IRS Audits - Part 4 Examining Process

[ Home ] [ Services ] [ FAQ ] [ Site Map ] [ Contact Us ]

IRS Audits

Chapter 11. Examining Officers Guide (EOG)

Section 6. Changes in Accounting Methods

4.11.6  Changes in Accounting Methods

4.11.6.1  (05-13-2005)
References for Changes in Accounting Methods

  1. The following references are for Changes in Accounting Methods:

    • IRC section 446 - General Rule for Methods of Accounting

    • IRC section 481 - Adjustments Required by Changes in Method of Accounting

    • Treas. Regs. 1.446 and 1.481

    • IRM 4.2.3 - Examination Techniques

    • LMSB Change in Accounting Method Site: http://lmsb.irs.gov/hp/pftg/change_method/

    • Rev. Ruling 90-38 - Although the Commissioner is authorized to consent to a retroactive accounting method change, a taxpayer does not have a right to a retroactive change, regardless of whether the change is from a permissible or impermissible method.

    • Rev. Proc. 97-27 - This advance consent (voluntary change) revenue procedure provides the general procedures under Treas. Reg. 1.446-1(c) for obtaining the consent of the Commissioner of Internal Revenue to change a method of accounting for federal income tax purposes. Rev. Proc. 97-27 was modified by Rev. Proc. 2002-19.

    • Rev. Proc. 2002-9 - This automatic consent (voluntary change) revenue procedure provides the procedures by which a taxpayer may obtain automatic consent to change the methods of accounting described in the Appendix. Pronouncements issued subsequent to the publication of Rev. Proc. 2002-9 that refer to this revenue procedure have modified it to include in its Appendix other methods of accounting. Prior automatic consent procedures include Rev. Proc. 97-37, Rev. Proc. 98-60 and Rev. Proc. 99-49. Rev. Proc. 2002-9 was modified by Rev. Proc. 2002-19 and Rev. Proc. 2002–54.

    • Rev. Proc. 2002-18 - This revenue procedure provides the procedures under IRC section 446(b) and Treas. Reg. section 1.446-1(b) for changes in method of accounting imposed by the Service (involuntary changes). Examiners should refer to this procedure when raising an accounting method change issue during an examination. This revenue procedure also provides the procedures that the Service (other than examiners) may use for accounting method issues resolved by the Service on a non-accounting method change basis. This revenue procedure is effective for examiner's reports issued on or after July 1, 2002.

    • Rev. Proc. 2002-19 - This revenue procedure modifies Rev. Proc. 97-27 and Rev. Proc. 2002-9 to provide new procedures for obtaining consent for a change of accounting method. This procedure introduced a method change without audit protection for an "issue pending" for a tax year under examination, and shortened the spread period for a taxpayer-favorable (negative) IRC section 481(a) adjustment.

    • Publication 538 (Rev. 3/2004) - Accounting Periods & Methods

      Note:

      Changes in taxpayer accounting methods is a highly technical area. This chapter is designed to provide a brief overview and is not meant to be the exclusive research tool.

       

     

4.11.6.2  (05-13-2005)
Overview for Changes in Accounting Methods

  1. The term "method of accounting" is not specifically defined in the Code or regulations. In general, an accounting method is a set of rules used to determine when and how income and expenses are taken into account for federal income tax purposes.

  2. Taxable income must be computed under the method of accounting regularly used by the taxpayer in keeping its books. However, variations between financial and tax reporting are allowed where other IRC requirements, such as IRC sections 162 and 263, are met and the method of accounting clearly reflects income. If no method of accounting has been regularly employed or if the method employed does not clearly reflect income, the computation will be made under a method that, in the opinion of the Commissioner, clearly reflects income. A method of accounting will not be regarded as clearly reflecting income unless all items of income and expenses are treated with reasonable consistency. However, consistency alone is not the sole criteria for an accurate determination of income. Key concepts in determining what constitutes a method of accounting are (1) timing and (2) consistency.

