Maneuvering Through the Proposed Rules for Post-Transaction Accounting Methods

EXECUTIVE SUMMARY

• The IRS and Treasury have issued proposed regulations under Secs. 381(c)(4) and (c)(5) for determining and changing methods of accounting following certain corporate transactions.
• Similar to the current regulations, the proposed regulations generally would require a continuation of pre-transaction accounting methods of both the distributing and surviving corporation where their respective trades or businesses are not integrated post-transaction. Additionally, if the trades or businesses are integrated post-transaction, the continuing method generally is the method of the corporation with both the greatest asset bases and the greatest gross receipts. If neither corporation meets this requirement, the surviving corporation’s method generally is deemed to continue.
• The proposed regulations generally would conform accounting method change procedures and Sec. 481(a) adjustment spread periods with general accounting method change guidance; however, in certain cases, the proposed regulations would deny the audit protection normally afforded accounting method changes.

The IRS and Treasury have issued proposed regulations that address the process for determining and changing methods of accounting following certain corporate reorganizations and liquidations.¹ Accounting methods represent tax attributes that could carry over to a corporation— including a newly formed corporation—that survives a reorganization or liquidation (the surviving corporation).²

The current regulations in this area create confusion by using different regimes to identify and implement carryover methods for inventory and noninventory methods. This confusion, coupled with the fact that accounting methods are generally evaluated in conjunction with tax provision or tax return preparation and not as part of the transaction, has resulted in noncompliance. Without departing from the fundamental concepts of the current regulations, the proposed regulations would establish greater consistency between separate rules governing inventory methods and most noninventory methods.³

Although the accounting methods of a corporation that distributes or transfers assets (the distributing corporation) generally carry over to a surviving corporation, ⁴ the proposed regulations would clarify the carryover process as well as prescribe rules for situations in which parties to a transaction had used different methods. Most important, the proposed regulations would provide rules for determining what method a surviving corporation must use if it operates the parties’ trades or businesses (the businesses) as a single business after the transaction.

The proposed regulations would continue to reflect a complex process that taxpayers must navigate in order to determine the accounting methods carrying over to a surviving corporation. This article explains the anticipated improvements to this process and explores opportunities created and issues left unresolved by the proposed regulations.

Rules for Determining Post-Transaction Accounting Methods

Operating Separate and Distinct Businesses

Continuation of accounting methods: The proposed regulations would generally require a continuation of accounting methods where the businesses of a distributing corporation will operate as separate and distinct businesses from the surviving corporation’s businesses.⁵ In essence, each pretransaction business would operate independent of the others, such that the methods of the distributing corporation’s businesses would carry over to the surviving corporation, and the surviving corporation would continue using its methods for its own businesses. Because no accounting methods would change, the surviving corporation could continue or use each permissible method without securing IRS consent.

Example 1: A Corp. merges with and into B Corp. in a transaction qualifying under Sec. 381(a). B will operate its pretransaction financial consulting business separate and distinct from A’s business of selling financial products. B has used the nonaccrual experience method to account for amounts that it does not anticipate receiving from customers, whereas A has used the specific writeoff method to deduct bad debts. Under the proposed regulations, B would continue to use the nonaccrual experience method for its financial consulting business and would use the specific write-off method for its newly acquired financial products business.

The proposed regulations themselves provide no additional guidance about how taxpayers would identify separate and distinct businesses, stating that “[s]eparate and distinct trades or businesses has the same meaning as provided in §1.446- 1(d).” ⁶ At a minimum, a taxpayer could not have separate and distinct businesses unless it maintains complete and separate books and records for each business. ⁷ However, mere compliance with this recordkeeping requirement would not be sufficient where the use of different accounting methods creates or shifts profits and losses between businesses in a way that prevents a clear reflection of the taxpayer’s income.⁸ In any event, the proposed regulations would look at how the surviving corporation operates the businesses, in either a separate or combined manner, taking into account any planned integration activities rather than focusing exclusively on the state of operations at the date of the transaction.⁹

Observation: Taxpayers have often relied on the fact that the businesses had not been integrated as of the end of the year that included the transactions to support the position that changes to the principal methods were not required. The current regulations do not specifically address when taxpayers determine post-transaction integration. By including any planned integration activities, the proposed regulations would more accurately define the time frame for assessing whether the rules for integrated businesses apply.

The proposed regulations do not explicitly address what rules would apply where a surviving corporation operates separate and distinct businesses as well as integrated businesses after a transaction. Although it seems reasonable that methods should continue for separate and distinct businesses, the proposed regulations would require a surviving corporation to determine principal methods whenever it operates an integrated business after a transaction.

