Tax Accounting
The first so-called mass accounting method automatic change procedure issued by the IRS was Rev. Proc. 97-37. It contained 24 changes, which generally were viewed as common, low-risk changes for both the IRS and taxpayers. Rev. Proc. 97-37 provided in Section 1, Purpose, that the revenue procedure “generally provides simplified, uniform procedures and terms and conditions to obtain automatic consent to make these changes.” In Section 5, Terms and Conditions, the IRS did provide that “[a]n accounting method change filed under this revenue procedure must be made pursuant to the terms and conditions provided in this revenue procedure” and that a Sec. 481(a) adjustment must be taken into account. In light of the stated policy of simplified rules, combined with the provided general terms and conditions, there appeared to be little concern that changes could be held invalid upon examination.
Much has changed in the last 14-plus years. Currently, Rev. Proc. 2011-14 has over 137 automatic changes. (Rev. Proc. 2011-14 was issued by the IRS on January 10, 2011, and is effective for applications filed on or after January 10, 2011, for a year of change ending on or after April 30, 2010.) Many of the changes are not the common, low-risk changes that were included in the original mass automatic change procedure. No language referring to simplified procedures is contained in the document. Clarification of the language regarding the computation of the Sec. 481(a) adjustment, coupled with the requirement in some cases to request a second method change under Sec. 263A, has resulted in some taxpayers being ineligible to use the more recent automatic method change procedures. This creates a real concern that a change may be invalidated upon examination if not completed with the precision required by the new revenue procedure. Today, taxpayers should consider a number of issues before requesting an automatic method change.
Background
Sec. 446(e) and Regs. Sec. 1.446-1(e)(2)(i) require taxpayers to secure IRS consent before changing a method of accounting for federal income tax purposes. To that end, the IRS has published two sets of procedures for requesting such changes: Rev. Proc. 97-27, which contains the procedures for requesting advance consent to change an accounting method, and Rev. Proc. 2011-14, which describes the procedures for receiving automatic consent. Rev. Proc. 2011-14 contains an appendix that describes each method change eligible for automatic consent. All other accounting method changes require advance consent. To receive automatic consent, taxpayers must comply with the general and specific method change requirements in Rev. Proc. 2011-14. Section 5.01 of Rev. Proc. 2011-14 notes that “an accounting method change filed under this revenue procedure must be made pursuant to the terms and conditions provided in this revenue procedure.” If the taxpayer does not comply with the terms, conditions, and other provisions of Rev. Proc. 2011-14, it is not eligible to receive automatic consent for the method change. Section 6.01 of Rev. Proc. 2011-14 specifically states that “consent is granted only to the extent that the taxpayer complies with all of the applicable provisions of this revenue procedure.”
Regardless of whether a particular change is eligible for advance or automatic consent, the taxpayer must formally request the accounting method change by filing Form 3115, Application for Change in Accounting Method, with the IRS. Advance consent method changes must be filed during the tax year of change. Automatic method changes may be filed until the filing of the federal income tax return for the year of change. The taxpayer must also recognize an adjustment under Sec. 481(a) to capture the cumulative difference, solely as a result of the change, between the prior method and the new method of accounting to prevent duplications or omissions when computing taxable income.
Once filed, a Form 3115 may be reviewed either by the IRS National Office or by an IRS examining agent. A method change may be disallowed if the taxpayer did not fully comply with the terms or conditions of making the change. If a change is disallowed on examination, a technical advice may be issued instructing the taxpayer to amend any prior tax returns to reflect the original method of accounting. If the method change resulted in a negative adjustment (reduction to taxable income), the tax liability may be increased on the prior year’s tax return. In addition, any audit protection may be rescinded, which could have negative consequences if the change was made to correct an improper method of accounting. Thus, disallowance of a method change could be costly to the taxpayer.
Automatic Method Change Requirements
During 2008, in Rev. Proc. 2008-52 (a previous version of the mass automatic change procedures), the IRS modified certain automatic method changes to include a new requirement that ties a taxpayer’s ability to request the change to whether the taxpayer is capitalizing that particular cost under Sec. 263A. If the taxpayer is required to capitalize the cost under Sec. 263A and is not currently capitalizing the cost, the automatic procedures indicate that the taxpayer is not eligible for automatic consent. This Sec. 263A requirement raises a number of issues that taxpayers should consider before requesting an automatic method change.
The first issue is whether the automatic method change is subject to the Sec. 263A requirement. Taxpayers can identify method changes subject to this requirement by reviewing the appendix to Rev. Proc. 2011-14. For many automatic changes, the IRS has included a section on inapplicability, which discusses the situations in which automatic consent is not available. For example, Appendix Section 19.01(2) of Rev. Proc. 2011-14 (which discusses the requirements to receive automatic consent to change the timing of incurring employee bonuses) states that:
This change does not apply to a taxpayer that is required under § 263A and the regulations thereunder to capitalize these costs with respect to which the taxpayer wants to change its method of accounting under this section 19.01(2) of the APPENDIX if the taxpayer is not capitalizing these costs, unless the taxpayer concurrently changes its method to capitalize these costs in conjunction with a change to a UNICAP method under section 11.01 or 11.02 of this APPENDIX (as applicable).