  3. Timing: Treas. Reg. 1.446-1T(e)(2)(ii)(a) provides that a change in the method of accounting includes a change in the overall plan of accounting, as well as a change in the treatment of any material item. A material item is any item which involves the proper time for inclusion of the item in income or the taking of a deduction. In determining whether a practice involves the proper time for inclusion of an item in income or taking of a deduction, the relevant question is generally whether the practice permanently changes the amount of taxable income over a taxpayer's lifetime. If the practice does not permanently change taxable income over a taxpayer's lifetime, but does or could change the taxable year in which taxable income is reported, it involves timing and is therefore a method of accounting. See Rev. Proc. 91-31. Generally, if the issue involves when an item is deductible or included in income, as opposed to whether, the issue involves timing, and may be a method of accounting.

  4. Consistency: Treas. Reg. 1.446-1T(e)(2)(ii)(a) further provides that although a method of accounting may exist without a pattern of consistent treatment of an item, a method of accounting is not established in most instances without consistent treatment. The treatment of a material item in the same way in determining the gross income or deductions in two or more consecutively filed tax returns (without regard to any change in status of the method as permissible or impermissible) represents consistent treatment of that item for purposes of Treas. Reg. 1.446-1T(e)(2)(ii)(a). If a taxpayer treats an item properly in the first return that reflects the item, however, it is not necessary for the taxpayer to treat the item consistently in two or more consecutive tax returns to have adopted a method of accounting. If a taxpayer has adopted a method of accounting under these rules, the taxpayer may not change the method by amending its prior income tax return(s). See Rev. Rul. 90-38.

  5. A change in the characterization of an item may constitute a change in method of accounting if the change has the effect of shifting income from one period to another. For example, a change from treating an item as income to treating the item as a deposit is a change in method of accounting. See Rev. Proc. 91-31.

  6. A change in method of accounting does not include correction of mathematical or posting errors, or errors in the computation of tax liability (such as errors in computation of the foreign tax credit, net operating loss, percentage depletion, or investment credit). Likewise, a change in method of accounting does not include a change in treatment resulting from a change in underlying facts. See Treas. Reg. 1.446-1T(e)(2)(ii)(b).

  7. The following is a non-exclusive list of accounting method issue areas commonly encountered by examiners:

    • Capitalization issues - IRC sections 263(a) and 263A relative to inventory, tangible assets and intangible assets,

    • Accounting for liabilities that involve timing - IRC section 461(h),

    • Accounting for when income is recognized - IRC section 451,

    • Depreciation method change issues involving changes in recovery periods, conventions, or depreciation methods. (See Chief Counsel Notice 2004–007 and field guidance for depreciation changes posted on the LMSB Change in Accounting Method Site.)

    • Inventory valuation issues including LIFO inventory - IRC sections 471 and IRC section 472,

    • Accrual to Cash - Rev. Proc. 2002-28 and

    • Accounting for long-term contracts - IRC section 460

     

4.11.6.3  (05-13-2005)
Adoption of a Method of Accounting

  1. A taxpayer filing its first return may adopt any permissible method of accounting. See Treas. Reg. 1.446-1(e)(1). Once the taxpayer adopts a proper method of accounting by filing its return using such method, it may not adopt a different method of accounting by the filing of an amended return.

  2. However, a taxpayer filing its first return using an improper method of accounting may change to a proper method by the filing of an amended return. The amended return MUST be filed prior to the filing of the next year's return. See Rev. Rul. 72-491, 1972-2 C.B. 104.

  3. Two returns filed for consecutive years using an improper method, establishes a method of accounting from which consent to change is required. Amended returns may not be used to change such method. See Rev. Proc. 90-38.

4.11.6.4  (05-13-2005)
Requirement To Secure Consent To Make A Method Change

  1. IRC section 446(e) and Treas. Reg. 1.446-1(e) state that, except as otherwise provided, a taxpayer must secure the consent of the Commissioner before changing from an "adopted" or "established " method of accounting for federal income tax purposes. Treas. Reg. 1.446-1(e)(3)(i) requires that, in order to obtain the Commissioner's consent to make a method change, a taxpayer must file a Form 3115, Application for Change in Accounting Method, during the taxable year in which the taxpayer desires to make the proposed change. See also Rev. Proc. 97-27, section 5.01 and Rev. Proc. 2002-9, section 6.02.

  2. Unless specifically authorized by the Commissioner, a taxpayer may not make a retroactive change in method of accounting, regardless of whether the change is from a permissible or an impermissible method. See Rev. Rul. 90-38.

