L.A. Bar Tax Section Members Comment on Changes in Accounting Method

Contact Persons:

The 2005-2006 IRS Priority Guidance Plan and IRS Notice 2005-97 propose to readdress some of the concepts regarding what constitutes a change in a method of accounting and what types of accounting method changes should be eligible for the automatic consent procedures. To further this end, this paper offers two separate and distinct, but related, proposals that the authors believe would alleviate tax controversy, reduce administrative burden, and promote sound tax administration and compliance: (1) clarifying the automatic consent procedure to include allowing as an automatic change all impermissible to permissible methods for the substantive areas of change enumerated in Revenue Procedure ("Rev. Proc.") 2002-9 and in the forthcoming Revenue Procedure; or (2) including an example in the revised regulations under Internal Revenue Code ("I.R.C.") § 446 modeled after Revenue Ruling ("Rev. Rul.") 58-74.

Proposal 1 recommends that the IRS clarify the automatic consent procedures of Rev. Proc. 2002-9 for taxpayers wishing to change from any impermissible to a permissible method of accounting for substantive areas of change enumerated in Rev. Proc. 2002-9 where the guidance currently provides the change must be from a permissible method to a permissible method. This paper proposes including this change in the IRS' update to Rev. Proc. 2002-9, even where the guidance is specific that the change has to be from a permissible to a permissible method.

Proposal 2 recommends that Treasury include the fact pattern of Rev. Rul. 58-74 in the final Treasury Regulation ("Treas. Reg.") § 1.446-1(e)(2). Rev. Rul. 58-74 is a long-standing and taxpayer relied upon example of what is not a change in or adoption of a method of accounting and its inclusion would add additional certainty to the area.

Both proposals should alleviate tax controversy, reduce unnecessary administrative burden and promote tax compliance, thereby permitting the reallocation of valuable IRS and taxpayer resources away from accounting issues involving short-term timing differences. These policy reasons should create substantial incentive for the IRS to consider the adoption of the proposals contained herein.

The Internal Revenue Service ("IRS") and the Treasury Department ("Treasury") through Notice 2005-97 have requested public comments on possible changes to Revenue Procedure ("Rev. Proc.") 2002-9, as clarified, modified and/or amplified by more recent guidance.³ One of the issues specifically identified for comment was whether any accounting method changes currently ineligible for the automatic consent procedures outlined in Rev. Proc. 2002-9 should be made eligible for automatic consent. This paper proposes clarifying the automatic consent procedure to include allowing as an automatic change the change from any impermissible method to any one of the permissible methods enumerated in Rev. Proc. 2002-9 and in the forthcoming Revenue Procedure.⁴ While the revenue procedure already generally allows impermissible to permissible changes, there are a few areas in the guidance that specify the allowed changes are only those from permissible to permissible methods. Those provisions should be clarified and expanded to make clear that any change from any impermissible method to a permissible method is allowed under the guidance without limitation of scope.

In addition, the IRS and Treasury have included on their 2005- 2006 Priority Guidance Plan, the revision of Internal Revenue Code ("I.R.C.")⁵ § 446, the definition of an accounting method and the determination of when a taxpayer has changed its method of accounting. Revenue Ruling ("Rev. Rul.") 58-74 is a long-standing ruling addressing a specific fact pattern under which the taxpayer may correct for the erroneous exclusion of certain I.R.C. § 174 expenses costs via the filing of amended returns. This paper proposes the inclusion of the factual pattern presented in Rev. Rul. 58-74 in the revised I.R.C. § 446 regulations as an example of a situation that does not constitute a change in accounting method.

II. PROPOSAL 1 -- EXPANSION OF THE AUTOMATIC CONSENT PROCEDURES

Rev. Rul. 90-38 specifically addressed the issue of using an impermissible method for two or more years. The Ruling notes that unless the Commissioner consents, a taxpayer, who has used an impermissible method for two or more years, may not retroactively change from that method of accounting by amending prior year returns, even if the period for amending the return for the first year in which the erroneous method was used has not expired.¹¹

B. Proposed Change to Rev. Proc. 2002-9

For example, it is recommended that Appendix § 2A regarding research and experimental expenditures be clarified. The provision allows for taxpayers to change from: (1) § 174(a) treatment to § 174(b) treatment, or visa versa; (2) § 174(b) treatment to a different period of amortization; or (3) §§ 174(a) or 174(b) treatment to § 263(a) treatment, or visa versa. A simple clarification is needed that any impermissible method for research and experimentation expenditures may be changed to one of the specified allowable methods.

