New procedure simplifies voluntary accounting method changes, but limits opportunities for taxpayers under examination.

• Author: Morgan, Daniel T.

Overview

The Internal Revenue Service issued a new revenue procedure on May 8, 1997, revising the general guidelines and applicable terms and conditions for requesting voluntary federal income tax accounting method changes. Rev. Proc. 97-27 makes significant changes to the five-year old rules provided in Rev. Proc. 92-20, including modifications of general filing requirements, window periods, rulers for taxpayers under examination, and terms and conditions -- most important, the elimination of the Category A and B distinction and the provision of a uniform four-year section 481(a) adjustment.(1)(*). The new procedure also provides further clarification of definitions such as "under examination" and "issues under consideration."

Generally, the new procedure increases the opportunity for taxpayers to make method changes, formalizes a number of existing IRS National Office polices, clarifies or eliminates many items that previously have been sources of disagreement, and attempts to encourage voluntary method changes. At the same time, it contains many provisions that limit a taxpayer's ability to make changes once they are contacted for examination and spawns a number of new issues that likely will be sources of future conflict.

Effective Date

The new procedure is generally effective for Forms 3115, Application for Change in Accounting Method, filed on or after May 15, 1997.(2) Transition rules are provided, however, that enable taxpayers to affirmatively choose to use most aspects of the terms and conditions of either Rev. Proc. 92-20 or Rev. Proc. 97-27 for certain pending Forms 3115 and new Forms 3115 filed before December 31, 1997.

Generally, the IRS National Office will apply the terms and conditions of Rev. Proc. 92-20 for a Form 3115 filed for a taxable year ending on or after May 15, 1997, and which is pending on or after May 15, 1997, unless the taxpayer requests in writing by the later of June 15, 1997, or the date the ruling letter is issued, to apply the terms and conditions of Rev. Proc. 97-27 (exclusive of the year of change).(3) For any Form 3115 filed after May 15, 1997, the National Office will apply the terms and conditions of Rev. Proc. 97-27. The taxpayer, however, may request the terms and conditions of Rev. Proc. 92-20 for applications filed on or before December 31, 1997, by attaching a statement to the Form 3115 requesting to apply the terms and conditions of Rev. Proc. 92-20 (exclusive of the year of change and application of window periods).(4) In addition, taxpayers in a window period provided under Rev. Proc. 92-20(5) on May 15, 1997, may file a Form 3115 during the remainder of that window period under the terms and conditions of Rev. Proc. 92-20.

Each procedure has advantages and disadvantages that taxpayers should consider with their particular factual situation to determine which procedure should be utilized under the transition rules. For example, taxpayers with a positive Category B section 481(a) adjustment with a six-year spread period or a negative Category A section 481(a) adjustment with a one-year spread period may prefer to utilize the provisions of Rev. Proc. 92-20.(6) Taxpayers with a negative Category B section 481(a) adjustment with a six-year spread period or positive Category A adjustment with a three-year spread period may prefer to utilize the provisions of Rev. Proc. 97-27 to obtain the uniform four-year spread provided under its terms.

Finally, for applications filed between May 15, 1997, and December 31, 1997, the IRS National Office has informally indicated that taxpayers will have the option to retract an election to have Rev. Proc. 92-20 apply only if there is no disagreement over the taxpayer's characterization of the method as Category A or Category B.

Anticipated Future Guidance

The IRS plans to issue a "mass automatic" change procedure "shortly" that will incorporate many of the existing automatic change procedures.(7) This procedure will likely include approximately a dozen new automatic method changes for requests that are routinely granted by the IRS. The terms and conditions in this mass automatic procedure presumably will conform to those provided in Rev. Proc. 97-27, including the four-year spread period. These automatic requests will probably be subject to IRS review and the Rev. Proc. 97-27 window periods discussed below. The goal of issuing additional automatic method changes is to allow the resources of both taxpayers and the IRS to be devoted to dealing with more substantive issues.

