What isn't a change in method of accounting?

• Author: Gann, Hal I.

Introduction

What Is a Method of Accounting?

A method of accounting is a rule that governs when an item of income or expense will be taken into account for federal income tax purposes. The paradigmatic example in the regulations is that a change from consistently claiming current deductions in the year assets are purchased to depreciating the cost of those assets is a change in method of accounting. Treas. Reg. [sections] 1.446-1(e)(2)(ii)(b).

Why Do Different Methods of Accounting Exist?

Because it is not always clear as a theoretical matter when income is earned or when expenses are incurred, it is helpful as an administrative matter to have each taxpayer select clear rules that its employees can follow instead of engaging in daily debates about whether the day's events increased or decreased the wealth of the taxpayer. The decision to expense or depreciate a long-lived asset is too simple to illustrate the point. Here is a harder example:

For $120 million, you sell a customer the right to buy up to 120 million units of your product at today's price during the next 10 years. Will you --

* Include the entire amount in this year's income?

* Include the entire amount in Year 10 when you know whether you won or lost the bet?

* Include $1 million a month for the next 120 months?

* Include $1 per unit as units are actually delivered?

* Revalue the contract every time the price of your product rises or falls, and recognize loss or gain as the buyer's rights become more or less valuable?

You probably won't choose that last treatment, but whatever you choose will become your method of accounting for this $120 million contract.

Why Does It Matter If a Treatment Is Called a "Method of Accounting"?

First, section 446(b) of the Internal Revenue Code grants the IRS broad discretion to decide whether or not a "method of accounting" clearly reflects the taxpayer's income, and to force the taxpayer to change methods that do not clearly reflect their income. Although there are exceptions,(1) the courts rarely hold that the Internal Revenue Service abused its discretion in this area, or in the closely-related area of inventory accounting methods under section 471(a). If anything, the courts seem to give the IRS even more leeway with respect to inventory methods.

Second, section 446(e) requires the taxpayer to obtain the Commissioner's consent before changing any method of accounting. The trouble is that a large company probably changes numerous small accounting methods every time it hires a new cost accountant or updates its accounting software. The company does not want to stifle efforts to improve its cost accounting. But any "improvement" in accounting is likely to be a method of accounting for which the company should have obtained the Commissioner's permission before extending the improvement to its tax accounting. And revenue agents have a nasty habit of deciding whether an improvement is a change in method based on whether it gives rise to a positive or negative adjustment to income, and whether it helps or hurts the taxpayer to go back and fix the problem for prior years.

Third, section 481 and the applicable revenue procedures generally allow a taxpayer several years to take into the income the effect of an unfavorable change in accounting method. This "spread period" can significantly ease the pain of the change. On the other hand, the amount of the adjustment under section 481 is special in a way that often hurts taxpayers -- it takes into account closed tax years back to at least 1954, and back to the taxpayer's first use of the method if the taxpayer wants a spread period.

Why Is the Commissioner's Permission Required to Change a Method of Accounting?

The main justification for consent is to allow the Commissioner to prevent omission or duplication of income by making an appropriate transition adjustment when a method is changed. Going back to the prepayment example, the Commissioner wants to make sure that even if you change methods after six years, you eventually report all $120 million of income. This is why the transition adjustment that the Commissioner is permitted to make under section 481 takes into account closed years.

Consent may also promote consistency and prevent taxpayers from flip-flopping among permissible methods that become more or less advantageous over time. The IRS gets particularly excited when it thinks the taxpayer is getting the benefit of hindsight.

Finally, consent gives the Commissioner notice of changes and an opportunity to assess the propriety of the new method before it is adopted, instead of during audit. Taxpayers, however, adopt their initial methods of accounting without oversight, so this justification is not terribly convincing.

When Isn't Permission Required?

This article lists 10 arguments that might work -- and some of the cases you can cite(2) -- in different situations. Taxpayers should bear in mind that most of these arguments can also be used to show that a treatment is not a method that triggers the Commissioner's clear reflection authority. But it is easier to focus on the permission issue because a couple of extra arguments are available there.