4.11.6.5  (05-13-2005)
IRC Section 481 and "Cut-off" Method

  1. Whenever a change in method of accounting is either imposed on or initiated by a taxpayer, there is a possibility for duplication or omission of income or deductions relating to transactions occurring in a year prior to the year of change.

4.11.6.5.1  (05-13-2005)
IRC Section 481(a) Concept

  1. A change in method of accounting generally requires an adjustment under IRC section 481(a). IRC section 481(a) requires those adjustments necessary to prevent amounts from being duplicated or omitted to be taken into account when the taxpayer's taxable income is computed under a method of accounting different from the method used to compute taxable income for the preceding taxable year. When there is a change in method of accounting to which IRC section 481(a) is applied, income for the taxable year preceding the year of change must be determined under the method of accounting that was then employed, and income for the year of change and the following taxable years must be determined under the new method of accounting as if the new method had always been used.

4.11.6.5.2  (05-13-2005)
IRC Section 481(a) Adjustments

  1. The IRC section 481(a) adjustment is computed as of the beginning of the taxable year for which the method is being changed (year of change). Simply stated, the adjustment represents the cumulative difference (without regard to the statute of limitations) between the present and proposed methods. The IRC section 481(a) adjustment may increase income (positive adjustment) or decrease income (negative adjustment). In addition to the following example, see Exhibit (1) for a more detailed example of computing an adjustment under IRC section 481(a).

    Example:

    A taxpayer that is not required to use inventories uses the overall cash receipts and disbursements method and changes to an overall accrual method. The taxpayer has $120,000 of income earned but not yet received (accounts receivable) and $100,000 of expenses incurred but not yet paid (accounts payable) as of the end of the taxable year preceding the year of change. A positive IRC section 481(a) adjustment of $20,000 ($120,000 accounts receivable less $100,000 accounts payable) is required as a result of the change.

     

4.11.6.5.3  (05-13-2005)
Spread Periods for IRC Section 481(a) Adjustments

  1. A net positive IRC section 481(a) adjustment increases income and may be referred to as a "taxpayer-unfavorable" adjustment. A net negative IRC section 481(a) adjustment decreases income and may be referred to as a "taxpayer-favorable" adjustment. When a taxpayer uses a voluntary method change procedure (e.g., Rev. Proc. 97-27) or a regulation provision, generally a net negative IRC section 481(a) adjustment is taken into account in the year of change (pursuant to Rev. Proc. 2002-19 effective for years ending on or after December 31, 2001). A net positive IRC section 481(a) adjustment is taken into account over four years starting with the year of change. When the Service imposes a method change (involuntary method change) as a result of an examination, in general the entire net positive or negative IRC section 481(a) adjustment is taken into account in the year of change. See Rev. Proc. 2002-18 for involuntary method change procedures.

4.11.6.5.4  (05-13-2005)
Mandatory IRC Section 481(b) Tax Limitation Computation

  1. When the Service imposes a method change (involuntary method change) as a result of an examination and there is a net positive IRC section 481(a) adjustment in excess of $3,000, it is mandatory that IRC section 481(b) be applied. IRC section 481(b) provides a limitation on the tax under Chapter 1 of the Internal Revenue Code for the taxable year of change that is attributable to the adjustments required under IRC section 481(a) and Treas. Reg. section 1.481-1 if the entire amount of the adjustment is taken into account in the year of change. See Exhibit (2) for an example of tax computation under IRC section 481(b).

4.11.6.5.5  (05-13-2005)
Method Change Using the "Cut-off" Method

  1. The Commissioner may determine that certain changes in method of accounting will be made without an IRC section 481(a) adjustment using a " cut-off" method. Under a cut-off method, only the items arising on or after the beginning of the year of change (or other operative date) are accounted for under the new method of accounting. Any items arising before the year of change (or other operative date) continue to be accounted for under the taxpayer's former method of accounting. See, for example, IRC section 263A (which generally applies to costs incurred after December 31, 1986, for non-inventory property), IRC section 461(h) (which generally applies to amounts incurred on or after July 18, 1984), and IRC section 1.446-3 (which applies to notional principal contracts entered into on or after December 13, 1993). Because no items are duplicated or omitted from income when a cut-off method is used to effect a change in accounting method, no IRC section 481(a) adjustment is necessary. The cut-off may be used in a taxpayer-initiated method change only where specifically allowed or required by statute, regulation or by the Commissioner in published guidance.

