"Drop-down" technique allows change in accounting method without IRS approval.

• Author: Janiga, John M.

An existing corporation desiring to change its accounting method but unable to secure IRS approval may nevertheless be able to accomplish its goal through the use of the "drop-down" technique. This method allows the corporation to place assets in one or more new corporations that are free to select the desired accounting method. However, use of the technique is fraught with peril for the uninitiated. This article explains various ways the technique can be used and attendant considerations and planning.

In certain situations, a corporation may benefit from a change in accounting method; for example, if an accrual-basis C corporation provides services on account, with payment received weeks or months after billing, a change to the cash basis would allow it to defer income recognition until receipt of payment.(1)

The Code and regulations usually do not permit such a change unless the corporation(2) secures prior IRS approval. In situations in which an accounting method change would be highly beneficial to the corporation, approval is not likely to be granted unless the corporation's present accounting method is incorrect.(3)

One method for changing corporate accounting method without securing IRS approval is the "drop-down" technique, which involves an existing corporation transferring some or all of its assets to a newly formed corporation, which thereafter operates the transferred business (or applicable portion thereof).(4) As a separate entity, the new corporation is free to select the desired accounting method.

Although relatively simple in concept, several issues must be addressed to successfully effect a drop-down. This article provides an overview of permissible corporate accounting methods; briefly discusses what constitutes a change in accounting method, the requirements for such a change and the IRS's power to deny approval; illustrates how a corporation might benefit from an accounting method change and analyzes the options; examines issues pertinent to the drop-down; and provides planning strategies.

Permissible Corporate Accounting Methods

Generally, under Sec. 446(a), taxable income must be computed under the method of accounting regularly employed in keeping the taxpayer's books. If no such method has been regularly employed, or if the method employed does not clearly reflect income, then, under Sec. 446(b), the taxpayer must use a method which, in the IRS's opinion, clearly reflects income. Subject to these requirements, a taxpayer can use the cash method, the accrual method, other methods permitted by the Code, or a combination of the foregoing (a "hybrid method") as permitted by regulations. These methods are "overall methods of accounting." A taxpayer engaged in more than one trade or business may use a different accounting method for each trade or business, according to Sec. 446(d), provided that, as dictated by Regs. Sec. 1.446-1 (d) (2), a "complete and separable" set of books and records is kept for each trade or business.

Significant administrative or statutory restrictions limit a corporation's ability to use the cash method. First, Regs. Sec. 1.446-1 (a) (4) (i) prohibits the use of the cash method to measure sales and cost of goods sold (COGS) if use of inventories is material to the business; thus, a merchandising corporation must use the accrual method for reporting sales and COGS. Second, regardless of whether inventories are material, Sec. 448 (a) and (b) require a corporation to use the accrual method in computing taxable' income, unless it is (1) a farming business, (2) a qualified personal service corporation or (3) a corporation with average annual gross receipts for the most recent three-year period of $5 million or less.

Changes in Accounting Method

What Constitutes a Change?

Regs. Sec. 1.446-1 (e) (2) (ii) (a) defines a change in an accounting method(5) as including a change in a taxpayer's overall accounting method (e.g., a change from the accrual method to the cash method).

A change in accounting method also includes a change in the accounting treatment of any "material item" in an overall accounting method.(6) For example, a corporation computes income and expenses for tax purposes on the accrual basis, but reports real estate taxes on the cash basis. A change to report real estate taxes on the accrual basis would be a change in accounting method.(7)

Changing Accounting Method

The current administrative procedures governing accounting method changes are primarily contained in Rev. Proc. 92-20.(8) According to the procedure, a corporation not under examination(9) normally requests IRS permission by filing Form 3115, Application for Change in Accounting Method,(10) within the first 180 days of the tax year of the desired change.(11)

IRS Power to Deny Request

Even if a corporation timely files a proper Form 3115, IRS approval is not automatic. A change request may be denied, for example, if die corporation cannot establish to the IRS's satisfaction that the new accounting method clearly reflects income.(12) Further, even if the IRS approves the request, the corporation may be subject to a Sec. 481 adjustment, which prevents the duplication or omission of items of gross income or deduction that would otherwise result from an accounting method change.

The adjustment is computed, under Regs. Sec. 1.4811 (c) (1), by considering all affected income and deduction items as of the beginning of the year of the accounting method change. If the net effect of all of the adjustments is positive, the adjustment will increase income (a "positive" Sec. 481 adjustment); if the net effect of all of the adjustments is negative, the adjustment will reduce income (a negative" Sec. 481 adjustment).(13)

Generally, the adjustment must be taken into account entirely in the year of the accounting method change.(14) In certain cases, the adjustment can be spread over time if the change was voluntarily initiated by the taxpayer.(15)

Case Study

The Facts

Kent Corporation ("Kent"), incorporated in january 1990, is owned equally by sisters Ann (A) and Jean (j) Kent. Each holds 50% of the stock, with a fair market value (FMV) of $1 million and an adjusted basis of $750,000. Kent provides consulting services through two distinct divisions, L and M. The L division is geared to clients located in the state of Kent's headquarters; the M division is geared to clients in the four states contiguous to the state of Kent's headquarters. Kent has generated annual consulting contracts totaling $3 million, approximately 60% of which is attributable to the L division. The company renders services on account; on average, it takes three months to collect receivables. Currently, the company has total assets with an FMV of $2 million and an adjusted basis of $1.5 million, 60% of which is attributable to the L division.

The company's initial Federal income tax return was filed for calendar year 1990 on the accrual method; all subsequent returns have used that method, which is also used in its financial statements.

Options for Changing Methods

Kent is in a disadvantageous tax position, at least with regard to its contract income. Under the accrual basis, Kent must report the contract amounts as income in the year in which the services are rendered, even if payment is received in a later year (i.e., Kent is paying tax on its accounts receivable).(16) The cash method would provide a more desirable tax result because the income could be deferred until the cash is collected.

Can a change to the cash method be accomplished? One option is...