Tax accounting method changes: Procedures and potential issues during an IRS exam

Editor: Jeffrey N. Bilsky, CPA

Since the passage of the Inflation Reduction Act of 2022, P.L. 117–169, the IRS expanded its enforcement activity, including increased exams of complex business entities such as large partnerships and corporations.

During a complex business entity exam, accounting methods may be an area of focus — as they are the foundation upon which a business taxpayer calculates taxable income. This item provides a high–level discussion of the potential issues and procedures related to an accounting method change during an exam, either when filed by a taxpayer or when imposed as an involuntary change.

Accounting methods overview

A threshold matter for determining the proper procedure during an exam is whether a potentially identified issue is an accounting method (a timing issue, as discussed below) or is more properly classified as an error (a one–time mistake or item having a permanent taxable income impact). Generally, an error in a prior year can be corrected pursuant to general exam procedures or an amended return. However, an accounting method change is subject to specific procedures, as these changes are typically prospective and require IRS consent.

An accounting method is not specifically defined in the Code or regulations. Sec. 446(a) provides that taxable income shall be computed under a method of accounting generally selected by the taxpayer that would include not only the overall accounting method but also the treatment of any item. Rev. Proc. 2015–13 notes that if an item does not permanently change overall income or expense but does or could change the specific tax year(s) in which the item is taken into account, then it involves timing and may be an accounting method. In addition, accounting methods generally involve consistent treatment across several years.

The regulations under Sec. 446 provide that certain categories of items are not accounting method changes. For instance, a method change does not include “correction of mathematical or posting errors, or errors in the computation of tax liability,” or adjustments that do not involve the proper time for inclusion or deduction. A method change also does not include a situation where there is a change in the underlying facts leading to a change in treatment (Regs. Secs. 1.446–1(e)(2)(ii)(a) and (b)).

A taxpayer is required to obtain the IRS’s consent to make a change in its established accounting method. An annual revenue procedure, currently Rev. Proc. 2024–23, provides a list of specific changes that qualify to use the automatic method change procedures (under which the IRS gives deemed consent to the change). With some exceptions, a method change not specified in the annual revenue procedure must be made under the nonautomatic method change procedures, which require the IRS to review and give explicit consent for a taxpayer to make the method change.

Most accounting method changes are made with a Sec. 481(a) adjustment, which represents the cumulative taxable income difference between the present (existing) method and the proposed (new) method. When a taxpayer makes a voluntary accounting method change, it generally recognizes the taxable income impact of any negative Sec. 481(a) adjustment as a reduction of taxable income entirely in the year of change and any positive Sec. 481(a) adjustment as an increase to taxable income ratably over the four tax years beginning with the year of change, absent any election or procedural requirements that may alter this four–year spread. The Sec. 481(a) adjustment spread, along with the potential for audit protection (discussed below), are incentives for taxpayers to make voluntary accounting method changes before they are under exam.

Determining whether a taxpayer is under exam

In addition to determining whether an issue involves an accounting method, taxpayers looking to make an accounting method change should be aware of the timing and scope of any ongoing IRS exam. Rev. Proc. 2015–13, as modified and clarified by other revenue procedures, outlines procedural requirements for both automatic and nonautomatic accounting method changes, including guidelines for determining when a taxpayer is deemed to be under exam and when an item is under consideration.

Rev. Proc. 2015–13 has been clarified by Rev. Proc. 2015–33 and modified by Rev. Proc. 2016–1 (and its successors), Rev. Proc. 2017–59, Rev. Proc. 2021–26, and Rev. Proc. 2021–34. A discussion of these changes is outside the scope of this item. According to Rev. Proc. 2015–13, a taxpayer is generally considered “under examination” as of the date the taxpayer is contacted in any manner by a representative of the IRS for the purpose of scheduling or conducting any type of exam of the return. A member or former member of a consolidated group is under exam if it is or was a member of the consolidated group during the tax year(s) under exam. A controlled foreign corporation not required to file a federal income tax return is considered under exam if any of its controlling domestic shareholders are under exam for a year in which they were a U.S. shareholder.