Owing to the likely conformity of terms and conditions to Rev. Proc. 97-27, taxpayers considering using the automatic change procedure should analyze the potential benefits and burdens of the different spread periods provided in current automatic procedures as compared with the four-year period expected to be provided in the new mass automatic procedure. For example, taxpayers wishing to utilize Rev. Proc. 96-31 for under-depreciated assets should consider filing Forms 3115 to obtain a one-year spread of the resulting negative section 481(a) adjustment prior to the effective date of the anticipated procedure.(8) Similarly, taxpayers considering a termination of their LIFO election and planning to file under Rev. Proc. 88-15 should consider taking steps to retain a six-year spread of any positive section 481(a) adjustment.(9)

The mass automatic change procedure may contain transition rules similar to Rev. Proc. 97-27. The transition rules may afford taxpayers the option to utilize current automatic change procedures or the terms and conditions of the new procedure. There is no guarantee, however, that such a provision will be included or which taxpayers, if any, will be able to utilize the transition rules.

The IRS plans to issue a third procedure before yearend that will provide guidance for involuntary method changes. Rev. Proc. 97-27 indicates that audit protection is not available if the method was adjusted as an involuntary method change.(10) The procedure, however, does not define when an involuntary method change has been made on examination. The involuntary change procedure should provide guidance on when an involuntary method change has occurred. This guidance likely will result in changes in how taxpayers and the IRS settle issues raised under examination. The potentially contentious nature of how the involuntary change procedures are applied to examination settlements may result in this procedure being issued in proposed form.

Methods of Accounting

Section 446(e) of the Code requires the taxpayer to obtain the Commissioner's consent before changing any method of accounting. If, however, a taxpayer has not adopted a method of accounting or the treatment does not result in a change in method of accounting, the taxpayer is not required to request the consent of the Commissioner. Therefore, before focusing on the details of requesting a change in method of accounting, it is important to ascertain whether the treatment of a particular item constitutes a method of accounting.

Whether a particular treatment is a method of accounting is also important because of the broad discretion granted to the IRS to change a taxpayer's method of accounting in order to clearly reflect income.(11) Further, a change in a taxpayer's method of accounting generally results in an adjustment to prevent amounts from being duplicated or omitted in determining taxable income when the taxpayer uses a different accounting method from the method used in the preceding year.(12) To encourage voluntary compliance, taxpayers are allowed to recognize the resulting section 481(a) adjustment ratably over a four-year period under Rev. Proc. 97-27.(13) For involuntary changes, the IRS can include the entire section 481(a) adjustment in income for the earliest open year under examination.(14)

Method of Accounting Defined. Rev. Proc.97-27 provides a definition of an accounting method change generally consistent with the definition in Rev. Proc. 92-20.(15) 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 a material item. A material item is defined to be any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.(16) Thus, in determining whether the treatment of an item involves timing, the relevant question is whether the practice permanently affects the amount of taxable income recognized over the taxpayer's lifetime. If the practice does not permanently affect the taxpayer's lifetime income, but rather does or could change the taxable year in which income is reported, it involves timing and is therefore a method of accounting.(17)

Although a method of accounting may exist under this definition without a pattern of consistent treatment, in most instances a method of accounting is not adopted without consistent treatment. The treatment of a material item in the same way in two or more consecutively filed tax returns represents consistent treatment.(18) If a taxpayer treats an item properly in the first return that reflects the item, however, it is deemed to have adopted a method of accounting.(19) Once a taxpayer has adopted a method of accounting, the taxpayer may not change its method by filing amended tax returns, but must request permission of the IRS National Office by filing a Form 3115.(20)

There are a number of common situations that do not give rise to a change in accounting method. A change in method of accounting does not include the correction of mathematical or posting errors, errors in the computation of tax, a change that does not involve the proper time for inclusion of the item in income or the taking of a deduction, or a change in treatment resulting from a change in underlying facts.(21)

Item Characterization 1e a Method of Accounting.

Rev. Proc.97-27 includes the following new provision, which potentially treats item...