The rules for principal methods would control the determination of overall methods as well as methods for particular items without limiting their scope to integrated businesses. To the extent that methods for particular items are business specific, the rules for separate and distinct businesses and the rules for integrated businesses would reach the same result; otherwise, the principal methods determined for integrated businesses would become the method for all businesses with that item.

Example 2: Assume the same facts as Example 1, except that B had a business of selling financial products in addition to its business of providing financial consulting services, and B had been operating these businesses as separate and distinct businesses. If B will operate its financial products business and A’s financial products business as an integrated business after the merger without combining the consulting business, B’s ability to continue using the nonaccrual experience method for its consulting business, which is operated as a separate and distinct business after the merger, would depend on whether the nonaccrual experience method constitutes a principal method.

The proposed regulations appear to contemplate that a surviving corporation could find itself with an overall hybrid method (i.e., use of cash method for some items and accrual method for other items) after a transaction even though no party used a hybrid method before the transaction. The overall hybrid method would result where different overall methods had been used for separate and distinct businesses and the surviving corporation continues to use those different methods for the businesses after the transaction. The continuation of those methods results in a new overall method for the surviving corporation.

Example 3: C Corp. used an overall cash method for its personal service business, and D Corp. used an overall accrual method for its manufacturing business. D merged with and into C, and C now operates the two pre-merger businesses as separate and distinct businesses. After the merger, under the proposed regulations, C would use an overall hybrid method.

Impermissible carryover methods: Under the proposed regulations, a surviving corporation generally would not carry over an impermissible accounting method from a distributing corporation. ¹⁰ Instead, the surviving corporation would need IRS consent to use a different method. In the event that the impermissible nature of the distributing corporation’s method results solely from the fact that a taxpayer must use a single method for a particular item in all the taxpayer’s businesses, the surviving corporation would determine the principal method (under the rules, described below, applicable to integrated businesses) and would use a permissible principal method for each of its businesses in the future without first securing IRS consent.¹¹

Example 4: Assume the same facts as Example 1, except that A had been using an impermissible reserve method to account for bad debts. Under the proposed regulations, B would continue to use the nonaccrual experience method for its financial consulting business but would need IRS consent to use the specific write-off method as an alternative to A’s impermissible method.

The proposed regulations would generally classify an impermissible method as a method that “fails to clearly reflect” the surviving corporation’s income, with the clear reflection standard determined under Sec. 446(b) principles. Although the courts have generally afforded the Service broad discretion in determining whether a method of accounting clearly reflects income, that discretion is not unlimited. As a result, in some cases methods contrary to the regulations or other IRS published guidance have been determined to clearly reflect income.¹² Nonetheless, a surviving corporation should consider whether the IRS would consider a carryover method to clearly reflect income in determining to carry over a distributing corporation’s methods of accounting.

Operating Integrated Businesses

Principal methods of accounting: The proposed regulations generally would require a surviving corporation to use principal methods of accounting where it does not operate the parties’ businesses as separate and distinct (i.e., where it combines or integrates the businesses).¹³ In particular, a principal method would reflect the one method that an integrated business must use after the transaction. The surviving corporation would not need IRS consent to use a permissible principal method even though such use could constitute a change in method of accounting.

A surviving corporation would need to determine its overall principal method and the principal method for particular items under the proposed regulations. As a default, the proposed regulations generally would treat the surviving corporation’s overall method and methods for particular items as the principal methods. ¹⁴ Under the default treatment, only the methods used by the businesses acquired from the distributing corporation might change to conform to the surviving corporation’s principal methods.

Example 5: E Corp. merged with and into F Corp. Prior to the merger, both E and F conducted advertising services businesses. F now operates the activities as a combined business. As accrual-method taxpayers, E included its advance payments in gross income upon receipt, whereas F accounted for its advance payments under the deferral method of Rev. Proc. 2004-34.¹⁵ If the methods F had used before the merger were the principal methods, then the proposed regulations would require F to use an overall accrual method and to continue using the deferral method for the combined operations, which would require a method change with respect to E’s pre-merger business.

In two instances, the proposed regulations would treat a distributing corporation’s methods as principal methods. First, the distributing corporation’s method for a particular item would become a principal method where the surviving corporation had not adopted a method for that item.¹⁶ The distributing corporation’s method would carry over to the surviving corporation because the surviving corporation has no default method that could become the principal method for the item.

Second, all the distributing corporation’s noninventory methods would become principal methods where the distributing corporation is larger than the surviving corporation.¹⁷ For this purpose, a distributing corporation would be considered larger if:

• The aggregate adjusted bases of its assets exceed the aggregate adjusted bases of the surviving corporation’s assets immediately prior to the transaction; and
• Its aggregate gross receipts over a representative period exceed the surviving corporation’s aggregate gross receipts over the same period.