All automatic method changes that are subject to this Sec. 263A requirement include similar language within their respective sections of Rev. Proc. 2011-14. All automatic method changes subject to the Sec. 263A requirement, including their relevant appendix sections, are listed in Exhibit 1.
The next issue a taxpayer should consider is whether it has property subject to Sec. 263A. Sec. 263A applies to tangible personal property produced or acquired for resale by the taxpayer (e.g., inventory or self-constructed assets) as well as real property held for sale by the taxpayer. While this appears to be a straightforward determination, there have been disagreements between the IRS and taxpayers in certain industries as to whether the taxpayers have property subject to Sec. 263A. This is a common issue for businesses providing both goods and services to their customers. The taxpayer may view itself as a service provider, but the IRS may view the taxpayer as a reseller or a producer of inventory. A taxpayer that has not historically complied with Sec. 263A, for whatever reason, may need to revisit this position to become eligible to request certain automatic changes.
A taxpayer should also consider whether the cost is subject to capitalization under Sec. 263A. The taxpayer should review the activities underlying the cost and compare them to the capitalizable costs and activities in the Sec. 263A regulations. If the cost is not required to be capitalized, the taxpayer will not be subject to the Sec. 263A requirement. Take, for example, a taxpayer requesting to change its timing of incurring employee bonuses for selling and marketing employees. Under Regs. Sec. 1.263A-1(e)(3)(iii), selling and marketing activities are listed as indirect costs not required to be capitalized. Because the taxpayer is not required to capitalize its selling and marketing employee bonuses, the Sec. 263A requirement would not be applicable to its method change.
If a taxpayer concludes that it is requesting to change a Sec. 263A cost, it must then determine whether it is currently capitalizing the cost to its Sec. 263A property. This raises the issue of what is meant by the phrase “capitalizing the cost” in the automatic procedures. Must the taxpayer be 100% in compliance with Sec. 263A with regard to the cost? Will the taxpayer meet the requirement if its Sec. 263A calculation includes only a portion of the cost? Is the taxpayer capitalizing the cost if the related book-tax difference is omitted from the Sec. 263A calculation but the underlying unadjusted book cost is capitalized?
So far, no additional guidance has been provided as to how this requirement should be interpreted or applied. There is no language within Rev. Proc. 2011-14 explicitly stating that the taxpayer must be capitalizing the cost to the extent required under Sec. 263A. As a result, Rev. Proc. 2011-14 appears to require capitalization of at least a portion of the cost in order to meet the Sec. 263A requirement. Since Sec. 263A calculations are prepared on a tax basis, a taxpayer may also need to be capitalizing a portion of the related book-tax difference in order to meet the Sec. 263A requirement.
Determining whether a taxpayer is capitalizing a particular cost under Sec. 263A requires a review of the taxpayer’s methods of allocating costs to the relevant property. A taxpayer’s Sec. 263A calculation is typically prepared as an add-on calculation to the costs already capitalized to the property for financial reporting purposes. In order to identify the costs and activities allocated to the property, a taxpayer should review the costs allocated for financial reporting purposes, in addition to the costs and book-tax differences included in the separate Sec. 263A calculation.
If a cost is not currently capitalized under Sec. 263A, the automatic procedures require the taxpayer to request a method change to begin capitalizing the cost in order to be eligible for automatic consent. Rev. Proc. 2011-14 states that the Sec. 263A method change to capitalize the cost should be requested under the relevant Sec. 263A appendix sections of the automatic procedures. Rev. Proc. 2011-14 also indicates that the change under Sec. 263A should be requested on the same Form 3115 as the original automatic change. Thus, if the taxpayer is not capitalizing the cost when the Form 3115 is filed, Rev. Proc. 2011-14 requires the Sec. 263A method change to also be requested under the automatic procedures in order for the taxpayer to comply with the Sec. 263A requirement.
This creates additional complexity for the taxpayer because only certain Sec. 263A method changes are eligible for automatic consent. The requirements for requesting an automatic Sec. 263A method change are contained in Appendix Sections 11.01 and 11.02 of Rev. Proc. 2011-14 but are often difficult for the taxpayer to meet. The taxpayer may be required to make additional changes to its Sec. 263A methods, beyond just capitalizing the cost in question, in order to qualify for automatic consent. A taxpayer may request to begin capitalizing a cost under the automatic procedures only if the taxpayer’s Sec. 263A allocation methods are specifically described in the regulations (Rev. Proc. 2011-14 defines which allocation methods are considered to be “specifically described in the regulations”). If the taxpayer is not using specifically described allocation methods, it must change its allocation methods to qualify for an automatic Sec. 263A method change.
