IRS guidance on the nonaccrual experience method of accounting.

• Author: Madden, David

In Notice 2003-12, the IRS provided interim guidance to taxpayers seeking to change to, or from, the nonaccrual experience (NAE) method of accounting under Sec. 448(d)(5). The NAE method permits certain service providers to exclude amounts from gross income that, based on experience, they do not expect to collect (based on a formula that takes into account the history of uncollected receivables relative to total receivables). The Service released Notice 2003-12 pending the issuance of final regulations. Taxpayers can rely on the notice until the Service issues final regulations, which will probably include the rules in the notice. Notice 200312 is effective for tax years ending after March 9, 2002.

Background

Sec. 448(d)(5) provides that, in the case of any taxpayer using an accrual method for amounts received from performing services, it does not have to accrue any portion of such amounts, which, on the basis of its experience, it does not expect to collect (NAE method). Temporary regulations under Sec. 448 were promulgated in June 1987 and included various alternative methods for computing experience. These regulations (the original temporary regulations) were withdrawn and supplanted in April 1988 by temporary regulations (amended temporary regulations) currently in effect.

Six-year moving average. Temp. Regs. Sec. 1.448-2T(e)(2) replaced the methods permitted under the original temporary regulations in determining which amounts a taxpayer is not required to accrue under Sec. 448(d)(5), with a six-year moving-average formula method. Under this method, a taxpayer computes its uncollectible amount by multiplying its yearend accounts receivable balance by the ratio of the total bad debts of accounts receivable sustained during the current year and five preceding tax years (adjusted for recoveries of bad debts during the same period) to the sum of the accounts receivable earned (i.e., the total sales resulting in accounts receivable) during the same six-year period.

Black Motor formula. It soon became apparent, however, that the six-year moving-average formula often understated many taxpayers' actual bad-debt experience. This problem was illustrated in Hospital Corp. of America (HCA), 107 TC 116 (1996), in which the taxpayer used a method known as the "Black Motor" formula (after Black Motor Co., 125 F2d 977 (6th Cir. 1942)), to compute its bad-debt experience for its 1987 and 1988 tax years.

Under this formula, a taxpayer computes its...