A surviving corporation would determine gross receipts for this test over the most recent period of 12 consecutive months ending on the transaction date or, if shorter, the period during which all parties were in existence.¹⁸

Example 6: Assume the same facts as Example 5, except that the aggregate adjusted bases of assets and the gross receipts over the prior 12-month period for E both exceeded the comparable amounts for F. Because the proposed regulations would consider E to be larger than F, E’s methods would constitute the principal methods. After the merger, F would use an overall accrual method and would recognize advance payments upon receipt, which would require a method change for F ’s pre-merger business.

A distributing corporation would need to appear larger due to both its asset bases and gross receipts in order to have all the principal methods. Otherwise, the default rules would treat the surviving corporation as having the principal methods.

Example 7: Assume the same facts as Example 5, except that the aggregate adjusted bases of assets for E exceed the asset bases of F, but F ’s gross receipts over the prior 12-month period exceed the comparable gross receipts of E. Because the proposed regulations would consider E’s failure to satisfy both tests as an indication that E is smaller than F, F’s methods would constitute the principal methods.

Observation: Under the current regulations, taxpayers have often struggled to apply the principal method rules where one party to a merger had larger asset bases and the other party had larger receipts for a particular item. Under the current regulations, there would be no principal method and each party would continue to use the established methods until the acquirer received consent to change to a single method. The overall principal method test for noninventory methods coupled with the default principal method rule in the proposed regulations would provide administrable rules in determining the carryover of accounting methods.

With respect to inventory methods, the proposed regulations would treat a distributing corporation’s inventory method as the principal method where it holds more inventory of a particular type of goods than a surviving corporation.¹⁹ For this purpose, the proposed regulations would generally determine relative inventory holdings from the fair market value (FMV) of those goods. However, a surviving corporation could elect to use a simplifying convention that would determine relative inventory holdings from the values of the parties’ total inventories rather than the values of particular types of goods. The election would essentially consider the party holding inventory with the greatest aggregate value as having all the principal inventory methods.²⁰

Other than the use of readily measurable amounts, the relative size of a distributing corporation seems to have little relevance in determining the noninventory methods that a surviving corporation should use after a transaction. In a situation in which a minnow surviving corporation swallows a whale distributing corporation, it makes sense to treat the distributing corporation’s methods as the principal methods. But where the entities are comparable in size, the relevant dollar amount of items subject to a method might provide a better measure of a principal method, such as using relative FMVs of goods to determine principal inventory methods. It seems inconsistent, however, to determine principal noninventory methods from asset bases and gross receipts taken into account under an established method but to determine principal inventory methods from FMVs; consistency would suggest that a surviving corporation should determine principal inventory methods based on inventory values established through the parties’ methods immediately prior to the transaction.

The proposed regulations, however, would justifiably sacrifice some logical relationships in order to make a determination of principal methods workable. By characterizing all noninventory methods of either the surviving corporation or distributing corporation as the principal methods, taxpayers would avoid the difficulty of comparing numerous items to decide which methods should prevail.

With minimal opportunities for overlap, the proposed regulations would apply clear standards for determining principal methods. Nonetheless, in certain circumstances, the potential for overlap does exist, and the Service should address this issue in the final regulations.

Example 8: G Corp. merged with and into H Corp. Prior to the merger, G used the simplified production method for its production of particular inventory goods and noninventory property held primarily for sale to determine additional Sec. 263A costs allocable to ending inventory and the other assets. Prior to the merger, H used a burden rate method to allocate additional Sec. 263A costs to its ending inventory for its production of identical goods and to its noninventory property held primarily for sale. The FMV of G’s inventory exceeded the value of H’s inventory immediately prior to the transaction; however, H’s gross receipts and assets bases exceeded comparable amounts for G. After the merger, H will integrate the business operations of the production activities.

Because G necessarily applied the simplified production method to its inventory and noninventory items,²¹ it is not clear whether the rules governing principal noninventory methods under the proposed regulations should govern due to the production of noninventory property or whether the rules governing principal inventory methods should govern due to the inventory items. It seems reasonable to conclude that a need to apply the UNICAP rules in accounting for merchandise would establish an inventory accounting method,²² such that G’s simplified production method must be applied to both the inventory and the noninventory items of the combined operations. The final regulations, however, should make that conclusion clear. Where a surviving corporation would need to change to a distributing corporation’s method, the proposed regulations would allow the surviving corporation to make any available election even if such an election would return the surviving corporation to its pre-transaction method.²³ The proposed regulations illustrate this point for a surviving corporation that had previously elected to amortize bond premium. The proposed regulations explain that where a distributing corporation had a principal method of not amortizing bond premium, a surviving corporation could elect to amortize bond premium after a Sec. 381(a) transaction.²⁴