4.11.6.6  (05-13-2005)
Procedures for Obtaining Consent

  1. A taxpayer may use the following procedures to obtain the required consent to change its method of accounting:

    1. Special procedures established by statutes, regulations or IRS publications

    2. Automatic consent procedures (Rev. Proc. 2002-9 and successors)

    3. Advance consent procedures (Rev. Proc. 97-27 and successors)

     

  2. Exhibit (3) summarizes the differences between the advance consent procedure and the automatic consent procedure.

  3. Exhibit (4) summarizes the citation for key terms and concepts used in the voluntary method change arena.

4.11.6.6.1  (05-13-2005)
Special Procedures Established by Statute, Regulations or IRS Publications

  1. Normally, a taxpayer uses the general automatic consent procedures (Rev. Proc. 2002-9 and successors) or the general advance consent procedures (Rev. Proc. 97-27 and successors) to request consent to change its method of accounting. In some instances, however, a statute, regulation or IRS publication may establish unique procedures, terms and conditions for obtaining consent to change a method of accounting. For example see IRC sections 174, 263A, 448, and 460 and the related treasury regulations. Thus, it is important that the examiner determine the authority being used to support the change in method of accounting.

4.11.6.6.2  (05-13-2005)
Voluntary Change - Advance Consent (Rev. Proc. 97-27 and Successors)

  1. Rev. Proc. 97-27 contains procedures for obtaining advance consent to change a method of accounting. In general, these procedures apply to all accounting method changes initiated by a taxpayer, except those accounting method changes that must be made under the automatic consent procedures (Rev. Proc. 2002-9 or successors) or special procedures established by statutes, regulations or IRS publications.

  2. The "advance consent" Revenue Procedure 97-27:

    1. Is effective for Forms 3115 filed on or after May 15, 1997.

    2. Requires payment of user fee.

    3. Requires Form 3115 to be filed with the Commissioner during year of change. For example, a calendar year taxpayer must file the Form 3115 from January 1st through December 31st of the year of change.

    4. Provides that taxpayer receive accounting method change ruling letter (consent) prior to implementing a method change.

    5. For years ending on or after December 31, 2001, the IRC section 481(a) adjustment period is four taxable years for a net positive adjustment for an accounting method change, and one taxable year for a net negative adjustment for an accounting method change. See Rev. Proc. 2002-19.

     

4.11.6.6.3  (05-13-2005)
Voluntary Change - Automatic Consent (Rev. Proc. 2002-9 and Successors)

  1. Rev. Proc. 2002-9 contains general procedures for obtaining automatic consent to change certain methods of accounting which are described in the Appendix of Rev. Proc. 2002-9 or subsequent pronouncements. These procedures are the exclusive procedures for obtaining consent to make any of these specific accounting method changes.

  2. The "automatic consent" Revenue Procedure 2002-9:

    1. Is effective for taxable years ending on or after December 31, 2001.

    2. Requires no user fee,

    3. Requires timely duplicate filing of the Form 3115,

      (i) The original Form 3115 must be attached to the timely filed (including extensions) return for the year of change. A copy of Form 3115 must be filed with Office of Chief Counsel no earlier than the first day of year of change, and no later than the date the original Form 3115 is filed with the timely filed federal Income Tax return. For example, a calendar year taxpayer who files its year X1 return (with proper extensions) on September 1, X2 may file a copy of the Form 3115 with the Office of Chief Counsel during the year of change, or no later than September 1, X2 to obtain consent to the change for the year X1.
      (ii) Under certain circumstances, an automatic six-month extension to file Form 3115 is granted from the due date of the return (excluding extensions) - [See Rev. Proc. 2002-9 section 6.02(2)(b)(i)].

