|SCOTT GRIMES, CPA, is a partner of Norman, Jones, Enlow, & Co., Dublin, Ohio. Victor Sanchez , CPA, is a senior tax accountant with Norman, Jones, Enlow & Co, Reynoldsburg, Ohio. Marilyn K. Wiggams , CPA, is a tax manager with Norman, Jones, Enlow & Co, in Dublin and dean of business programs at the DeVry Institute of Technology in ColumbusNorman, Jones, Enlow & Co, Ohio.|
To the relief of many businesses, new rules now make it easier than ever before for an entity to obtain IRS consent to change its method of accounting for its operations. Revenue procedure 97-27, 1997-21 IRB, contains the procedures, terms and conditions that apply when taxpayers request permission to make such changes under IRC section 446. It modifies and supersedes revenue procedure 92-20, 1992-1 CB 685, eliminating many of the complex rules found there. This review of revenue procedure 97-27 discusses some of the planning opportunities available to entities considering a change in accounting method.
|Who Is Affected? |
The accounting method change provisions of revenue procedure 97-27 apply to any "business" entity including
CHANGE RULES CHANGE
An accounting method change may involve switching from one permissible method to another or from an impermissible method to a permissible one. The use of impermissible methods is relatively common and will be addressed in greater detail later in this article.
The new revenue procedure provides eligible entities with incentives to encourage voluntary compliance with proper tax accounting principles. A taxpayer generally receives more favorable terms and conditions if it files the request before the IRS contacts it for an examination of its current method. In addition, revenue procedure 97-27 says the taxpayer as well as the return preparer may be subject to penalties if the IRS finds the entity is using an impermissible method.
Change in accounting method. A change in an entity's accounting method is a change in its overall plan of accounting for gross income or deductions (cash or accrual methods), or a change in the treatment of a material item. A material item involves the proper timing of when to include that item in income or if the item can be taken as a deduction. If a practice does not permanently affect a taxpayer's lifetime income but does affect the taxable year in which income is reported or a deduction taken, the practice involves timing and is considered a method of accounting.
An entity generally does not adopt an accounting method without consistent treatment—the treatment of a material item in the same way for purposes of determining gross income or deductions in two or more consecutively filed tax returns. If a taxpayer treats an item properly in the first return that reflects the item, however, it is considered to have adopted a method of accounting. Corrections of mathematical or posting errors or errors in the computation of tax liability are not considered changes in accounting method.
Terms and conditions for a change. Usually, a taxpayer files Form 3115, Application for Change in Accounting Method , during the taxable year in which it wants to make a change; retroactive method changes are not permitted. Certain changes (such as changes in the last-in, first-out [Lifo] inventory method) must be made using a cut-off method. That means only items originating on or after the beginning of the year of change are accounted for under the new method and items preceding the year of change continue to be accounted for under the old method.
Most accounting method changes, however, involve an IRC section 481(a) adjustment. When section 481(a) is applied, an entity must determine income for the taxable year preceding the year of change under the old method and income for the year of change and subsequent years under the new method—as if the new method had always been used. When the new method is adopted, section 481(a) requires an entity to take into account those adjustments necessary to prevent amounts from being duplicated or omitted.
Ordinarily, an entity must make a change initiated by the IRS as part of an examination that results in a positive (increase to taxable income) section 481(a) adjustment in the earliest taxable year under examination. The section 481(a) adjustment period for taxpayer-initiated changes, however, generally is four tax years, beginning with the year of change, for both positive and negative adjustments. This uniform four-year spread replaces various adjustment periods in the old procedure.
The exhibit on page 67 shows a comparison of the difference in recognition and timing of a positive section 481(a) adjustment between a change initiated by the IRS and one initiated by the taxpayer.
SCOPE OF THE CHANGES
Revenue procedure 97-27 applies to most taxpayers wishing to request the IRS's consent to change their methods of accounting for federal tax purposes. However, it does not apply to automatic change procedures—certain changes in overall method of accounting from cash to accrual set forth in other revenue procedures. The IRS issued revenue procedure 97-37, 1997-33 IRB, which consolidates and supersedes much of the previously published automatic change guidance. Revenue procedure 97-27 also does not apply to taxpayers under examination, except as discussed below, or to taxpayers before an appeals officer or a federal court when the accounting method change is an issue under consideration.