Impermissible principal methods: The proposed regulations would prohibit a surviving corporation from using an impermissible principal method of either the surviving corporation or a distributing corporation.²⁵ Where an identified principal method is impermissible, the surviving corporation would need to secure IRS consent to use a different method in accordance with the procedural guidance under Sec. 446(e).²⁶

Observation: Under the current regulations, there is confusion as to how a taxpayer may obtain consent to change an impermissible method—by filing a private letter ruling request or by filing a Form 3115, Application for a Change in Accounting Method. The government has been inconsistent in its application of the provisions of the current regulations, in some cases accepting a Form 3115 and in others requiring a private letter ruling request. In addition, the terms and conditions of the consent to the change varied, with the Service in some cases allowing a spread period for the Sec. 481(a) adjustment and audit protection and in others requiring the adjustment to be recognized in the year of the transaction and no audit protection. By allowing taxpayers to change from an impermissible principal method under the general accounting method change procedures, the proposed regulations would allow them to obtain audit protection for prior years and, in some cases, a four-year spread for any positive Sec. 481(a) adjustment resulting from the change.

By requiring a surviving corporation to seek IRS consent whenever it identifies an impermissible principal method, the proposed regulations would overlook an opportunity to simplify the process. In particular, one party to a transaction might have used a permissible nonprincipal method to account for an item that otherwise would become subject to an impermissible principal method of accounting. Instead of requesting consent to use a method other than the impermissible principal method, the surviving corporation could simply use the permissible nonprincipal method for the item. That alternative would minimize the administrative burdens of both the surviving corporation and the Service in complying with the method carryover rules.

Example 9: I Corp. merged with and into J Corp. Before the merger, I used the simplified production method for its non–de minimis production and resale activities for particular goods to determine additional Sec. 263A costs allocable to ending inventory. Before the merger, J used the simplified resale method to determine additional Sec. 263A costs allocable to ending inventory of identical goods. The FMV of J’s inventory exceeded the value of I’s inventory immediately before the transaction. After the merger, J will integrate the business operations of the resale activities. Due to J’s non–de minimis production activities following the merger, J may not use the simplified resale method even though it would represent the principal inventory method. Therefore, J would need to request consent to use a different method, such as the simplified production method used by I immediately before the transaction.

Observation: Taxpayers presumably would willingly forgo a simplified approach given that the burden of requesting consent to use a new method secures audit protection for an impermissible principal method. The IRS might therefore give taxpayers an option to request consent and receive audit protection or to default to a permissible nonprincipal method used by a party to the transaction without receiving the benefit of audit protection.

Voluntary Method Changes

The proposed regulations would allow any party to a transaction to request consent to change an accounting method for the year during which the transaction is anticipated to occur.²⁷ For requests involving businesses that the surviving corporation will operate as integrated businesses after a transaction, the IRS would grant consent only where the proposed regulations would treat the requested method as the method that the surviving corporation must use after the transaction. Conversely, the parties could seek consent to change any methods of separately operated businesses as well as any carryover method that would become impermissible solely because the surviving corporation could use only one method for all its separate businesses.

Where a surviving corporation will integrate businesses after a transaction, the proposed regulations would seem to provide varying latitude to parties to a transaction. The party that would have the principal methods presumably could request consent to change to any permissible method of accounting because the surviving corporation must use the principal methods after the transaction. Although the proposed regulations literally limit a requested method to the method that the surviving corporation must use (i.e., a method used by the party with the principal methods), it seems more reasonable to interpret the regulations as permitting a party with a nonprincipal method to request consent to use a method that is the same as a permissible principal method. Thus, the party with principal methods can request consent to use any permissible method, whereas any other party can only request consent to use a method consistent with a permissible principal method.

For voluntary method change requests filed in anticipation of a transaction, it is not clear whether the proposed regulations contemplate delaying consent until the completion of the transaction or granting conditional consent to make a method change. Due to the fluid nature of acquisition negotiations and planning, parties to a transaction might lack definitive information about plans to integrate business operations, factors used to determine permissible principal methods (e.g., relative inventory values), and/ or post-transaction structures that would determine a party’s status as the surviving corporation.

The proposed regulations seem to acknowledge the difficulty of making this determination in advance by specifying that a determination about whether the surviving corporation will operate an integrated business will be made at the time of the transaction.²⁸ Although parties might wait to file a method change request until they have this information, waiting might not be a viable option for parties with tax years that might end as a result of a transaction. A good-faith application based on known information should be accepted for this purpose as long as the Service does not dismiss the filing as a mere protective application.