Rev. Proc. 2015–13 also provides specific rules for when an exam is deemed to be closed for these purposes, depending on the outcome of the exam (e.g., whether it is a no–change, agreed, or unagreed case) and whether the taxpayer is pursuing additional action including IRS Office of Appeals (Appeals) or Tax Court consideration. A taxpayer seeking to utilize these provisions should confirm that it has received the appropriate notification.

Finally, taxpayers should be aware of whether the accounting method for an item is an “issue under consideration”for the tax years under exam. Rev. Proc. 2015–13 defines a taxpayer’s method of accounting for an item as an issue under consideration if the examining agent provides the taxpayer with written notification (e.g., an information document request) specifically citing the treatment of the item as such. Although Rev. Proc. 2015–13 provides examples of when an item may be an issue under consideration, this determination can be nuanced and dependent on the wording used in the written notification.

Voluntary (taxpayer-initiated) accounting method changes

A taxpayer may voluntarily file an automatic or a nonautomatic accounting method change while it is under exam, although the ability to obtain audit protection for the item being changed may be limited. Therefore, a taxpayer should evaluate the best time for filing an accounting method change when it is under exam.

A taxpayer generally receives audit protection when it files an accounting method change, which means that the IRS will not require the taxpayer to change its method of accounting for the same item for a tax year prior to the requested year of change. This is particularly important if a taxpayer is changing from an impermissible method of accounting, as audit protection can help mitigate exposure to interest and penalties. Note that for certain automatic accounting method changes, the IRS does not grant audit protection, regardless of whether the taxpayer is under exam at the time it files the method change. 

A taxpayer that is under exam will not receive audit protection unless it is able to qualify under an exception. These exceptions, outlined below (Rev. Proc. 2015–13, §8.02), require that a taxpayer file within a certain time frame or that the method change meet certain characteristics:

• The method change is filed within a three-month window. The three-month window occurs around the extended due date of the taxpayer’s return (from the 15th day of the seventh month of the taxpayer’s tax year to the 15th day of the 10th month of its tax year). To use this exception, the taxpayer must have been under exam for at least 12 consecutive months as of the first day of the window, and the method of accounting for the item being changed must not be an issue under consideration.
• The method change is filed within a 120-day window. This window runs for 120 days following the date an exam of the taxpayer ends, regardless of whether a subsequent exam has commenced. The method of accounting for the item being changed must not be an issue under consideration. This window is particularly useful for taxpayers that are frequently or continually under exam.
• The present method is not before the director. This exception applies if the taxpayer is making a change from a clearly permissible method of accounting, or a change from an impermissible method of accounting that was adopted subsequent to the tax year(s) under exam. The term “director” refers to those identified in Rev. Proc. 2014-1, Section 1.01(3) (or its successor).
• The method change is filed by a new member of a consolidated group that participates in the IRS Compliance Assurance Process (CAP). This exception allows a corporation that has joined a consolidated group that participates in CAP the ability to file an accounting method change in the tax year the corporation joins the group, if the corporation is not otherwise under exam and the item is not an issue under consideration.
• The method change results in a negative Sec. 481(a) adjustment. This exception allows a taxpayer to make a method change for an item that results in a negative Sec. 481(a) adjustment for the year of change and would have resulted in a negative Sec. 481(a) adjustment in each tax year under exam if the change for the item had been made in those tax year(s). This exception permits a taxpayer to change an item an examining agent likely would not examine.

A taxpayer that files an accounting method change while under exam and does not meet any of these exceptions will not receive audit protection when filing the method change. However, the taxpayer may elect, by checking the appropriate box (“Audit protection at end of exam”) on line 7b of the Form 3115, Application for Change in Accounting Method, the “no examination–imposed change and item not under consideration” exception, which provides the taxpayer will receive audit protection on the date after the taxpayer’s exam ends. The audit protection granted under this exception applies to open tax years between the year examined and the year prior to the accounting method change, as long as the examining agent does not propose an adjustment for the same item and the item is not an issue under consideration. For example, assume a calendar–year taxpayer utilizing this exemption files an accounting method change for its 2025 year while under exam for its 2022 year. When the exam ends (if the agent has not proposed an adjustment and the issue is not an issue under consideration), the taxpayer in this example would receive audit protection for years 2023 and 2024 for the item for which the method change was filed. 

