Income and Related Deductions for an Item Considered for an Accounting Method Change

Editor: Greg A. Fairbanks, J.D., LL.M.

Tax Accounting

A growing number of guidance items and recently issued Chief Counsel Advice (CCA) 201442050 suggest the IRS is continuing to move toward viewing gross income and related deductions jointly as one item in determining whether an accounting practice constitutes a method of accounting or an error.

Although the statutes and regulations do not define “method of accounting,” Regs. Sec. 1.446-1(e)(2)(ii)(a) provides that a change in 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 items used in such an overall plan. A material item is any item that involves the proper time for its inclusion in income or for claiming a deduction. In determining whether an accounting practice constitutes a method of accounting or an error, the IRS generally inquires whether the accounting practice permanently affects the taxpayer’s lifetime income or changes the tax year in which the taxable item is reported.

The application of this lifetime-income test may produce different results depending on how one defines an “item.” However, there is no further definition of what is an “item.” This has been the cause of much controversy because of the consequences of whether a change in the treatment of an item is a change in method of accounting, which generally requires consent from the IRS.

For example, consider the situation in which a taxpayer has a capital contribution and must determine whether receipt requires the taxpayer to recognize gross income, which creates basis in a depreciable asset, or whether the taxpayer does not have gross income and has no basis in a depreciable asset. If the taxpayer uses a relatively broad definition of an item that includes both recognizing gross income and capitalizing and depreciating basis created by the gross income recognition, this item does not affect lifetime income, as the total gross income is eventually offset by the depreciation of the basis created by the gross income. However, when gross income and depreciable basis of a capital asset are viewed separately, one might get a different answer. If the taxpayer changes the treatment of recognizing gross income to not recognizing gross income, this affects the lifetime income and would not be a method of accounting. Similarly, the decision whether to record basis, when viewed separately from the gross income recognition, would affect the lifetime income and not be a method of accounting.

This was the situation in Saline Sewer Co., T.C. Memo. 1992-236, in which the Tax Court determined that no timing issue existed when a taxpayer failed to report customer connection fees as income and instead treated them as contributions to capital under Sec. 118. In addition to treating the fees as capital contributions under Sec. 118, the taxpayer reduced the basis of the property acquired with the fees by the amount of the contributions pursuant to Sec. 362. After determining that the customer connection fees did not qualify for the exclusion of Sec. 118, the IRS sought to adjust the taxpayer’s taxable income under Sec. 481 as a change in method of accounting to include the fees in income and increase the basis of the improvements constructed with the fees. The Tax Court, however, concluded that the omission of income was clearly not a timing issue but rather was a distortion of the taxpayer’s taxable income that would never be reflected in its lifetime taxable income. The Tax Court also concluded that restoring the depreciable basis was not a timing issue either, because the depreciation expenses were permanently forfeited upon the decrease in the basis of the asset.

In contrast to Saline Sewer, the IRS in Rev. Rul. 2008-30 concluded that a change from treating certain payments received from customers as nontaxable contributions to capital under Sec. 118(c) to treating them as taxable customer connection fees, or a change from treating customer connection fees as taxable customer connection fees to nontaxable contributions to capital under Sec. 118(c) are changes in method of accounting. The ruling declined to acquiesce to the holding in Saline Sewer and stated that the Tax Court in Saline Sewer did not consider the effect of the combined changes in income, basis, and depreciation on the taxpayer’s lifetime taxable income.

The IRS noted in its analysis that “taxable income,” as defined in Sec. 63, means gross income minus allowable deductions. Thus, the ruling concludes that an analysis of lifetime taxable income must consider the effect on both income and deductions. The IRS subsequently added the method changes at issue in Rev. Rul. 2008-30 as an automatic-consent method change in Rev. Proc. 2011-14.

Rev. Proc. 2011-14 lists other automatic-consent method changes that require a broad definition of item by considering the gross income and related deduction aspects together to be one item, including advances made by lawyers on behalf of clients, and tenant construction allowances. The method change related to advances allows lawyers who traditionally deduct expenses incurred in connection with contingent fee arrangements to treat those advances as loans. For this method change to not impact lifetime income, the lawyer must also change from including the reimbursement for the expenses as income to treating those amounts as repayment of a loan and deducting any amounts not reimbursed as bad debt deductions.

The method change related to tenant construction allowances is similar to the method change in Rev. Proc. 2008-30. It allows taxpayers to change from improperly having a depreciable interest in property subject to a tenant construction allowance to not having a depreciable interest in such property, or vice versa. Again, for this method change not to impact lifetime income, the tenant must include the tenant allowance in income to the extent the tenant has a depreciable interest in the property or exclude the tenant allowance if the taxpayer does not have a depreciable interest in the property.

In CCA 201442050, the IRS once again applied a broad “item” definition jointly to the gross income and related deductions attributable to a taxpayer’s oil and gas operations in a foreign country. The CCA’s facts explain that the taxpayer, an energy company with worldwide operations, conducted business in a foreign country through a wholly owned subsidiary, which was a member of the taxpayer’s consolidated group. The taxpayer entered into contracts with a foreign country related to oil and gas production shares. The taxpayer reported the contracts as leases (the lease method) but later changed to the contingent purchase price (CPP) method without requesting the IRS’s consent. For each contract, the taxpayer recognized the same cumulative amount of taxable income over the lifetime of the contract under either the lease method or the CPP method. The taxpayer’s use of the CPP method, however, resulted in additional amounts of foreign-source gross income and additional amounts of interest expense and basis with cost recovery, which had the effect of reducing the taxpayer’s U.S.-source taxable income and increasing its foreign-source taxable income by equal amounts. This favorably affected the taxpayer’s foreign tax credit computation, resulting in claims by the taxpayer for refunds of U.S. taxes.

The IRS observed that at first glance, the change in the reporting of the contracts from the lease method to the CPP method appeared to involve a permanent difference, because under the CPP method, the taxpayer recognized more gross income and more deductions than under the lease method. The IRS, however, noted that there is no increase in the lifetime taxable income under the contracts under the CPP method as compared with the lease method, when the items of income and deductions are considered together.

The CCA contains a lengthy discussion of case law and whether gross income and related deductions should be viewed broadly as one item for purposes of the lifetime-income test. The IRS concluded that where an item implicates both gross income and deductions, both of these should be considered jointly when applying the lifetime-income test. Accordingly, the IRS concluded that the taxpayer’s contract constituted a material item, and the change in its treatment presumptively constituted a change in method of accounting unless it fell within one of the recognized exceptions. After rejecting the taxpayer’s assertions that it was merely changing the characterization of its contracts or, alternatively, correcting an erroneous deviation from its established CPP method, the IRS concluded that the taxpayer had made an unauthorized change in method of accounting.

This CCA illustrates a recent development in the IRS’s trend of viewing gross income and related deductions under a contract broadly as one item for purposes of determining whether a taxpayer has changed its method of accounting. The characterization as an accounting method change or an error may have substantial implications for a taxpayer. The characterization as a method of accounting generally requires the IRS’s consent to change to a different treatment. Additionally, unlike the treatment of an error, which can be corrected on an amended return, the treatment as a method of accounting requires computing Sec. 481(a) adjustments, potentially by going back into closed years, and thus may create larger exposure for the taxpayer. On the other hand, a taxpayer that voluntarily changes its method of accounting may receive audit protection and spread an unfavorable Sec. 481(a) adjustment over four years.

EditorNotes

Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.