Request for Accounting Method Change for Prepaid Expenses Denied

Procedure & Administration

The Tax Court held that the IRS’s denial of a request for a change in accounting method that the taxpayer made outside the effective dates of the relevant regulations and revenue procedure was not an abuse of discretion.

Background

Lattice Semiconductor Corporation (Lattice) designs, develops, and markets high-performance programmable logic devices and related software. The company, which is located in Hillsboro, Oregon, is an accrual-method taxpayer.

Lattice traditionally incurred regular expenses from prepaid insurance, maintenance, and service contracts (contracts). These contract expenses were prepaid expenses under Sec. 263 and the regulations. The benefits of these contracts typically did not exceed 12 months, but the contract periods sometimes spanned two tax years. Before 2002, Lattice capitalized its prepaid expenses for contracts that extended substantially into the following year.

The IRS issued an advance notice of proposed rulemaking (ANPRM) in January 2002 stating that it expected to propose a rule that would no longer require capitalization of 12-month prepaid expenses under Sec. 263. The next month, the IRS issued an industry directive, Guidelines for the Application of Advance Notice of Rulemaking for Intangibles Under IRC 263(a), that stated the IRS likely would adopt the ANPRM’s 12-month rule despite the IRS’s contrary position at the time. The industry directive further cautioned that prior IRS consent was still required for accounting method changes.

The IRS published proposed regulations regarding 12-month prepaid expenses in December 2002 (REG-125638-01) that incorporated a 12-month rule where an expenditure could be deducted in the year incurred as long as the useful life of the resulting benefit did not extend beyond a year. The proposed regulations advised taxpayers not to seek an accounting method change in reliance upon the proposed rules until the IRS published final regulations.

Nine days later, Lattice applied for an accounting method change under Rev. Proc. 97-27 to deduct 12-month prepaid expenses spanning two tax years (relevant expenses). Lattice relied on the proposed regulations and U.S. Freightways Corp., 270 F.3d 1137 (7th Cir. 2001), rev’g 113 T.C. 329 (1999). The company then claimed a deduction for the relevant expenses for the first time when it filed its consolidated federal income tax return for 2002. Lattice calculated a consolidated net operating loss (CNOL) carryback from the 2002 deduction of the relevant expenses, which it carried back to 2000 and 1999. The company claimed a refund for those years based in part on the relevant expense deduction, even though it had not yet received approval to change its accounting method.

The IRS finalized the proposed regulations in 2004 (T.D. 9107). The final regulations were effective for amounts paid or incurred on or after December 31, 2003. The IRS subsequently released Rev. Proc. 2004-23, which provides procedures for automatic consent to accounting method changes that complied with the final regulations in principle. However, it specified that the IRS would not grant requests for accounting method changes under the final regulations for a year earlier than the effective date.

The IRS denied Lattice’s request to change its accounting method in May 2004 and issued a letter formally denying the change in June 2005 because Lattice had requested the accounting method change before the effective date of the final regulations. The IRS subsequently issued Lattice a deficiency notice disallowing the relevant expense deduction and the corresponding CNOL carrybacks, and Lattice timely filed a petition in Tax Court challenging the IRS’s determination. Lattice argued that the IRS had implemented an automatic rejection policy and automatically disregarded developing case law, while the IRS contended that it had acted within its proper discretion.

The Law

A taxpayer must secure IRS consent before changing its accounting method for computing income and is not allowed to unilaterally switch to a more financially beneficial method of accounting with the benefit of hindsight (Sec. 446(e)). The taxpayer must continue computing taxable income under its old accounting method if the IRS denies the taxpayer’s request to change its accounting method. In addition, the IRS can require a taxpayer to abandon the new accounting method and to report taxable income using the old method if the taxpayer changes its accounting method without first obtaining consent. The IRS has wide discretion to grant or deny such consent; if the IRS refuses to consent to a taxpayer’s requested change in accounting method, its determination is reviewed under an abuse of discretion standard.

The Tax Court’s Decision

The Tax Court held that the IRS had not abused its discretion in denying Lattice’s request to change its accounting method with respect to its prepaid contract expenses. Because Lattice could only deduct these expenses under the 12-month rule by changing its accounting method with the IRS’s consent, which Lattice had not done, the Tax Court further held that the IRS had properly disallowed the expenses.

Lattice relied primarily on one case, Zaninovich, 616 F.2d 429 (9th Cir. 1980), rev’g 69 T.C. 605 (1978). The Tax Court acknowledged that the Ninth Circuit had reversed its decision in Zaninovich and held that 12-month rental payments by a cash-method taxpayer were fully deductible in the year of payment. However, in doing so the Ninth Circuit specifically distinguished between an accrual-basis taxpayer (such as Lattice) and a cash-basis taxpayer (such as the one in Zaninovich). Thus, the Tax Court found that Zaninovich applies only to cash-basis taxpayers and does not indicate that the Ninth Circuit would follow a 12-month rule for accrual-basis taxpayers. Lattice also cited as support for its position the Seventh Circuit case U.S. Freightways Corp., in which the Seventh Circuit reversed the Tax Court and adopted the 12-month rule for accrual-method taxpayers. Because that decision is binding only in the Seventh Circuit, the Tax Court declined to apply it to Lattice, which was under the Ninth Circuit’s jurisdiction.

Lattice further argued that Zaninovich and U.S. Freightways indicate that the Ninth Circuit would have adopted a 12-month rule for accrual-method taxpayers even without enactment of the final regulation and that the IRS imposed its interpretation of the Code to disregard developing case law. The Tax Court stated that U.S. Freightways was inconsistent with its decision and the decisions of other courts of appeals at the time and refused to speculate on whether the Ninth Circuit would have adopted the 12-month rule for accrual taxpayers. Accordingly, the Tax Court found that the IRS did not abuse its discretion in rejecting Lattice’s accounting method change after Zaninovich and U.S. Freightways.

Reflections

The taxpayer in this case apparently thought the court would be sympathetic to an accounting method change that in some sense merely jumped the gun. However, Lattice ignored the proposed regulations’ explicit directive that taxpayers were not to seek an accounting method change in reliance upon the proposed rules, and it failed to convince the court that early adoption of the method was permissible.

Lattice also argued that the IRS’s rejection of its accounting method change request was arbitrary and capricious because the IRS had instituted an automatic rejection policy. Lattice asserted that the IRS rejected all accounting method change requests aiming to benefit from the 12-month rule if such requests did not comply with the procedures under Rev. Proc. 2004-23. Consequently, Lattice took the position that this automatic rejection policy meant the IRS had failed to evaluate Lattice’s accounting method change request under traditional application procedures and developing case law.

The Tax Court determined it did not need to consider this question. Having already found that the IRS acted within its discretion in rejecting Lattice’s accounting method change request under then-existing case law as applied to Lattice’s circumstances, the court stated that it did not need to speculate whether the IRS would have reached a different conclusion if considering a similarly situated taxpayer in a circuit where the case law supported a different conclusion.

Lattice Semiconductor Corp., T.C. Memo. 2011-100