Editor: Albert B. Ellentuck, Esq.
A corporation that has adopted an accounting method cannot change that method simply by amending prior-year income tax returns; IRS permission is required to change methods (Sec. 446(e)). Corporations must request a change even if they are changing from an improper method. Usually, corporations can obtain permission to change accounting methods if there are valid business reasons for making the change. However, the IRS will not grant the change if the proposed method does not clearly reflect income. In addition, permission will not be granted unless the corporation agrees to the prescribed terms and conditions set forth by the IRS for making the change (Regs. Sec. 1.446-1(e)(3)(i)).
The IRS or the taxpayer can initiate a change in accounting method. Taxpayers that file a request for change before being contacted for an IRS examination generally receive more favorable terms and conditions (e.g., a later year of change and a longer Sec. 481(a) adjustment period for positive adjustments). A change initiated by the IRS during examination generally receives less favorable terms and conditions and may also be subject to penalties.
Observation: A change in accounting method should not be confused with the correction of an error, which is handled on an amended return. For this purpose, errors include mathematical or posting errors, or errors in the computation of tax (e.g., errors in computing a foreign tax credit, net operating loss, percentage depletion, or investment credit) (Regs. Sec. 1.446-1(e)(2)(ii)(b)).
Changes in accounting method can be categorized into automatic changes and nonautomatic changes. The procedures for making changes differ depending on which category the change falls into. Automatic accounting method changes receive more favorable treatment: There is no user fee payable to the IRS, and the Form 3115, Application for Change in Accounting Method, can be filed at any time during the year and up to the filing date, including extensions, of the tax return for the year of change. Nonautomatic accounting method changes require payment of a user fee and filing the Form 3115 by the last day of the tax year of change.
Changes That Receive Automatic Consent
Rev. Proc. 2008-52, as amplified, clarified, and modified by Rev. Proc. 2009-39 and Rev. Proc. 2010-44, provides the procedures for obtaining automatic IRS consent for accounting method changes. Although Rev. Proc. 2008-52 provides uniform procedures for many automatic accounting method changes, it applies to a lengthy list of accounting method changes, including a change in overall method of accounting (e.g., cash to accrual) and submethods of accounting (e.g., depreciation or LIFO). The guidance also grants automatic approval to a list of special methods of accounting (e.g., long-term contracts and receipt of advance payments). Practitioners with clients eligible for an automatic method change should carefully review Rev. Procs. 2008-52, 2009-39, and 2010-44.
These revenue procedures encourage taxpayers to adopt permissible accounting methods and correct impermissible methods. Filing Form 3115 protects the taxpayer and the preparer against penalties and, in many cases, secures “audit protection,” providing relief for taxpayers from IRS adjustments in prior periods in which impermissible methods have been used.
Nonautomatic Changes in Accounting Method
The general rules and procedures for obtaining IRS approval for taxpayer-initiated accounting method changes that do not receive automatic IRS consent are found in Rev. Proc. 97-27, as amplified and modified by Rev. Proc. 2002-19, as amplified and clarified by Rev. Proc. 2002-54, as modified by Rev. Proc. 2007-67, and as modified and clarified by Rev. Proc. 2009-39. This revenue procedure is a lengthy and complex document. Practitioners with clients who are requesting a change in accounting method or who have exposure to accounting method issues are advised to review it carefully.
Form 3115 can be filed any time during the requested year of change. However, the IRS may not act on requests filed near the end of the year before the deadline for filing that year’s tax return. This can necessitate an amended return if the change is approved after the original return has already been filed. Thus, taxpayers should file a change request as early in the year as possible. The appropriate user fee must accompany the form.
Generally, accounting method changes granted under Rev. Proc. 97-27 result in audit protection for taxpayers. That is, the taxpayer will not be required to retroactively change the method in question in an earlier year because of an audit. Once the IRS contacts a taxpayer to schedule an audit, a request for change in accounting method cannot be filed. However, there are four exceptions to this rule:
- Taxpayers continuously under audit for at least 12 consecutive months can file Rev. Proc. 97-27 change requests within the first 90 days of the tax year for methods not already placed under review or in suspense by the examining agent.