If a taxpayer’s exam ends and the examining agent imposes an accounting method change, a taxpayer familiar with the accounting method change rules may be concerned that it cannot change from that method for five years. Under Rev. Proc. 2015–13, for most automatic accounting method changes, a taxpayer is not eligible to make a change for an overall method of accounting, or for the same item, if the taxpayer has changed or applied for consent to change its overall method or the item in the five tax years ending with the year of change. Fortunately, if a method change is imposed by the IRS in an exam, this eligibility rule is waived.

Exam-imposed accounting method changes

When a taxpayer is under exam, and if an examining agent determines either the taxpayer is using an impermissible accounting method or the taxpayer changed its method of accounting in a prior year without obtaining consent (an “unauthorized change”), the agent is permitted to impose a change in accounting method. If the taxpayer is on a permissible method, the IRS is generally not allowed to impose another permissible method in an exam.

Rev. Proc. 2002–18 generally governs the procedures for examining agents making exam–imposed accounting method changes. It also provides options for an Appeals officer and counsel for the government to resolve an accounting method issue in Appeals or before a federal court (these rules are beyond the scope of this item). Rev. Proc. 2002–18 grants an examining agent authority to resolve accounting method issues by placing the taxpayer on a new method that complies with the relevant federal income tax law, or, in cases where the taxpayer has made an unauthorized change, putting the taxpayer back on the method of accounting used prior to such a change. Taxpayers should note that, in cases where multiple permissible methods exist, the examining agent may choose to impose the least taxpayer–favorable method. Although Rev. Proc. 2002–18 provides some discretion as to the year of change, an exam–imposed accounting method change will generally be made in the earliest tax year under exam.

In addition to Rev. Proc. 2002–18, Section 4.11.6 of the Internal Revenue Manual (IRM) outlines the steps examining agents should take when evaluating accounting methods during an exam. The IRM is not binding but does provide information regarding IRS procedures. According to the IRM, taxpayers should expect to receive written notice from the examining agent that confirms an accounting method change is being made and describes the new method of accounting (IRM §4.11.6.7.7). This written notice may or may not take the form of a closing agreement. When a closing agreement is executed, the new method generally becomes final as of the date of the agreement. Otherwise, the new method generally becomes final when the period for filing a refund claim for the year of change closes under Sec. 6511 or on the date of a final court order requiring the change.

An exam–imposed accounting method change may be made either with a Sec. 481(a) adjustment or on a cutoff basis. If the change is made with a Sec. 481(a) adjustment, the full amount of such adjustment is recognized into taxable income in the year of change, regardless of whether the adjustment is positive or negative. The examining agent may choose to use a cutoff approach if such approach is prescribed by statute, regulations, or other authorities or if the taxpayer’s records are insufficient to compute an accurate Sec. 481(a) adjustment (Rev. Proc. 2002–18, §5.04(2), and IRM §4.11.6.7.6(5)).

Taxpayers should be aware of how adjustments to taxable income imposed under exam may affect the year under exam as well as other open tax years. In contrast to some adjustments made for non—accounting method items, adjustments made under exam for accounting method items may have ramifications for tax years beyond the year under exam. If tax returns have been filed for years succeeding the year under exam, the taxpayer may be required to amend those returns to reflect the new method. Additionally, the taxpayer will be required to reflect the new method on any future tax returns unless the taxpayer obtains permission to change to a different method. 

Benefits to awareness of the rules

Understanding the accounting method change rules applicable when a taxpayer is under exam, as compared to not under exam, can be beneficial for taxpayers when making decisions regarding their tax accounting methods. Practitioners and taxpayers should be aware of whether a taxpayer’s accounting methods are appropriate and the potential impact if an accounting method issue is raised during an exam.

Editor Notes

Jeffrey N. Bilsky, CPA, is managing principal, National Tax Office, with BDO USA LLP in Atlanta.

For additional information about these items, contact Bilsky at jbilsky@bdo.com.

Contributors are members of or associated with BDO USA LLP.