Taxpayers not under examination. In general, all forms 3115 filed on or after May 15, 1997, must be filed during the year of change. This time limit also applies to short taxable years. The new procedure extends the time period for filing from the first 180 days of the tax year of change under the old method to the end of the taxable year. The IRS grants an extension of time to file an application only in unusual and compelling circumstances. If an automatic change procedure applies, the time for filing generally is by the due date of the tax return, including extensions, for the year of change.
Taxpayers under examination. Taxpayers may no longer file form 3115 during the first 90 days after the beginning of an examination, making voluntary compliance even more important under the new procedure. An exam begins on the date an IRS representative contacts the taxpayer in any manner to schedule any type of examination.
Adjustment Period |
Company Z, a calendar-year corporation, has a net positive section 481(a) adjustment of $320,000 at the end of 20X1. If Company Z initiates a change in its accounting method under revenue procedure 97-27 for the 20X2 tax year, the company will recognize one-fourth of the 481(a) adjustment in the four succeeding years, starting with 20X2. However, if Company Z is under examination for 20X1 and the IRS makes an accounting change adjustment, the entire section 481(a) adjustment will be taxable in the year of examination.
|20 X 1||$320,000||-|
|20 X 2||-||$80,000|
|20 X 3||-||$80,000|
|20 X 4||-||$80,000|
|20 X 5||-||$80,000|
Taxpayers may file form 3115 during the first 90 days of any taxable year (the 90-day window) if the taxpayer has been under examination for at least 12 consecutive months as of the first day of the taxable year and the accounting change is not an issue currently under consideration or in suspense at the time form 3115 is filed. This new procedure extends the window from 30 to 90 days and shortens from 18 to 12 the consecutive months of examination.
Taxpayers may file form 3115 during the 120-day period following the date an examination ends (the 120-day window), regardless of whether the IRS has begun a subsequent exam, if the change in accounting is not an issue currently under consideration or in suspense at the time form 3115 is filed. The date the examination ends depends on its outcome. For example, if the IRS accepts the return as filed, the examination ends on the date of the no-change letter.
A taxpayer under examination and not within the 90-day or 120-day windows may file form 3115 with the consent of the IRS district director. However, the IRS will grant consent only in limited circumstances.
ADJUSTMENT PERIOD EXCEPTIONS
Some exceptions result in a shorter or accelerated uniform four-year adjustment period. For instance, if the year of change or any taxable year during the section 481(a) adjustment period is a short taxable year, the section 481(a) adjustment is included in income in the short year as if that year is a full 12-month taxable year. The section 481(a) adjustment is not prorated for the shorter period. If the entire adjustment is less than $25,000 (either positive or negative), the taxpayer may elect a one-year adjustment period.
Some of the rules regarding the adjustment period remained intact:
- Taxpayers that cease to engage in business or terminate their
existence must take the remaining balance of any section 481(a)
adjustment into income in the year of such occurrence. A taxpayer
ceases to engage in a trade or business if substantially all of the
business' assets are transferred to another taxpayer. Examples of
such transfers include incorporating the business, selling the
business, a taxable liquidation or contributing the business' assets
to a partnership.
- For transfers to which IRC section 381(a) applies (a merger or
reorganization), the taxpayer is not required to accelerate the
section 481(a) adjustment; however, the transferee corporation steps
into the transferor's shoes.
- Special rules exist for transfers in consolidated groups.
In the case of a company converting to or from S corporation status, the adjustment period generally is not accelerated; however, special rules regarding the discontinuance of Lifo can result in acceleration. Finally, if an automatic change procedure applies, the adjustment period may vary depending on the circumstances. The new automatic change procedure—revenue procedure 97-37—generally provides for a four-year adjustment period consistent with revenue procedure 97-27.
GENERAL APPLICATION PROCEDURES
The IRS reserves the right to decline to process any form 3115 or to require different terms for changes granted if it finds its decision is in the best interest of sound tax administration. The taxpayer is considered to be initiating a change without the IRS commissioner's consent for any accounting method changes that are made without authorization or without complying with the procedure's provisions. On examination, the IRS may require the taxpayer to reflect the change in an earlier or later year and lose the benefit of spreading the section 481(a) adjustment over a number of years.
