting does not clearly reflect income, Sec. 446(b) states that the computation of taxable income shall be made under a method that, in the IRS’s opinion, clearly reflects income.
Regs. Sec. 1.446-1(e)(2)(ii)(a) provides that “[a] change in the method of accounting includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan.” A change in method of accounting is distinguished from an adoption of a method, a correction of a mistake, or a change in underlying facts or business policy.
Taxpayers may apply with the IRS to change a method of accounting via Form 3115, Application for Change in Accounting Method. Sec. 446(e) generally requires consent of the Service before a taxpayer may change a method of accounting. The IRS has broad discretion to approve or disapprove a change. Permission is not granted unless the taxpayer and the Service agree to certain conditions. The IRS may also force the taxpayer to change its method of accounting when that method does not clearly reflect taxable income.
The Capital One Case
In Capital One Financial Corp., 130 T.C. No. 11 (2008), the Tax Court denied a retroactive change in treatment of credit card late-fee income, stating that the purported change in accounting method was a change in the treatment of a material item and that Capital One did not follow proper procedures for securing the change in accounting method.
On August 5, 1997, Congress enacted the Taxpayer Relief Act of 1997, P.L. 105-34, which added Sec. 1272(a)(6)(C)(iii). This section requires taxpayers to treat credit card receivables as creating or increasing original issue discount (OID) on the pool of credit card loans to which the receivables relate. The IRS subsequently issued Rev. Proc. 98-60, which explained how taxpayers could secure automatic consent to change their method of accounting for pools of credit card receivables.
From 1995 through 1999, Capital One recognized late-fee income at the time the fee was charged to the cardholder for both financial accounting purposes and federal income tax purposes (i.e., current-inclusion method). On its 1998 tax return, Capital One filed a Form 3115 to change its method of accounting for interest and OID to apply the provisions of Regs. Sec. 1272(a)(6)(C)(iii). The Form 3115 stated that Capital One “requests permission under Section 12.02 of Rev. Proc. 98-60 to change its method of accounting for interest and original issue discount that are subject to the provisions of Section 1004 of the Tax Relief Act of 1997.” Capital One continued to treat late-fee income under the current-inclusion method on its 1998 and 1999 tax returns. However, on its 2000 tax return, Capital One began treating the late-fee income as increasing OID.
The IRS issued a notice of deficiency to Capital One for 1997, 1998, and 1999. Subsequent to filing its 2000 tax return, Capital One filed a petition with the Tax Court challenging the notices of deficiency. In a later amended petition, Capital One claimed that it was entitled to treat the late-fee income as increasing OID on its pool of credit card loans, thus reducing taxable income for 1998 and 1999. The IRS disagreed with this treatment of the late-fee income for 1998 and 1999, arguing that Capital One had not properly requested (and accordingly had not received) consent to change its method of accounting for late fees for 1998 and 1999. Therefore, Sec. 446(e) prohibited a retroactive change in the treatment of the late-fee income for those years from the current-inclusion method to a method conforming to the provisions of Sec. 1272(a)(6)(C)(iii).
Tax Court Position
The Tax Court held in favor of the IRS, stating that Capital One did not comply with the procedures in Rev. Proc. 98-60 for requesting consent to change a method of accounting for pools of credit card receivables. The Form 3115 filed by Capital One did not mention late-fee income. On its 1998 and 1999 tax returns, Capital One treated income from overlimit fees, cash advance fees, and interchange fees as increasing OID on its pool of credit card loans under Sec. 1272(a)(6)(C)(iii). It did not afford similar treatment to the late-fee income, instead recognizing late-fee income under the current-inclusion method.
The Form 3115 filed by Capital One gave no indication that the late-fee income would be treated as OID. In fact, the Tax Court indicated that the language used in the Form 3115 was “ambiguous and vague.” The ambiguity in the description of the items to be changed was only clarified by the treatment of the late-fee income on the 1998 and 1999 tax returns. The court held that by failing to mention late-fee income on the Form 3115, and similarly failing to account for late-fee income as OID on the 1998 and 1999 tax returns, Capital One did not seek proper consent for the change.
Capital One argued in the alternative that even if it did not meet the requirements of Rev. Proc. 98-60, it was still entitled to change its treatment of late-fee income because it was not changing the treatment of a “material item.” Capital One contended that late-fee income was a component of interest, including OID, and was not itself a separate “item.” Consequently, Capital One could make changes to these components of interest without first receiving the Service’s consent. The Tax Court disagreed, stating that late-fee income is a separate and distinct item of income. Capital One earned more in late-fee income than any other type of fee, and late fees were earned for reasons independent of the reasons other types of income are earned, such as finance charges, overlimit fees, interchange fees, and cash advance fees.
As demonstrated by the Capital One case, a taxpayer filing Form 3115 to initiate a change in accounting method must be certain to follow all procedures required to effect such a change and be clear and specific as to the items to which the change in accounting method will apply. In addition, the requested change must be reflected in the tax return for the year of change.
Frank J. O’Connell Jr. is a partner in Crowe Chizek in Oak Brook, IL.
Unless otherwise noted, contributors are members of or associated with Crowe Chizek.
For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or firstname.lastname@example.org.