Comprehensive list of automatic method changes provides opportunities

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

Rev. Proc. 2019-43, issued in November 2019, includes new taxpayer-favorable guidance for leasing arrangements, tax inventory under Sec. 263A, and revenue recognition, all just in time for the onslaught of changes in method of accounting in these areas for 2019 federal income tax returns. Rev. Proc. 2019-43 supersedes Rev. Proc. 2018-31 as the new comprehensive list of accounting method changes that are eligible for automatic consent under Rev. Proc. 2015-13. This much-anticipated annual update finally allows taxpayers and practitioners to see what new automatic changes and favorable terms and conditions the IRS provides.

Significant modifications for leasing

A taxpayer that wishes to change its characterization of sale, lease, or financing transactions can file a Form 3115, Application for Change in Accounting Method, under the provisions of Section 6.03 of Rev. Proc. 2019-43. For example, a taxpayer that is the lessee or lessor of certain property can file a method change under this section to change its method of accounting from improperly treating the property as sold (or purchased) by the taxpayer to properly treating the property as leased (or financed) by the taxpayer, or vice versa.

Separately, a taxpayer that wishes to change its treatment of tenant construction allowances can file an accounting method change under Section 6.08 of Rev. Proc. 2019-43. Under this section, a taxpayer that is a lessee or lessor can change its method of accounting for tenant construction allowances (other than allowances that qualify under Sec. 110) from improperly treating the taxpayer as having a depreciable interest in the property subject to the tenant construction allowances for federal income tax purposes to properly treating the taxpayer as not having a depreciable interest in such property for federal income tax purposes, or vice versa. This change applies only to amounts that are spent on depreciable property, so tenant allowances spent on moving expenses are not eligible.

Under the old automatic method change procedures described in Rev. Proc. 2018-31, both of these method changes were made by taxpayers on a cutoff basis and without audit protection. As a result, taxpayers applied the proposed method only to new agreements entered into on or after the tax year of change. So taxpayers were not allowed to change their method for existing agreements under the automatic provisions and did not get audit protection, despite disclosing their impermissible method on the Form 3115. A taxpayer had the option of changing its method of accounting under the nonautomatic provisions of Rev. Proc. 2015-13 but only if the taxpayer provided a representation, signed under penalties of perjury, from the counterparty to the agreement that the counterparty’s treatment was consistent with the taxpayer’s proposed method. For example, if a taxpayer changed its treatment of tenant construction allowances to stop treating itself as having a depreciable interest in certain property, then the counterparty had to provide a statement, signed under penalties of perjury, that the counterparty treated itself as having a depreciable interest in the property.

In contrast, the new procedures in Rev. Proc. 2019-43 provide that a change in method of accounting for a transaction entered into before the year of change (i.e., existing agreements) is eligible to be made under the automatic method change procedures of Rev. Proc. 2015-13 with a Sec. 481(a) adjustment and with audit protection. The new procedures only require a statement with the name of the counterparty instead of the representation, signed under penalties of perjury, from the counterparty. As a result, making a method change under the new procedures is likely to be significantly less burdensome for many taxpayers than under the nonautomatic procedures. Finally, although the new procedures allow for audit protection under Section 8 of Rev. Proc. 2015-13 for years prior to the year of change, there is no ruling protection, which means that the IRS can still examine whether the proposed method is the correct permissible method for the transaction.

Broadened audit protection rules for Sec. 263A method changes

In November 2018, the IRS issued final regulations (T.D. 9843) under the uniform capitalization rules of Sec. 263A that will likely cause most taxpayers with inventories that are not small businesses to have to change their methods of accounting to comply with the new rules on their 2019 federal income tax return. The changes are expected to impose a significant additional burden and greater complexity on many businesses, particularly manufacturers that do not capitalize all direct costs for financial statement purposes, taxpayers using the simplified production method, and taxpayers without audited financial statements. The regulations are effective for tax years beginning on or after Nov. 20, 2018.

