By Paul K. Gibbs, CPA, Washington, DC, and Carol Conjura, J.D., CPA, Washington, DC
Editor: Mary Van Leuven, J.D., LL.M.
A taxpayer’s accounting methods determine the time for reporting income and expenses. Classifying the treatment of an item of income or expense as a method of accounting can provide a taxpayer with certain benefits when changing the method. Sec. 446(e) generally requires a taxpayer to obtain the IRS’s consent before changing a method of accounting. This consent requirement applies to (1) a change from one proper method of accounting to another, (2) a change from an improper method to a proper method, and (3) most changes from one elective status to another. Classification of the treatment as a method of accounting may:
- Allow a taxpayer changing to a more favorable method to reach back into closed tax years (i.e., years in which the deduction would otherwise be lost).
- Allow a taxpayer changing to a less favorable method to spread the increase in taxable income generally over four tax years. (Rev. Procs. 97-27 and 2002-9 require some taxpayers to accelerate the recognition of a positive Sec. 481(a) adjustment.)
- Generally prevent the IRS from proposing an audit adjustment in an earlier tax year for the particular item of income or expense when the taxpayer has received permission to change such method of accounting (i.e., audit protection). There are, however, limited exceptions when a taxpayer does not receive audit protection (e.g., changes in the treatment of sale or lease transactions, changes in the method or amortization period for research and experimentation expenditures, and changes in the treatment of de minimis original issue discount).
Method of Accounting
The term “method of accounting” is not specifically defined in the Code or regulations. Regs. Sec. 1.446-1(e)(2)(ii)(a) generally defines a method of accounting as any practice involving the treatment of the overall plan of accounting for items—such as the cash or accrual method—or the treatment of any specific material item of income or expense within such an overall plan. Thus, the term applies to a taxpayer’s overall accounting method and accounting for specific items. Examples of overall methods of accounting are cash receipts and disbursements, accrual, hybrid, and combinations of overall methods with a method prescribed for an individual item. Examples of methods for individual items of income or expense include the accounting treatment for research and experimentation expenditures, depreciation, and installment sales (Regs. Sec. 1.446-1(a)(1)). Special methods of accounting, or limitations on particular methods, are required in certain situations. Taxpayers that sell merchandise, for example, must use the accrual method for purchases and sales but may use the cash method for all other items of income and expense, provided income is otherwise clearly reflected.
An accounting method can be described as a regular practice for determining when to recognize items of income or expense in taxable income. The regulations, IRS rulings, and court cases generally conclude that a method of accounting has the following characteristics:
- It must affect the computation of a material item;
- It must be consistently applied and predictable in its application; and
- It must be “adopted” by the taxpayer.
Material Item and Timing
In the IRS’s view, “material” in the tax accounting sense does not relate to the absolute or relative magnitude of the dollar amount of an item; instead it relates to timing. Regs. Sec. 1.446-1(e)(2)(ii)(a) defines a material item as “any item which involves the proper time for inclusion of the item in income or the taking of the deduction.” Notwithstanding the specificity of this regulation, some courts still look at materiality in a monetary sense (see Witte, 513 F2d 391 (D.C. Cir. 1975)).
Generally, materiality turns on whether the practice permanently changes the amount of the taxpayer’s lifetime income. If the practice does not permanently change the taxpayer’s lifetime income, but does or could affect the tax year in which income is reported, the practice involves timing and is therefore a method of accounting (see Rev. Proc. 91-31, 1991-1 CB 566). On the other hand, if the practice permanently changes the taxpayer’s lifetime taxable income, it is the IRS’s long-standing position that this is a correction of an error. For example, a change in a taxpayer’s method of allocating or apportioning gross receipts, cost of goods sold, or expenses, losses, and deductions under the Sec. 199 manufacturer’s deduction is not a change in method of accounting. See Regs. Sec. 1.199-8(a); see also, e.g., TAM 9746002.
Accordingly, the following types of items are not considered to be material (and not a method of accounting) because they do not affect the timing of income or expense recognition:
- Misclassification of capital gain or loss as ordinary, or vice versa;
- Change in allocation method that affects the computation of the absolute amount but not the period in which the item is reported (see Letter Ruling 8545011); and
- Treatment of an item that affects the taxpayer’s lifetime income but not the assignment of items to tax periods where the item is properly adjusted through the filing of an amended return (see Regs. Sec. 1.446-1(e)(2)(ii)(b); Knight-Ridder Newspapers, Inc., 743 F2d 781 (11th Cir. 1984); Rev. Proc. 91-31; and TAM 9841003).
The IRS included two items in its 2007–2008 Priority Guidance Plan specifically addressing what constitutes a method of accounting, demonstrating both the importance of and uncertainty surrounding this issue. The first item involves general guidance under Sec. 446 regarding whether a change between (1) separately reporting an item as income and deducting a related expense (either in the same or a different tax year) and (2) either (a) excluding the item from income and not deducting the expense or (b) netting the item of income with the related expense is a change in method of accounting. The second item involves reconsidering Rev. Rul. 58-74 on changes from an impermissible method regarding Sec. 174 costs. In the prior guidance, the IRS ruled that the taxpayer’s failure to currently expense all research and experimental (R&E) expenses consistent with its selected method of accounting for R&E expenses under Sec. 174 was a correction of an error within the taxpayer’s method of accounting, not a change in accounting method. Furthermore, the IRS allowed the taxpayer to amend its returns to correct the error, even though the taxpayer’s treatment had been consistently applied for several years. But see Chief Counsel Advice 200728001 (a change in treatment of the portion of a sale attributable to unrealized accounts receivable from the installment method to the cash method is an accounting method change).
