Pitfalls and opportunities of automatic accounting method changes.

• Author: Kalis, Frank J., Jr.

An often-misunderstood provision of Section 5.01 of Rev. Proc. 98-60, involves the change from a so-called "hybrid" accounting method to the overall accrual method. A hybrid method may include a method of treating a single item (or a limited number of items) under the cash method, with all other items of income and expense accounted for under the accrual method. Therefore, a taxpayer otherwise using the overall accrual method that fails to accrue a deduction or income until paid or received (i.e., the cash method), could be eligible to automatically change its method of accounting for such item. Importantly, taxpayers changing from a hybrid method to the overall accrual method and not currently using the recurring item exception may automatically change to such method for all expense items as part of such change.

Eligibility

For a taxpayer with inventory, the automatic change from the cash or hybrid method to the accrual method under Section 5.01 of Rev. Proc. 98-60 is limited to small resellers, small resellers with de minimis production activities or resellers eligible to use the simplified resale method under Kegs. Sec. 1.263A-3(d), provided that (1) the taxpayer "adopts" a proper inventory method under Sec. 471 and (2) a taxpayer subject to Sec. 263A and eligible to use the simplified resale method under Regs. Sec. 1.263A-3(d) "adopts" a proper method under that section. Rev. Proc. 98-60 is designed to allow taxpayers not in compliance with Sec. 263A to automatically change to a method that both tends to overcapitalize costs and is easily verifiable by the IRS.

In general, a "small reseller" is defined in Regs. Sec. 1.263A-3(b)(2) as a reseller whose average annual gross receipts for the three tax years immediately preceding the year of change do not exceed $10 million. Production activities are defined in Regs. Sec. 1.263A-3(a)(2)(iii)(A) as de minimis if:

* The gross receipts from the sale of the property produced by the reseller are less than 10% of the trade or business's total gross receipts; and

* The labor costs allocable to the trade or business's production activities are less than 10% of the reseller's total labor costs allocable to its trade or business.

The use of the term "adopt" ppears to be misplaced. A taxpayer may adopt any permissible method in the first year of its existence or, if later, the first year it has an item. Indeed, if it is the first year a taxpayer has inventories, the adoption of an inventory method is...