Taxpayers would need to remain aware that special procedural rules described in the proposed regulations would apply to any voluntary, post-transaction method change request filed for the year during which the transaction occurs. In particular, the regulations would not limit their scope to carryover-related requests. Although the procedures generally impose no onerous burdens on taxpayers, the special procedures might come as a surprise due to their application to requests that could have no relationship to a prior transaction. For example, where a Sec. 381(a) transaction results in the closing of a tax year or occurs close to the year end of the surviving corporation, any method change requests filed with the IRS within 180 days of the transaction would be subject to the provisions in the proposed regulations.

Rules for Implementing Accounting Method Changes

Process for Changing to a Permissible Principal Method

Filing requirement: The proposed regulations would allow a change to a permissible principal method without the filing of a Form 3115 (i.e., the surviving corporation would not need to secure IRS consent to make the change).²⁹ The surviving corporation would merely reflect the change on its return for the year of the transaction. Note that where a surviving corporation changes one of its methods to a principal method, the proposed regulations would require the return to reflect only the use of the principal method starting with the day immediately after the transaction.

Except as noted below, the terms and conditions imposed by Regs. Sec. 1.446- 1(e) or applicable revenue procedures, which normally would govern a voluntary change to the principal method, would generally apply to a change to a principal method despite the involuntary nature of the change.³⁰

Sec. 481(a) adjustment: The proposed regulations would require that a surviving corporation determine a Sec. 481(a) adjustment, if any, and its adjustment period in a manner generally consistent with Regs. Sec. 1.446-1(e) and applicable revenue procedures as if the surviving corporation had voluntarily initiated the method change.³¹ In particular, the proposed regulations would instruct a taxpayer to consult applicable revenue procedures to determine whether it should change to a principal method on a cutoff basis and, if not, what spread period to use.

The proposed regulations provide insufficient guidance about how a surviving corporation would determine an applicable revenue procedure. It seems reasonable to assume that the proposed regulations intend for surviving corporations to consult revenue procedures governing specific types of changes (e.g., Rev. Proc. 2008-52,³² which provides automatic consent for certain accounting method changes). But it is not clear how a surviving corporation would take any scope limitations into account. Due to the involuntary nature of a change to a principal method, the proposed regulations should instruct taxpayers to determine an applicable revenue procedure, for purposes of determining a Sec. 481(a) adjustment and spread period, without regard to the general scope limitations. This approach would be consistent with the proposed denial of audit protection for changes to a principal method of accounting, as discussed below. The final regulations, however, need to make that clarification.³³

The proposed regulations would require a surviving corporation to compute any Sec. 481(a) adjustment as of the beginning of the first day following a transaction. ³⁴ This mid-period adjustment would logically flow where a distributing corporation’s methods change to principal methods because the distributing corporation’s tax year ends with the transaction. However, the adjustment would appear odd where the surviving corporation’s methods change to the principal methods because the surviving corporation would use different methods for the same items during its year of change. In any event, the proposed regulations would require that the surviving corporation take any Sec. 481(a) adjustment into account beginning with its year that includes the transaction.

Observation: Under the proposed regulations, if a surviving corporation is required to change to a distributing corporation’s principal method and the transaction occurs during the surviving corporation’s tax year, the surviving corporation would effectively be required to close its books and records as of the transaction date to compute the Sec. 481(a) adjustment. Because accounting methods generally are not considered until after year end, retroactively closing the books of the surviving corporation as of the transaction date may not be administratively feasible.

Audit protection: Despite providing treatment comparable to voluntary method changes, the proposed regulations would deny audit protection for changes to principal methods made as a result of the Sec. 381(a) transaction.³⁵ This denial would mean that the Service could require a surviving corporation or a distributing corporation—whichever changes its original methods to the principal methods—to change an improper original method for a year ending before the transaction date. Essentially, a party with a method that changes to a permissible principal method would face audit exposure if it previously used an impermissible method.

Treasury and the IRS believe no audit protection is warranted because a change to a principal method would occur without disclosing an improper method.³⁶ In particular, a surviving corporation would report any Sec. 481(a) adjustment on its return but would not file a Form 3115 to separately identify an improper method. The proposed regulations appear to recognize audit protection as a reward for voluntary disclosure.

Treasury and the IRS further suggest that any party to a transaction using an improper method could receive audit protection by voluntarily requesting consent to change that method before the transaction.³⁷ They indicate that a party could file a Form 3115 before a transaction, which achieves the disclosure, and change a method that would otherwise change to a principal method. However, in the preamble, the government notes that the IRS generally will not consent to a method change where the requesting party would be required to change to a different method under the principal method rules.

