Request for accounting method change for prepaid expenses denied.

• Author: Beavers, James A.

Request for Accounting Method Change for Prepaid Expenses Denied

The Tax Court held that the IRS's denial of a request for a change in accounting method that the taxpayer made outside the effective dates of the relevant regulations and revenue procedure was not an abuse of discretion.

Background

Lattice Semiconductor Corporation (Lattice) designs, develops, and markets high-performance programmable logic devices and related software. The company, which is located in Hillsboro, Oregon, is an accrual-method taxpayer.

Lattice traditionally incurred regular expenses from prepaid insurance, maintenance, and service contracts (contracts). These contract expenses were prepaid expenses under Sec. 263 and the regulations. The benefits of these contracts typically did not exceed 12 months, but the contract periods sometimes spanned two tax years. Before 2002, Lattice capitalized its prepaid expenses for contracts that extended substantially into the following year.

The IRS issued an advance notice of proposed rulemaking (ANPRM) in January 2002 stating that it expected to propose a rule that would no longer require capitalization of 12-month prepaid expenses under Sec. 263. The next month, the IRS issued an industry directive, Guidelines for the Application of Advance Notice of Rulemaking for Intangibles Under IRC 263(a), that stated the IRS likely would adopt the ANPRM's 12-month rule despite the IRS's contrary position at the time. The industry directive further cautioned that prior IRS consent was still required for accounting method changes.

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The IRS published proposed regulations regarding 12-month prepaid expenses in December 2002 (REG-125638-01) that incorporated a 12-month rule where an expenditure could be deducted in the year incurred as long as the useful life of the resulting benefit did not extend beyond a year. The proposed regulations advised taxpayers not to seek an accounting method change in reliance upon the proposed rules until the IRS published final regulations.

Nine days later, Lattice applied for an accounting method change under Rev. Proc. 97-27 to deduct 12-month prepaid expenses spanning two tax years (relevant expenses). Lattice relied on the proposed regulations and U.S. Freightways Corp., 270 F.3d 1137 (7th Cir. 2001), rev'g 113 T.C. 329 (1999). The company then claimed a deduction for the relevant expenses for the first time when it filed its consolidated federal income tax return for 2002. Lattice...