A taxpayer that is not using specifically described allocation methods may still be using a reasonable allocation method under Sec. 263A. What happens to a taxpayer in this scenario that needs to begin capitalizing a cost to remain eligible for the automatic procedures? Is the taxpayer required to request a change from one permissible method to a different permissible method to fit its Sec. 263A change into the automatic procedures? In this situation, the taxpayer may prefer to request its Sec. 263A method change under the advance consent procedures in order to retain its current allocation methods. The Sec. 263A requirement applies at the time the taxpayer requests the automatic method change. If the taxpayer requests an advance consent Sec. 263A method change for the same tax year (prior to filing the automatic change), the taxpayer will be treated as capitalizing the cost under Sec. 263A and will be in compliance with the Sec. 263A requirement when the automatic change is filed. This approach may require advance planning by the taxpayer because advance consent changes must be filed during the tax year of change, while automatic changes can, and often are, filed up until the filing date of the federal income tax return.
A taxpayer that must begin capitalizing a cost due to the Sec. 263A requirement should closely review its Sec. 263A methods and determine whether any additional changes are necessary to file an automatic Sec. 263A method change. A taxpayer that does not qualify for an automatic Sec. 263A method change should consider correcting its Sec. 263A treatment of the cost during the tax year under the advance consent procedures. Doing so should make certain that the taxpayer meets the Sec. 263A requirement when it files the automatic change at a later date.
Sec. 481(a) Adjustments
In recent years, the automatic procedures were updated to emphasize another area where taxpayers must also consider Sec. 263A. Section 2.05 of Rev. Proc. 2011-14 states that when computing a Sec. 481(a) adjustment, “a taxpayer must take into account all relevant accounts.” To illustrate this requirement, the revenue procedure includes an example of a taxpayer requesting to change its timing of incurring salary bonuses under Sec. 461. Section 2.05(1) states that “the § 481(a) adjustment for a change in the proper time for deducting salary bonuses under § 461 reflects any necessary adjustments for amounts of salary bonuses capitalized to inventory under § 263A.” Unlike the first Sec. 263A requirement discussed above, which applies only to certain automatic method changes, the requirement to reflect all relevant accounts within a Sec. 481(a) adjustment applies to all automatic method changes.
There is no additional guidance regarding the procedures a taxpayer should follow to reflect all relevant accounts, including Sec. 263A, within its Sec. 481(a) adjustment. The only guidance readily available for adjusting costs allocated to property under Sec. 263A is contained in Regs. Sec. 1.263A-7, which discusses how to compute the Sec. 481(a) adjustment for a Sec. 263A method change. In general, taxpayers compute the adjustment under the facts-and-circumstances revaluation method in Regs. Sec. 1.263A-7(c)(2)(iii). Under this approach, taxpayers revalue the property by adjusting the costs capitalized under Sec. 263A for any prior year that is relevant in determining the total revalued balance of the property.
For taxpayers identifying inventory on a first-in, first-out (FIFO) basis, the taxpayer adjusts its prior-year Sec. 263A calculation to reflect the item changed (e.g., salary bonuses under the new accounting method). For a taxpayer with self-constructed assets or inventory identified on a last-in, first-out (LIFO) basis, applying Regs. Sec. 1.263A-7(c)(2)(iii) will result in significant additional work for the taxpayer. For self-constructed assets or other non-inventory property, the taxpayer adjusts the prior Sec. 263A calculations for each relevant asset vintage year affected by the method change. For example, a taxpayer that has self-constructed assets with a seven-year useful life would adjust the Sec. 263A calculations for the prior seven tax years in order to revalue the property. For LIFO inventory, the taxpayer adjusts the prior Sec. 263A calculations for each year for which the taxpayer has a historical LIFO layer. Regs. Sec. 1.263A-7(c)(2)(v) does provide a simplified rule that allows LIFO taxpayers to instead use the average change in capitalized Sec. 263A costs for the three most recent tax years to revalue the historical LIFO layers. Unfortunately, no such simplification exists for self-constructed assets or other non-inventory property.
For taxpayers with Sec. 263A property, applying the guidance in Regs. Sec. 1.263A-7 significantly increases the administrative burden of quantifying a Sec. 481(a) adjustment for any automatic method change involving a capitalized cost. The taxpayer may spend considerable time computing an amount that ultimately may be only a small component of the total Sec. 481(a) adjustment. However, Rev. Proc. 2011-14 makes it clear that the Sec. 481(a) adjustment must reflect the corresponding change in costs capitalized under Sec. 263A. A taxpayer requesting a method change for a cost subject to Sec. 263A should quantify and include in its Sec. 481(a) adjustment the change in costs capitalized under Sec. 263A.
Conclusion
In recent years, the IRS has expanded the requirements for receiving automatic consent for a method change. As noted above, Rev. Proc. 2011-14 grants automatic consent only to the extent the taxpayer complies with all the applicable provisions. Failure to meet these expanded requirements will cause a taxpayer to be ineligible to use the automatic method change procedures and may cause its method change to be ruled invalid during an examination, resulting in additional taxes, interest, and penalties. When requesting an automatic change, a taxpayer must review all the requirements in Rev. Proc. 2011-14 and confirm that it has complied with each relevant provision. Exhibit 2 summarizes issues to consider when requesting automatic method changes.
EditorNotes
Jon Almeras is a tax manager with Deloitte Tax LLP in Washington, DC.
For additional information about these items, contact Mr. Almeras at (202) 758-1437 or jalmeras@deloitte.com.
Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.