       

    4. Provides that, if the taxpayer fully complies with the provisions of the revenue procedure, the taxpayer is "deemed" to have been granted consent for the requested method change and, if applicable, receives audit protection for years prior to year of change. See Rev. Proc. 2002-9 section 7,

    5. For taxable years ending on or after December 31, 2001, the IRC section 481(a) adjustment period is four taxable years for a net positive adjustment for an accounting method change, and one taxable year for a net negative adjustment for an accounting method change. See Rev. Proc. 2002-19,

     

  3. In determining whether an automatic method change was properly made, the examiner should first consider the automatic change revenue procedure in effect for the year the taxpayer made the change to verify the specific method change is included in the Appendix of the procedure. If not, the examiner should then check to see if the change was addressed in any subsequent pronouncement that modified the automatic consent procedure. Finally, the examiner should verify the taxpayer properly followed the terms and conditions for that specific change in the applicable procedures.

4.11.6.6.4  (05-13-2005)
Audit Protection Resulting from a Voluntary Method Change

  1. Most accounting method changes are granted with audit protection, which means that the Service will not require the taxpayer to change its method of accounting for the same item for a taxable year prior to the year of change. For example, a taxpayer has been using an impermissible method of accounting for several years for certain items. In 2003, the taxpayer files an application under Rev. Proc. 2002-9 to change to a proper method of accounting for such items. If the change is made with audit protection, the Service would not be able to propose an adjustment for the improper method of accounting for such items in an examination of an earlier taxable year. Rev. Proc. 97-27 section 9; Rev. Proc. 2002-9 section 7.

  2. The Service has provided specific exceptions to audit protection in some pronouncements. See, for example, the automatic consent procedures (Rev. Proc. 2002-9) which indicate that audit protection is not granted for specified method changes. Examiners should determine what method change was made and determine if audit protection was granted for that specific method change.

4.11.6.6.5  (05-13-2005)
Scope Limitations for Voluntary Method Changes

  1. In general - The scope limitations are the rules within a voluntary method change procedure that indicate when (in what circumstances) the taxpayer may or may not use such guidance to request a voluntary method change. For example, a scope limitation generally prohibits taxpayers from requesting consent for a method change once they have been contacted for examination. This scope limitation is subject to several exceptions, as discussed in (3), below.

  2. Waiver of scope limitations - In some instances, the scope limitations that would otherwise apply to a voluntary method change request may be waived by statute, regulation, or IRS publication. A scope limitation waiver may be limited to certain circumstances or to certain taxable years. For example, some procedures may indicate that scope limitations are waived unless the accounting method to be changed is an "issue under consideration," while other procedures may indicate that scope limitations are waived only for a certain taxable year or years. Accordingly, examiners need to review carefully the applicable guidance to determine the nature and extent of scope limitations applicable to a given voluntary method change request. See, for example, Treas. Reg. section 1.263(a)-4(p)(2); section 1.263(a)-5(n)(2); and Rev. Proc. 2004-23 section 4.01(1).

  3. Taxpayers under examination - The general rule (scope limitation) is that a taxpayer may not request a voluntary method change while under examination for any year. However, this general rule has the following exceptions:

    1. 90-day window - The taxpayer may file a Form 3115 within the first 90 days of a taxable year if (1) the taxpayer has been under examination for at least 12 consecutive months as of the first day of the taxable year, and (2) the method which the taxpayer seeks to change is not an issue under consideration or an issue that has been placed in suspense. This window allows taxpayers under continuous examination an opportunity to use the voluntary change procedures.

    2. 120-day window - The taxpayer may file a Form 3115 within the 120-day period following the date an examination ends, provided the change requested is not an issue under consideration or an issue that has been placed in suspense at the time the form is filed.

    3. Consent of director - If the taxpayer is under examination and is not in one of the two windows described above, they may request the examiner's permission (director consent) to submit a Form 3115. The team/group manager, as delegated by the director, will normally consent to the filing of the application unless the method of accounting to be changed would ordinarily be included as an item of adjustment in the year(s) for which the taxpayer is under examination. For example, a taxpayer changing from a proper method of accounting (to go to another proper method) would normally receive director consent because its proper method of accounting would not be an item of adjustment.

    4. Changes lacking audit protection - If a method change is (i) eligible for the automatic consent procedures (listed in the appendix of Rev. Proc. 2002-9 or elsewhere), and (ii) the description of the change indicates that the change is made without audit protection (for example, Rev. Proc. 2002-9, appendix section 4B.01), then the taxpayer may make the change, even if it is under examination. This allows the taxpayer to get on a proper method on a going-forward basis, but does not preclude the agent from pursuing the method as an audit issue in the back years, because no audit protection is given.