Not Just Timing

Accounting Methods Are "Just Timing"

Treas. Reg. [sections] 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 income or deductions or a change in the treatment of any material item used in that overall plan that involves the proper time for including an item in income or taking a deduction. Rev. Proc. 92-20, 1992-1 C.B. 685, is the IRS's manual for making changes in methods of accounting. It provides that in determining whether a practice involves the proper time for including an item in income or taking a deduction, the relevant question is generally whether the practice permanently changes the amount of taxable income over the taxpayer's lifetime. If the practice does not permanently affect the taxpayer's lifetime taxable income, but does change the taxable year in which taxable income is reported, it involves timing and is considered a method of accounting. 1992-1 C.B. at 688. See also Rev. Proc. 91-31, 1991-1 C.B. 566, 567.

Therefore, You Do Not Need Permission If its "Not Just Timing"

Under Treas. Reg. [sections] 1.446-1(e)(2)(ii)(b), deducting as interest or salary expense a payment to an officer that was really a dividend is not a method because dividends paid are never deductible. Deducting as a business expense an amount that was really a personal expense is not a method because personal expenses are never deductible. Other obvious examples of items that are "not just timing" are mistakenly including in income an item that is exempt from tax under section 103 or section 115.

The regulations also say that errors in the computation of the foreign tax credit, net operating loss, percentage depletion, or investment credit are not methods of accounting. Although the IRS may argue that these four items were included in the regulations as examples of "mathematical or posting errors in the computation of tax liability," that argument does not explain the coincidence that all four are permanent items. The Court of Federal Claims favored this reading in Travelers Insurance Co. v. United States, 28 Fed. Cl. 602, 614 (Fed. Cl. 1993) (the foreign tax credit computation takes place only after taxable income has been computed and all timing matters have been resolved).

If the practice affects whether another tax credit is available, the permanent loss of that credit is not just timing. Although the IRS may argue that credits never affect lifetime taxable income, the rationale of Travelers should extend to tax credits not mentioned by the regulations.

If the practice involves the proper year to take a loss or deduction, the Code and regulations provide that the loss or deduction must be taken in the proper year. See Treas. Reg. [sections] 1.461-1(a)(3) (the expenses, liabilities, or loss of one year generally cannot be used to reduce the income of a subsequent year); I.R.C. [sections] 165(a) and Treas. Reg. [sections] 1.165-1(d) (losses are deductible only in the year they are sustained). This is not just timing because the courts deny permanently taxpayers' claims for losses if the claims are not made for the year the loss was actually sustained. See, e.g., L.B. Maytag v. Commissioner, 32 T.C. 270 (1959) (taxpayer claimed loss deduction upon abandonment of last of five oil and gas leases that it considered a single asset; the court held taxpayer should have deducted losses as each lease was abandoned and permanently denied the deductions for the other four leases).

If the practice affects whether income is reported as ordinary or capital gain or loss, the rate differential for gains and possible expiration of capital losses is not just timing. If the capital loss limitation does not apply (e.g., because this is a section 1231 asset) and the rate differential for the taxpayer and year at issue is expressed as a capital gains rate (instead of an exclusion of part of the capital gain), the IRS might argue that the differential does not affect lifetime taxable income. It would be interesting to see how a court would react to this sort of permanent difference in tax.(3)

Characterization

Income or Recovery of Basis?

In Underhill v. Commissioner, 45 T.C. 489 (1966), the taxpayer had for many years purchased notes at a discount and reported any principal payments received on the notes as part recovery of basis and part taxable income (recovery of the discount). In 1961, the taxpayer stopped reporting any taxable income until his basis was fully recovered, relying on Phillips v. Frank, 295 F.2d 629 (9th Cir. 1961), which held that where the taxpayer owns a "speculative" note and may never recover its basis, principal payments are reported as return of basis until the taxpayer's basis is recovered.

Because Mr. Underhill had not asked...