Whether a change in valuation method is a method of accounting has been addressed. In Bank One Corp., 120 TC 174 (2003), aff’d in part, vacated in part, and remanded sub. nom. JPMorgan Chase & Co., 458 F3d 564 (7th Cir. 2006), the Tax Court found that the taxpayer’s valuation method for its swaps for purposes of Sec. 475(a)(2) did not take into account factors considered necessary by the court and that a change in the taxpayer’s determination of market value of such swaps was a change in method of accounting.
Consistency and Predictability
Not only must the item of income or expense be a material item in order for the treatment of that item to be deemed a method of accounting, but a taxpayer in most instances must also treat that item consistently from one tax year to the next (Regs. Sec. 1.446-1(e)(2)(ii)(a)).
An inherent characteristic of consistency is the concept of predictability—consistency of results when the method is applied to different occurrences of the item. The consistency requirement is often considered more important than the requirement of conformity between the taxpayer’s book and tax accounting methods. See Geometric Stamping Co., 26 TC 301 (1956), acq. in result, 1958-2 CB 3; Regs. Sec. 1.471-2(b) (“greater weight is to be given to consistency than to any particular method of inventorying or basis of valuation so long as the method or basis used is in accord with [the regulations herein]”).
The consistency requirement applies to different occurrences of the same item, not occurrences of different items. Furthermore, under Sec. 446(d) and Regs. Sec. 1.446-1(d)(1), when a taxpayer is engaged in more than one separate trade or business, it may use different accounting methods for each trade or business. A distinct and separate set of books must be kept for each trade or business (Regs. Sec. 1.446-1(d)(2)).
Even when an accounting procedure is erroneous, if it is consistently applied, it may constitute an accounting method. See Huffman, No. 06-2134 (6th Cir. 3/4/08), aff’g 126 TC 322 (2006), which confirms the IRS’s interpretation that a taxpayer’s use of a consistent erroneous method, including a treatment that involves a computational error that does not result in a permanent difference in the taxpayer’s lifetime income, is a method of accounting. Huffman specifically rejected the applicability of Korn Industries, Inc., 532 F2d 1352 (Ct. Cl. 1976), because the taxpayer’s actions in Korn were to correct a deviation from its long-established method of valuing inventories, whereas in Huffman the error “neither was an interruption in a history of proper application of that method nor was it restricted to only a portion of the costs to be taken into account in valuing inventories” (Huffman, 126 TC 322 (2006)). See also Rev. Rul. 77-134 (indicating that the IRS will not follow the Korn decision when a clerical error is persistent) and Wayne Bolt and Nut Co., 93 TC 500 (1989) (holding taxpayer’s consistent use of a “flawed and disorganized” inventory accounting system where no physical inventories were taken, leading to numerous errors, constituted a method of accounting requiring IRS permission to change).
Method Adopted by Taxpayer
The rules and procedures governing accounting methods become relevant only when a taxpayer has “adopted” an accounting method. Guidelines in Rev. Rul. 90-38 for determining when a taxpayer has adopted a method of accounting are dependent on whether the method used by a taxpayer is a proper or an improper (i.e., erroneous) method.
- If a taxpayer treats an item properly in the first return that reflects the item, the use of that method on a single tax return is sufficient to indicate that the taxpayer has adopted the method, once the due date for the return has passed.
- If the method of accounting is erroneous, however, the taxpayer must file two consecutive tax returns using that method in order for the method to be adopted.
Once a taxpayer adopts a method, whether or not the method is proper, the taxpayer must obtain IRS approval before changing to another method (Regs. Sec. 1.446-1(e)(2)(i)). Amending a return is generally not a permissible way to retroactively adopt or change a method of accounting (Rev. Rul. 90-38). It is important to note that these rules on the adoption of an accounting method apply even if a taxpayer changed to the new method without IRS consent as required by Sec. 446(e). See TAM 9421003 (finding that the taxpayer established a new method of accounting by using it consistently for at least two tax years, even though it had changed to that method without IRS consent).
The regulations allow the taxpayer discretion in adopting accounting methods. They require the adoption of “such forms and systems as are, in [the taxpayer’s] judgment, best suited to [the taxpayer’s] needs.” The acceptability of a method chosen through the use of such discretion is limited by the requirements of clear reflection of income, consistency of application, and adherence to generally accepted accounting practices (Regs. Sec. 1.446-1(a)(2)). Furthermore, an accounting method that consistently applies generally accepted accounting principles (GAAP) usually will be regarded as clearly reflecting income, provided all items of gross income and expense are treated consistently from year to year. However, adherence to GAAP does not necessarily mean that the method clearly reflects income when the Code or regulations specifically provide for the use of an alternative accounting method. See Thor Power Tool Co., 439 US 522 (1979) (taxpayer’s use of an inventory valuation method did not clearly reflect income under Sec. 446, even though the method complied with GAAP).
Properly assessing whether the treatment of an item constitutes a method of accounting is important for a number of reasons. Changing the treatment of an item that is not a method of accounting does not require a taxpayer to submit to the consent requirements of Sec. 446. However, the change in treatment of an item of income or expense as an accounting method change confers certain benefits on the taxpayer, including eliminating the need to file an amended return, which is generally required if changing the item’s treatment is a correction of an error, rather than a change in accounting method. In addition, a taxpayer generally receives audit protection and is permitted to spread the impact of an unfavorable change over a four-year period. If the taxpayer is changing to a more favorable accounting method, the treatment of the item as a method of accounting also allows the taxpayer to recapture otherwise lost deductions (or avoid having to double count items of income) from closed years.
Mary Van Leuven ia a Senior Manager at Washington National Tax KPMG LLP in Washington, DC
The information contained in this Tax Clinic is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser. The views and opinions expressed are those of the authors and do not necessarily represent the views and opinions of KPMG LLP.
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