Despite encouraging taxpayers to correct their improper methods voluntarily, the denial of audit protection does not provide any significant benefit in this context. First, as a practical matter, the prospect of receiving audit protection would not encourage taxpayers to ferret out improper accounting methods during the often chaotic period prior to a transaction. Instead, the surviving corporation would most likely identify improper methods only during the post-transaction integration of accounting information. Second, as noted above, parties to a transaction might lack sufficient foresight to determine which party would have the principal methods. The prospect of receiving audit protection would merely encourage the parties to file requests to align their methods prior to a transaction, which would amount to protective filings for the party deemed to have the principal methods or a futile exercise where the deal falls apart. Finally, the prospect of receiving audit protection would encourage parties to file method change applications independently of and in addition to complying with the proposed regulations, which creates a duplication of efforts and an increase in administrative burdens.

Treasury and the IRS should extend audit protection to any party with an improper method that would change to a principal method provided the method of accounting is not, as of the transaction date, an issue under consideration or an issue before appeals or a federal court. This approach would create greater consistency with the general approach of treating these changes like voluntary method changes and would recognize that a “reward” of audit protection is unlikely to change behavior immediately before a transaction. To the extent the IRS or Treasury wants disclosure, the proposed regulations could simply require the surviving corporation to specifically identify any changed improper methods as part of filing its first post-transaction income tax return.

Changing an Impermissible Carryover or Principal Method

Filing requirement: A surviving corporation that identifies an impermissible carryover or principal method under the proposed regulations would generally need to file a Form 3115 to use a proper method.³⁸ The surviving corporation would generally follow the revenue procedure applicable to that type of change (i.e., a revenue procedure providing automatic consent to make the change or a revenue procedure requiring advance consent to make the change).³⁹ Current procedural guidance applies special rules to taxpayers under examination, before appeals, and before federal courts, and those rules preclude a taxpayer from requesting consent to change a method of accounting where that method is an item under consideration by exam, appeals, or a federal court, except in limited circumstances. As indicated in the preamble to the proposed regulations, either the final regulations or the procedural guidance should clarify how any scope or other filing limitations would apply to a surviving corporation requesting consent to change an impermissible carryover or principal method of accounting.⁴⁰

In addition to using a special label on the application, a surviving corporation seeking advance consent would use special rules to determine the due date for a request. That due date would fall on the later of (1) the normal due date for the Form 3115, which normally occurs on the last day of the year of change, or (2) the earlier of the date occurring 180 days after the transaction or the date on which the surviving corporation files its federal income tax return for the year of the transaction. These special rules would generally achieve consistency with the due dates for voluntary change requests but would provide a surviving corporation with additional time to make a request where a transaction occurs near its year end.

Although the proposed regulations clearly contemplate that a surviving corporation might file a method change request near the due date for its federal income tax return, the proposed regulations provide no guidance about how the surviving corporation should prepare the return. The proposed regulations would not permit a surviving corporation to use an impermissible carryover or principal method; however, the delay inherent in the process of securing consent to use another method could leave the surviving corporation with an obligation to file a return but without consent to use a permissible method to prepare the return.

Sec. 481(a) adjustment: Under the proposed regulations, taxpayers would need to distinguish those impermissible methods that would change by requesting consent under a revenue procedure from those impermissible methods that would change under the proposed regulations. Where a surviving corporation had used an impermissible principal method, it would file a Form 3115 to change its method. Because the requested method would take effect on the first day of the year of the transaction, the method would become a permissible principal method and the distributing corporation’s methods (whether permissible or impermissible) would change to that method in accordance with the proposed regulations. In contrast, where a distributing corporation had used an impermissible carryover or principal method, the surviving corporation would file a Form 3115 to change the distributing corporation’s method. Any of the surviving corporation’s methods (whether permissible or impermissible) that would change to the requested method would be included on the Form 3115.

A surviving corporation would compute and take into account any Sec. 481(a) adjustment in a manner consistent with the applicable revenue procedure governing the change. Because the proposed regulations contain no special calculations for the adjustment, a surviving corporation would presumably compute a Sec. 481(a) adjustment for any change to the surviving corporation’s method as of the first day of its year of change. It also seems reasonable to assume that an adjustment attributable to a change in the distributing corporation’s method would reflect the distributing corporation’s items and the surviving corporation’s items as of the transaction date.

It is not clear from the proposed regulations whether the government contemplated that a surviving corporation, which had not received consent for the method change before filing the return for the tax year that includes the transaction, might attempt to roll forward the year of change.⁴¹ Although the later year of change would eliminate the need to file an amended income tax return for the year of the transaction, it might trigger a recomputed net negative Sec. 481(a) adjustment or an accelerated net positive adjustment. In addition, it is not clear whether rolling forward the year of change would be consistent with the proposed regulations’ requirement that the principal method be changed from an impermissible method. Further, it is not clear how the surviving corporation would prepare a return for the year of the transaction.

