Tax Court Rejects Taxpayer’s Argument That Denial of Accounting Method Change Was Arbitrary

The Tax Court held that the IRS’ rejection of a taxpayer’s accounting method change request was not the result of an “automatic rejection policy” and that the IRS acted within its proper discretion in denying the request (Lattice Semiconductor Corp., T.C. Memo. 2011-100).

The taxpayer produced electronic components and related software. It regularly incurred expenses from various prepaid contracts; these expenses were prepaid expenses under Sec. 263. The benefits from the contracts typically did not exceed 12 months, although the contracts themselves sometimes spanned two years. Before 2002, the taxpayer capitalized its prepaid expenses for contracts that extended substantially into a following year.

In December 2002, the Treasury Department issued proposed regulations, under which it would no longer require capitalization of 12-month prepaid expenses under Sec. 263. The proposed regulations would allow deduction of expenditures during a year, as long as the resultant benefit did not extend beyond the year. The preamble to the proposed regulations advised taxpayers not to seek an accounting method change in reliance on the proposed regulations until the regulations were finalized.

Nine days later, the taxpayer applied for an accounting method change to deduct 12-month expenses spanning two tax years, and (before receiving approval for the method change) it claimed a deduction for the relevant expenses on its 2002 return.

In January 2004, the Treasury Department finalized the proposed regulations (T.D. 9107), allowing taxpayers to deduct 12-month prepaid expenses paid or incurred after December 31, 2003. The IRS subsequently issued Revenue Procedure 2004-23, providing procedures for taxpayers to obtain automatic consent to change their accounting method to comply with the final regulations. The revenue procedure specified that automatic consent would be denied for years earlier than the regulations’ effective date.

The IRS initially denied the taxpayer’s accounting method change request in May 2004 and issued a letter formally denying the request in June 2005. The IRS also disallowed the taxpayer’s deduction and issued a deficiency notice.

The case ended up in Tax Court, where the taxpayer argued that the IRS had implemented an automatic rejection policy and had disregarded developing case law in the area. The IRS argued that it had acted within its proper discretion in denying the request to change accounting method and that the taxpayer was ineligible to deduct the relevant expenses before the regulations were finalized.

The taxpayer relied on a Ninth Circuit case, Zaninovich, 616 F.2d 429 (9th Cir. 1980), rev’g 69 T.C. 605 (1978), to argue that Ninth Circuit taxpayers (such as the taxpayer in this case) can deduct expenses under the 12-month rule. The Tax Court rejected this applicability of Zaninovich, since it dealt with a cash-method taxpayer, and in this case the taxpayer used the accrual method. A Seventh Circuit case the taxpayer also cited (U.S. Freightways Corp., 270 F.3d 1137 (7th Cir. 2001), rev’g 113 T.C. 329 (1999)) did apply to accrual-method taxpayers, but the Tax Court refused to follow it because it applies only to taxpayers in the Seventh Circuit. The court found that the IRS acted within its discretion in rejecting the taxpayer’s accounting method change request under then-existing case law as it applied to the taxpayer’s circumstances.

The taxpayer also argued that the IRS had instituted an automatic rejection policy, which was arbitrary and capricious. The taxpayer claimed 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 Revenue Procedure 2004-23, and that this automatic rejection meant that the IRS did not evaluate the taxpayer’s change request under “traditional application procedures and developing case law.”

The Tax Court said it did not need to decide the question of whether the IRS had implemented an automatic change request policy because it had already decided the IRS had acted within its proper discretion in rejecting the taxpayer’s accounting method change request.

Finally, the court held that the IRS was justified under Sec. 7805(a) in enforcing the effective date of the final regulations.

The court held that the IRS did not abuse its discretion in rejecting the taxpayer’s accounting method change request and requiring the taxpayer to use its old method of accounting.