An entity must file form 3115, with the appropriate user fee—as scheduled in revenue procedure 98-1—with the IRS commissioner in Washington, D.C. Exempt organizations must file with the assistant commissioner. If the commissioner grants permission for the accounting method change, the taxpayer will receive a ruling letter identifying the item(s) to be changed, the section 481(a) adjustment and any terms and conditions. If the taxpayer decides to make the change, it must sign, date and return a copy of the ruling letter within 45 days of issuance and attach a copy to its income tax return for the year of change.
When a taxpayer is requesting accounting method changes for more than one trade or business, separate forms 3115 may be required. If requesting a change for only one of the trades or businesses, the IRS will consider the effects of the change on the profits or losses between the trades or businesses. A common parent may request an identical change on behalf of more than one member of a consolidated group on one form 3115 with a reduced user fee. All aspects of the requested change must be identical, except for the section 481(a) adjustment.
In general, if a taxpayer timely files form 3115 and complies with the terms and conditions granted, it will not be required to change its method of accounting for the same item for a taxable year before the year of change.
Except for transition rules, revenue procedure 97-27 is effective for forms 3115 filed on or after May 15, 1997. Forms 3115 filed under revenue procedure 92-20 for taxable years ending on or after that date that were still pending approval can instead apply revenue procedure 97-27 if a request is made before the later of June 15, 1997, or the issuance of the letter ruling granting or denying the consent to change. A taxpayer that filed form 3115 on or before December 31, 1997 also can request to apply revenue procedure 92-20.
ANALYZE THE PLANNING OPPORTUNITIES
CPAs should analyze any areas of exposure that may exist for their employers or clients and consider possible accounting method changes. The IRS has stepped up its review of accounting methods in various types of businesses and professions, requiring some to change methods. (See " IRS Focuses on Accounting Methods, " JofA, Feb98, page 30.) In particular, the IRS has attacked the overall use of the cash method in numerous recent cases. Any small business that maintains inventories or transfers a significant amount of materials, supplies, prescriptions or other products to its customers (such as construction contractors or veterinarians) in addition to providing services, is subject to attack. For example, in Thompson Electric, Inc. v. Commissioner , T.C. Memo 1995-292, the IRS successfully required an electrical contractor to change from the cash to the accrual method.
In addition, the IRS has been aggressive in challenging specific accounting practices, such as Lifo inventory computations. A successful IRS challenge of an impermissible Lifo practice could result in termination of the Lifo election with disastrous tax consequences. Another area of risk CPAs should consider is the treatment of certain advance customer deposits as liabilities rather than as income. Generally, cash or accrual basis taxpayers must report advance deposits as income unless a specific exception applies. Some companies may have exposure under these rules, while other companies may already be reporting the advance deposits as income when they could qualify to defer the income under an exception.
In the Ohio district, for example, the IRS is actively looking for uniform capitalization (IRC section 263A) noncompliance, as well as noncompliance with the older full absorption inventory rules that apply to manufacturers. Problems can arise when a business conducts both resale and manufacturing operations. In the Ohio district, the IRS also has questioned the accrual of state and local taxes under the all events test or the economic performance rules. The IRS publishes audit guidelines for various types of businesses as part of its market segment specialization program. CPAs can use these guidelines as a good source to identify potential accounting method issues.
Finally, CPAs may find a planning opportunity under the IRC section 475 mark-to-market requirement for dealers in securities. An unintended result of this section and related regulations is that the trade receivables of any type of business (retailers, wholesalers or manufacturers) may apparently be treated as securities that could be marked-to-market. Thus, section 475 may serve as a surrogate for the reserve method for bad debts, which has been repealed since 1986. Some companies are making an accounting method change based on this provision.
FOR THE BENEFIT OF EMPLOYERS AND CLIENTS
In light of the increased IRS scrutiny and because entities receive more favorable terms and conditions when they change accounting methods voluntarily (before an IRS examination) this area of tax practice has become an extremely important one for all CPAs. Accountants should also watch for situations where their employers or clients can benefit from accounting method changes by deferring income or accelerating deductions.