Audit protection: The proposed regulations would allow audit protection for a requested change on a Form 3115 from an impermissible carryover or principal method.⁴² Because a surviving corporation would request consent to change a method under generally applicable revenue procedures, audit protection would become available to the extent those procedures grant protection for a particular change. Even though the proposed regulations would require the surviving corporation to request consent to change to a permissible method, the IRS and Treasury would treat such a request as involving a voluntary disclosure of an impermissible method for which audit protection is considered appropriate.

Process for Voluntary Method Changes

The proposed regulations would permit any party to a Sec. 381(a) transaction to request voluntary method changes during the tax year of the transaction.⁴³ Such change requests would be subject to the procedural rules of Regs. Sec. 1.446- 1(e), including filing requirements, Sec. 481(a) adjustment, and audit protection provisions. As noted above, the Service anticipates granting consent for method changes related to integrated businesses only where the surviving corporation will continue to use the proposed method after the transaction.

Because these rules would apply to a distributing corporation as well as a surviving corporation, it appears that the proposed regulations would extend the due date for making requests for changes requiring advance consent beyond the end of the distributing corporation’s final tax year (i.e., the distributing corporation’s year that ends with the transaction). Therefore, the distributing corporation would have the opportunity to make voluntary method change requests during the short tax year that ends with the transaction and up to 180 days following the transaction. Thus, the proposed regulations provide the parties with some flexibility in correcting the distributing corporation’s impermissible methods and potentially managing pre-transaction taxable income or loss. For example, the extended due date for making advance consent accounting method change requests would give a distributing corporation the ability to make a request for a tax year ending with the transaction, which would seem to result in the distributing corporation obtaining audit protection for an impermissible method (despite a contrary suggestion in the preamble that the distributing corporation must file its request before the transaction in order to receive audit protection).⁴⁴

Example 10: K Corp. merges with and into L Corp. L will integrate the business operations of the merged entities. Assume that in this transaction L has the principal methods under the proposed regulations and that K had used an impermissible method before the transaction. If K’s impermissible method is simply changed to a principal method under the proposed regulations, audit protection is not available. If, however, K voluntarily requests consent to change its method to the principal method for its last tax year ending on the date of the transaction—through either the advance or the automatic consent procedure—K could receive audit protection for its use of an impermissible method for prior tax years.

As noted above, concurrent refinements to the general scope limitations and the terms and conditions in applicable revenue procedures would become necessary to accommodate voluntary method changes in the year of a Sec. 381(a) transaction.

Conclusion

Overall, the IRS and Treasury are to be commended for proposing regulations that are generally consistent with the Sec. 446(e) accounting method change procedures and terms and conditions and that provide for consistency between inventory and noninventory methods. The proposed regulations would provide clearer rules for determining whether businesses are integrated post-transaction as well as for determining the principal method of accounting for integrated businesses. However, as noted above, the final regulations should provide a way for taxpayers to obtain audit protection for impermissible methods that are required to be changed under the principal method rules.⁴⁵

EditorNotes

Jane Rohrs is on the staff of the Joint Committee on Taxation and is a member of The Tax Adviser’s editorial advisory board. At the time of writing, Ms. Rohrs was an executive director with Ernst & Young LLP’s National Tax Department. Glenn Walberg is an assistant professor of accounting at the University of North Carolina–Wilmington. For more information about this article, please contact Prof. Walberg at walbergg@uncw.edu.

Authors’ note: The views expressed in this article are those of the authors and not necessarily those of Ernst & Young LLP, the Joint Committee on Taxation or its staff, or the University of North Carolina–Wilmington.

Notes

¹ REG-151884-03, 72 Fed. Reg. 64,545 (November 15, 2007).

² Secs. 381(c)(4) and (5).

³ Separate rules govern carryovers of depreciation methods, which remain outside the scope of the proposed regulations; see Regs. Sec. 1.381(c) (6)-1.

⁴ Secs. 381(c)(4) and (5).

⁵ Prop. Regs. Secs. 1.381(c)(4)-1(a)(2)(i) and 1.381(c) (5)-1(a)(2)(i).

⁶ Prop. Regs. Secs. 1.381(c)(4)-1(b)(11) and 1.381(c) (5)-1(b)(10).

⁷ Regs. Sec. 1.446-1(d)(2).

⁸ Regs. Sec. 1.446-1(d)(3).

