Accounting method changes under Rev. Rul. 90-38.

• Author: Ezrati, Lester D.

Accounting Method Changes under Rev. Rul. 90-38

Tax Executives Institute (TEI) is concerned about the tax policy and administration implications of Rev. Rul. 90-38, 1990-1 C.B. 57. Rev. Rul. 90-38, which was issued by the Internal Revenue Service on April 10, 1990, holds that a taxpayer may not, without the Commissioner's consent, retroactively change from an erroneous to a permissible method of accounting by filing an amended return, even if the period for amending the return for the first year in which the erroneous method was used remains open.

Summary of Position

TEI respectfully submits that the position set forth in Rev. Rul. 90-38 is wrong and that it represents a questionable and unnecessarily harsh interpretation of the tax law. Whether or not legally defensible, Rev. Rul. 90-38 embodies unwise tax policy:

* It creates an imbalance between the rights of taxpayers and the IRS in circumstances where equal treatment is more appropriate.

* It undermines the IRS's objectives of encouraging good accounting practices and ensuring clear reflection of income.

* It is fundamentally inconsistent with basic rights granted taxpayers by Congress in establishing the statue of limitations for filing amended returns (and refund claims).

For the foregoing reasons, TEI believes that the ruling be withdrawn and replaced by a more flexible and balanced approach. Specifically, the IRS should adopt the following two-pronged test for automatically granting requests for a retroactive change in a method of accounting:

* The request must be for a change from a clearly erroneous to a permissible method; and

* The first use of the erroneous method must be in a year for which the statute of limitations on assessment remains open, and the permissible method must be consistently applied in that and all subsequent years.

The balance of this letter discusses the background of Rev. Rul. 90-38, details TEI's reasons for believing it represents a questionable interpretation of the tax law and bad tax policy, and explains why the adoption of the Institute's recommendations will vindicate the legitimate interests of both taxpayers and the government.

Background

Rev. Rul. 90-38, 1990-1 C.B. 57, reconsiders the factual situation in Rev. Rul. 70-539, 1970-2 C.B. 70. In Rev. Rul. 70-539, a corporation that was engaged in developing real estate capitalized interest, taxes, and carrying charges in the tax basis of its property in the first three tax returns it filed. In the fourth year, the taxpayer determined that this method of accounting was erroneous because the election statement required by the regulations under section 266 had not been filed. Since the year in which the erroneous capitalization method was first used remained open, the taxpayer filed a claim for that year to adopt as its accounting method the expensing of interest, taxes, and carrying charges. Expensing was deemed a permissible method in the absence of a valid election to capitalize. The IRS held in Rev. Rul. 70-539 that the claim, made on a timely filed amended return for the first year of use, was allowable.

In Rev. Rul. 75-56, 1975-1 C.B. 98, the IRS clarified that a change from an erroneous to a permissible method of accounting is not allowable where the year of first use of the erroneous method is closed. Thus, in that ruling, the taxpayer's erroneous method of accounting was deemed to have been previously adopted because the statute of limitations for the year of first use had expired. Prior adoption of the erroneous method triggered the requirement in section 446(e) of the Code and Treas. Reg. [section] 1.446-(e) that the Commissioner's consent to a change be obtained. Because the taxpayer had not timely sought the Commissioner's consent, its claimed deduction based on the permissible method of accounting was denied. Rev. Rul. 75-56 distinguished Rev. Rul. 70-539 by noting that the taxpayer in the earlier ruling, by timely amending its first return, was effectively adopting (not changing) its method of accounting.

In Rev. Rul. 90-38, the IRS revoked Rev. Rul. 70-539. It also modified Rev. Rul. 75-56 to eliminate any inference that the statute of limitations for the year of first use must have expired for the taxpayer to have adopted a method of accounting and, consequently, revoked the modified 1975 ruling as obsolete. Specifically, Rev. Rul. 90-38 holds that the filing of returns for two...