Income and related deductions for an item considered for an accounting method change.

• Author: Watkins, Tracy

A growing number of guidance items and recently issued Chief Counsel Advice (CCA) 201442050 suggest the IRS is continuing to move toward viewing gross income and related deductions jointly as one item in determining whether an accounting practice constitutes a method of accounting or an error.

Although the statutes and regulations do not define "method of accounting," Regs. Sec. 1.446-1(e)(2)(ii)(a) provides that a change in method of accounting includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material items used in such an overall plan. A material item is any item that involves the proper time for its inclusion in income or for claiming a deduction.

In determining whether an accounting practice constitutes a method of accounting or an error, the IRS generally inquires whether the accounting practice permanently affects the taxpayer's lifetime income or changes the tax year in which the taxable item is reported.

The application of this lifetime-income test may produce different results depending on how one defines an "item." However, there is no further definition of what is an "item." This has been the cause of much controversy because of the consequences of whether a change in the treatment of an item is a change in method of accounting, which generally requires consent from the IRS.

For example, consider the situation in which a taxpayer has a capital contribution and must determine whether receipt requires the taxpayer to recognize gross income, which creates basis in a depreciable asset, or whether the taxpayer does not have gross income and has no basis in a depreciable asset. If the taxpayer uses a relatively broad definition of an item that includes both recognizing gross income and capitalizing and depreciating basis created by the gross income recognition, this item does not affect lifetime income, as the total gross income is eventually offset by the depreciation of the basis created by the gross income. However, when gross income and depreciable basis of a capital asset are viewed separately, one might get a different answer. If the taxpayer changes the treatment of recognizing gross income to not recognizing gross income, this affects the lifetime income and would not be a method of accounting. Similarly, the decision whether to record basis, when viewed separately from the gross income recognition, would affect the lifetime income and not be a method of...