    5. Issue pending - A taxpayer under examination may make a voluntary change on a prospective basis without the benefit of audit protection for prior years if, at the time the Form 3115 is filed, the accounting method is an "issue pending" for any taxable year under examination. For this purpose, an issue is pending for any taxable year under examination if the Service has given the taxpayer written notification indicating an adjustment is being made or will be proposed with respect to the taxpayer's method of accounting. The issue pending exception was added by Rev. Proc. 2002-19.

     

4.11.6.6.6  (05-13-2005)
"Issue Under Consideration"

  1. "Issue under consideration" is a relevant concept when a taxpayer desires to make a voluntary method change and use the 90-day or 120-day windows found in the scope limitations of Rev. Proc. 97-27 or Rev. Proc. 2002-9. A taxpayer's method of accounting for an item is an issue under consideration for the taxable years under examination if the taxpayer receives written notification (for example, by examination plan, information document request (IDR), or notification of proposed adjustments or income tax examination changes) from the examining agent(s) specifically citing the treatment of the item as an issue under consideration. See Rev. Proc. 97-27 or Rev. Proc. 2002-9 for examples of what is an issue under consideration.

4.11.6.6.7  (05-13-2005)
Director Consent to File Form 3115 While Under Examination

  1. Nature of "director consent." The "director consent" provision allows a taxpayer under examination to file a Form 3115 (by obtaining "director consent" for such filing) when the taxpayer would otherwise be prohibited from filing a Form 3115.

    1. Director consent is consent to the filing of a Form 3115; it does not constitute approval of the method change request itself.

    2. Director consent does not constitute the consent of the Commissioner under IRC section 446(e) to change a method of accounting.

     

  2. When should the "Consent" be granted? The "Consent" should be granted in the following circumstances:

    1. When a change is requested from an impermissible method of accounting where the impermissible method was adopted in a year subsequent to the year(s) under examination; or

    2. When the taxpayer wants to change from a permissible method of accounting; or,

    3. When the examiner does not intend to raise a method of accounting issue for years under examination for the accounting method change requested by the taxpayer.

     

  3. How is a request for director consent processed? An examiner faced with a request for director consent from a taxpayer should do the following:

    1. If a taxpayer under examination wants to obtain the "Consent " to file a Form 3115, the taxpayer should be asked to put the request in writing.

    2. A copy of the Form 3115 (if available) that is the subject of the taxpayer's request should be attached to the taxpayer's request.

    3. If not otherwise provided on the Form 3115 presented, the taxpayer should be requested to provide the following information with the request:
      (1) Description of the method of accounting the taxpayer is changing from.
      (2) Description of the method of accounting the taxpayer is changing to.
      (3) The tax years currently under examination.
      (4) The examiner's name and telephone number.
      (5) The year of change requested by the taxpayer.
      (6) The reason(s) for requesting the method change.
      (7) The entity for which the method change is being requested (e.g. Parent or specific subsidiary)
      (8) What authority is being used by the taxpayer for the requested method change (e.g. Rev. Proc. 97-27, Rev. Proc. 2002-9, regulation, etc.)
      (9) If Rev. Proc. 2002-9 is being used, the specific Appendix section that is the basis for the method change requested including the assigned method change number found in the instructions to the Form 3115.
      (10) If a pronouncement is the authority (such as a Rev. Proc., Rev. Rul, or regulation section, etc.) the specific cite to such pronouncement should be obtained. (e.g., Rev. Rul. 2002-46)

    4. The request should be processed as expeditiously as possible as this involves coordination between the taxpayer, Area office, or National Office Chief Counsel.

    5. The request should be routed through the examiner to the team manager or group manager with the Form 3115 and a completed Summary Worksheet (see Exhibit 5) with a recommendation of response ("objection" or "non-objection" ). Note that each area may establish its own procedure as to the physical flow of the request from the taxpayer.

    6. If there are questions about the request, call your Area's technical coordinator or the LMSB Change in Accounting Method (CAM) Technical Advisor.

     

  4. Who should sign the "letter" ? In