- A taxpayer can file Form 3115 within 120 days of the end of an audit even if another audit has commenced, provided the method has not already been identified as an issue or placed in suspense under the second audit.
- Taxpayers under audit can request permission to change methods if the IRS consents, which it will normally do unless the accounting method in question would ordinarily be included as an adjustment item in the audit.
- Taxpayers can ask to change an accounting method that is an issue pending for any tax year under examination. However, audit protection is not granted. An issue is pending if the IRS has notified the taxpayer in writing that an adjustment is being made or will be proposed with respect to the taxpayer’s accounting method.
The IRS has broad authority to force a taxpayer using an erroneous or unacceptable method of accounting that does not clearly reflect income to change to one that does (Sec. 446(b)). The consequences of an IRS-initiated change are less favorable than when the taxpayer initiates the change. For example, the adjustment from an involuntary change is taken into account in the year of change, and the change generally occurs in the earliest open year (or the earliest year under examination), which leads to greater interest charges and penalties, if applicable.
The IRS has issued procedures for IRS-initiated accounting method changes when (1) no method of accounting has been regularly used, (2) the method used does not clearly reflect income, and (3) the accounting method issues are raised and resolved on a nonaccounting-method-change basis (Rev. Proc. 2002-18). These procedures instruct examiners to resolve timing issues as an accounting method change and to make the change in the earliest tax year under examination using a shorter Sec. 481(a) adjustment period for a positive adjustment.
Rev. Proc. 2002-18 includes model closing agreements for accounting method changes and accounting method issues resolved on a nonaccounting-method-change basis.
Sec. 481(a) Adjustment
When a corporation changes accounting methods, adjustments must be made to ensure that the change does not result in the omission or duplication of income or expense (Sec. 481(a)). These Sec. 481(a) adjustments can increase income (a positive adjustment) or decrease income (a negative adjustment) (Regs. Sec. 1.481-1(d)).
Generally, positive Sec. 481(a) adjustments are taken into income over four years. However, this period is shortened (usually to one year) in the following instances:
- De minimis rule: If a positive Sec. 481(a) adjustment is less than $25,000, the corporation may elect to use a one-year adjustment period.
- Termination of business: A corporation that ceases business operations must take the remaining balance of any Sec. 481(a) adjustment relating to those business operations into account in computing taxable income for the year of cessation.
- Cutoff method: Any change within the LIFO inventory method must be made using a cutoff method. Under a cutoff method, only the items arising on or after the beginning of the year of change are accounted for under the new method. Any items arising before the year of change continue to be accounted for under the old method of accounting.
Negative Sec. 481(a) adjustments are deducted in full in the year of the change in accounting method.
In today’s difficult economic times, corporations are looking everywhere they can to maximize cash. One option is to examine the various accounting methods that they are using—not just the overall method of accounting (cash or accrual), but the specific accounting methods or elections available to certain items or issues.
This possibility was highlighted by Congress’s recent extension of the net operating loss (NOL) carryback period from two years to three, four, or five years. This provision—available for tax years beginning in 2007, 2008, or 2009—allowed practitioners to help corporations identify opportunities to increase their NOLs through accounting method changes. Generally speaking, the extended NOL carryback period benefitted older corporations currently experiencing losses that had been profitable several years ago.
Some automatic accounting method changes that can increase NOLs are changes to more favorable capitalization or depreciation methods, deferral of recognition of advance payments, accelerated deductions of prepaid expenses, inventory valuation, and accelerated deduction of tax liabilities. Corporations can receive a future benefit as well as a current benefit via the Sec. 481(a) adjustment, which quantifies the cumulative effect of the change in method on taxable income.
This case study has been adapted from PPC’s Tax Planning Guide—Closely Held Corporations, 23d Edition, by Albert L. Grasso, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, Mary C. Danylak, Timothy Fontenot, James A. Keller, and Brian B. Martin, published by Thomson Tax & Accounting, Ft. Worth, TX, 2010 ((800) 323-8724; ppc.thomson.com ).
Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.