⁹ Prop. Regs. Secs. 1.381(c)(4)-1(e)(4) and 1.381(c) (5)-1(e)(7)(ii).

¹⁰ Prop. Regs. Secs. 1.381(c)(4)-1(a)(2)(ii) and 1.381(c)(5)-1(a)(2)(ii).

¹¹ Id.

¹² See, e.g., Johnson, 184 F.3d 786 (8th Cir. 1999).

¹³ Prop. Regs. Secs. 1.381(c)(4)-1(a)(2)(i) and 1.381(c)(5)-1(a)(2)(i).

¹⁴ Prop. Regs. Secs. 1.381(c)(4)-1(c)(1) and 1.381(c)(5)-1(c)(1).

¹⁵ Rev. Proc. 2004-34, 2004-1 C.B. 991.

¹⁶ Id.

¹⁷ Id.

¹⁸ Prop. Regs. Sec. 1.381(c)(4)-1(e)(5).

¹⁹ Prop. Regs. Sec. 1.381(c)(5)-1(c)(1).

²⁰ Id.

²¹ Regs. Sec. 1.263A-2(b)(2)(i).

²² Prop. Regs. Sec. 1.381(c)(5)-1(b)(1).

²³ Prop. Regs. Secs. 1.381(c)(4)-1(e)(2) and 1.381(c)(5)-1(e)(3).

²⁴ Prop. Regs. Sec. 1.381(c)(4)-1(a)(2)(iv), Example (3)(ii).

²⁵ Prop. Regs. Secs. 1.381(c)(4)-1(a)(2)(ii) and 1.381(c)(5)-1(a)(2)(ii).

²⁶ Prop. Regs. Sec. 1.381(c)(4)-1(d)(2)(i), which provides for special fi ling deadlines consistent with those currently available under Rev. Proc. 2005-63, 2005-2 C.B. 491.

²⁷ Prop. Regs. Secs. 1.381(c)(4)-1(a)(2)(iii) and 1.381(c)(5)-1(a)(2)(iii).

²⁸ Prop. Regs. Secs. 1.381(c)(4)-1(e)(4)(ii) and 1.381(c)(5)-1(e)(7)(ii).

²⁹ Prop. Regs. Secs. 1.381(c)(4)-1(a)(2)(i), (d)(1)(i), 1.381(c)(5)-1(a)(2)(i), and (d)(1)(i).

³⁰ Prop. Regs. Secs. 1.381(c)(4)-1(d)(1)(iii) and 1.381(c)(5)-1(d)(1)(iii).

³¹ Prop. Regs. Secs. 1.381(c)(4)-1(d)(1)(i) and 1.381(c)(5)-1(d)(1)(i).

³² Rev. Proc. 2008-52, 2008-36 I.R.B. 587.

³³ Although the IRS and Treasury intend to modify the scope limitations to allow voluntary method changes in the year of Sec. 381 transactions (including modifications to account for taxpayers under exam and in appeals), those modifications, without further clarifi cation, might suggest that taxpayers need to take into account the remaining scope limitations (e.g., the limitation on a taxpayer that had changed its method for an item within the past fi ve years) in identifying an applicable revenue procedure.

³⁴ Prop. Regs. Secs. 1.381(c)(4)-1(d)(1)(i) and 1.381(c)(5)-1(d)(1)(i).

³⁵ Prop. Regs. Secs. 1.381(c)(4)-1(d)(1)(ii) and 1.381(c)(5)-1(d)(1)(ii).

³⁶ Preamble to REG-151884-03.

³⁷ Id.

³⁸ Prop. Regs. Secs. 1.381(c)(4)-1(a)(2)(ii) and 1.381(c)(5)-1(a)(2)(ii).

³⁹ Prop. Regs. Secs. 1.381(c)(4)-1(d)(2) and 1.381(c)(5)-1(d)(2).

⁴⁰ Preamble to REG-151884-03.

⁴¹ Rev. Proc. 2007-67, 2007-48 I.R.B. 1072.

⁴² Preamble to REG-151884-03.

⁴³ Prop. Regs. Secs. 1.381(c)(4)-1(a)(2)(iii) and 1.381(c)(5)-1(a)(2)(iii).

⁴⁴ Preamble to REG-151884-03.

⁴⁵ Finalizing the proposed regulations is an item in the IRS and Treasury’s 2008–2009 Priority Guidance Plan. However, in a January 20, 2009, memo, White House chief of staff Rahm Emanuel generally instructed all executive departments and agencies not to send any pending regulations to the Federal Register for publication until President Obama’s appointees could review them. (See 74 Fed. Reg. 4,435 (January 26, 2009).) Thus, it is not clear whether final regulations will be published during the government’s current 2009 fiscal year.