Rev. Proc. 2019-43 incorporates the new procedures in Rev. Proc. 2018-56 that allow many taxpayers to comply with the new regulations by using the automatic procedures of Rev. Proc. 2015-13 to file a Form 3115. For example, many taxpayers will want to make changes to adopt new definitions and safe harbors, such as the new “alternative method” for defining Sec. 471 costs, the de minimis rules for direct costs, and the safe harbor for over/under variances or burdens. Additionally, many manufacturers will want to change to the modified simplified production method.

Generally, Section 8.01 of Rev. Proc. 2015-13 provides audit protection for prior years for an item when a taxpayer files a Form 3115 to change its method of accounting for that item. However, under Section 8.02 of Rev. Proc. 2015-13, audit protection is generally not provided when a taxpayer makes an accounting method change if the taxpayer is under IRS examination as of the date the taxpayer files the Form 3115 associated with the method change, unless certain exceptions described in Sections 8.02(1)(a) through (f) are met. Additionally, Section 7.03(3)(b) provides that taxpayers under IRS examination must recognize any positive Sec. 481(a) adjustments over two tax years, rather than over four tax years, unless certain exceptions described in Sections 8.02(1)(a) through (d) are met.

The new procedures described in Rev. Proc. 2019-43 temporarily suspend the general rule that a taxpayer under examination does not receive audit protection, if the taxpayer is making a method change to comply with the new final regulations under Sec. 263A. However, the new procedures do not suspend the general rule that requires taxpayers under examination to recognize positive Sec. 481(a) adjustments over two tax years. Therefore, while taxpayers currently under examination that are changing to conform to the final Sec. 263A regulations now benefit by receiving audit protection even if the issue is an item under consideration, taxpayers may not receive the benefit of recognizing a positive Sec. 481(a) adjustment over four tax years.

Automatic method changes for revenue recognition

Rev. Proc. 2019-43 includes several modifications to certain changes in revenue recognition under Section 16.12 of Rev. Proc. 2018-31 (as modified by Rev. Proc. 2018-60) that are favorable for taxpayers without an applicable financial statement. Rev. Proc. 2019-43 adds new automatic accounting method change procedures for taxpayers without applicable financial statements wanting to make a method change under Prop. Regs. Sec. 1.451-8(d)(4)(ii)(B) to defer advance payments based on earned income determined using a straight-line ratable basis over the term of the agreement. This was allowed under Rev. Proc. 2004-34, so Rev. Proc. 2019-43 provides similar rules for taxpayers that want to change to the proposed regulations.

In addition, under Rev. Proc. 2019-43, taxpayers without an applicable financial statement are now permitted to make a deemed change in method of accounting without filing a Form 3115 to comply with Prop. Regs. Sec. 1.451-8(d) when the Sec. 481(a) adjustment required by the method change is zero. Taxpayers are deemed to have made a method change under these streamlined procedures by simply filing their federal income tax return using the proposed accounting methods. While these streamlined method change procedures are administratively less burdensome than filing a Form 3115, taxpayers that use the streamlined method change procedures are not provided audit protection under Section 8.01 of Rev. Proc. 2015-13.

Since the issuance of Rev. Proc. 2018-31, the IRS has released a variety of guidance that provides automatic method change procedures for taxpayers wishing to comply with the new income recognition rules of Sec. 451, as amended by Section 13221 of the law known as the Tax Cuts and Jobs Act, P.L. 115-97. In conjunction with the modifications described above, Rev. Proc. 2019-43 revises the list of automatic accounting method changes to include the new automatic method change procedures initially provided in Rev. Proc. 2018-60 and Rev. Proc. 2019-37. Now that all the modifications to the procedures for revenue recognition are in one comprehensive listing, it is easier for taxpayers to trace whether their proposed changes in method of accounting are eligible under the automatic procedures.

Effective date

Taxpayers filing Forms 3115 on or after Nov. 8, 2019, for a tax year of change ending on or after March 31, 2019, must do so in accordance with the new automatic method change procedures of Rev. Proc. 2019-43. The IRS issued taxpayer-favorable transition rules for taxpayers that filed a nonautomatic accounting method change before Nov. 8, 2019. The transition rules are similar to the rules issued under prior guidance when a new comprehensive listing was released.

EditorNotes

Greg Fairbanks, J.D., LL.M., is a tax managing director 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.

Contributors are members of or associated with Grant Thornton LLP.