IRS offers another mark-to-market valuation safe harbor.

• Author: Thornton, David A.

On April 6, 2011, the Large Business and International (LB&I) Division of the IRS released Industry Issue Directive LB&.I-4-1110-033 instructing its examining agents to offer a safe-harbor election to certain taxpayers under examination regarding the market values used in their Sec. 475 calculations. This directive allows taxpayers who issue public financial statements to rely upon the fair market values (FMVs) of applicable securities as determined for financial reporting purposes in the mark-to-market calculations required under Sec. 475.

To qualify for the safe harbor, taxpayers must sign a certification statement with representations regarding the use of the financial statement values and provide it to the examining agent within 30 days of the agent's request. Failure to elect or to qualify for the safe harbor simply reverts the taxpayer back to standard IRS audit procedures, which may enable a challenge of the values used in the Sec. 475 calculations (even if the financial statement values are used). While the directive is welcome news to taxpayers, the language of the certification statement will require some modification, as the current version would disqualify many taxpayers from making the safe-harbor election on examination.

Background

Sec. 475 requires the use of mark-to-market accounting for certain securities held by a taxpayer that meets the definition of a dealer in securities. Under the mark-to-market accounting method, inventoried securities are carried at fair market value, with fluctuations in value reported as a component of current taxable income. Unrealized gains and losses on noninventoried securities subject to the mark-to-market rules are recognized in current taxable income as if the securities were sold for their FMV on the last day of the tax year. Sec. 475 docs not provide a definition of fair market value, nor does it provide any substantive guidance regarding how such value is to be determined. Consequently, the valuation of securities subject to Sec. 475 has been an area of potential disagreement between taxpayers and the IRS, particularly for complex financial instruments for which reliable market quotations are not available.

Taxpayers are required to value for purposes of preparing audited financial statements many of the securities requiring valuation under Sec. 475. While there is no statutory requirement that the IRS accept the values reported for financial reporting purposes, many taxpayers rely upon these values for purposes of compliance with Sec. 475 in order to avoid duplicative valuation efforts and associated costs. The IRS has not always agreed with the valuation methodologies employed by taxpayers for financial reporting purposes and has challenged the use of the financial statement values in the Sec. 475 calculations. However, in recent years the IRS has been trending toward allowing the use of financial statement values under limited circumstances.

Safe Harbor Under Regs. Sec. 1.475(a)-4

In an effort to reduce the level of disagreement...