The proposed change would provide an administratively clearer means for taxpayers to effectuate a change from an impermissible accounting method to a permissible method without requiring prior consent of the IRS.¹⁵ This proposal would not remove this type of change from the definition of a "change in accounting method," but rather, it would allow taxpayers to utilize the IRS' long established automatic consent procedures to adopt such a change. Such a procedure would reduce the administrative burden for both the IRS and taxpayers alike undertaking the accounting method change.¹⁶

III. PROPOSAL 2 -- REV. RUL. 58-74 INCLUSION IN FINAL I.R.C. § 446 REGULATIONS

The taxpayer in Rev. Rul. 58-74 deducted its research and experimental expenditures under IRC § 174(a).¹⁹ The taxpayer, however, failed to include certain qualifying expenses in its deduction, perhaps due to the difficult factual analysis required to determine whether certain actions met the I.R.C. § 174 definitions. Neither the dollar amount nor the number of years is described in the ruling.

The ruling concluded that the taxpayer must file amended returns to claim the additional expenses for the years in which those expenses were omitted.²⁰ The ruling stated that the failure to include the expenses in the original return as I.R.C. § 174 expenses did not amount to a change in method of accounting.²¹

The Court of Claims held that the taxpayer could file amended returns to correct for this error.²⁵ The Court cited to Rev. Rul. 58-74 as support for the proposition that the taxpayer had adopted a method of accounting for all of its installment sales and that the error could only be corrected via the filing of an amended return.²⁶

The IRS held in Rev. Rul. 90-38 that it would not follow Gimbel to the extent that it conflicts with the conclusions of that ruling.

The taxpayer in this ruling deducted its software development costs pursuant to Rev. Proc. 69-21 and did so from 1969 through 1985. In 1986, the taxpayer, for financial reporting purposes, began to capitalize software development costs for projects expected to cost more than $100,000.²⁹ The taxpayer made no adjustments for its tax return and, thus, capitalized these costs for tax purposes as well. The taxpayer continued in this manner for tax years 1986 through 1990, inclusive.

The taxpayer realized the error when preparing its 1991 tax return. The taxpayer filed amended returns for 1988, 1989, and 1990 seeking to deduct all of the software development costs for those tax years. Taxpayer's tax years 1986 and 1987 were closed by statute.

The IRS ruled that the taxpayer had changed its method of accounting. The IRS disagreed with the taxpayer that a posting error had occurred because: (a) the "degree of variance [i.e., the percentage capitalized as compared to the percentage deducted] from the taxpayer's original method of deducting currently all its software development costs is far too great to be a mere posting error;" and (b) the taxpayer consistently treated the development costs as capital expenditures for 5 years. Also of importance to note is that the first two years at issue were closed by statute.

The IRS addressed Rev. Rul. 58-74, but stated that it did not apply to this factual situation because this taxpayer had changed its method of accounting. The IRS also noted that Rev. Rul. 58-74 did not address the total amount of costs at issue, nor did it make a comparison of the amount that the taxpayer failed to deduct.³⁰

The taxpayer in Rev. Rul. 58-74 adopted a method of accounting by deducting its I.R.C. § 174 expenses. The taxpayer indicated its intention to continue using this method by continuing to deduct I.R.C. § 174 expenses, but inadvertently excluded certain qualifying expenses. The taxpayer has not adopted a new method, nor has the taxpayer changed its method. Instead, the taxpayer has made an error.

The proposed example clearly differentiates between factual situations based on two critical criteria: (a) whether all impacted years are within open statutes of limitation; and (b) whether the taxpayer committed an error as opposed to adopting or changing its method of accounting.

IV. PROBLEMS ADDRESSED BY THE PROPOSED CHANGES

The IRS' overriding objective with respect to the adoption and/or the change of accounting methods should be to facilitate the use of a correct and permissible accounting method that clearly reflects the taxpayer's federal taxable income, thereby resulting in the proper determination of a taxpayer's federal tax liability.

The changes proposed in this paper would improve the current Federal tax system by providing simplicity and certainty for the IRS and taxpayers. The limitation of potential controversy on this issue would maximize valuable IRS resources by shifting them to pursue more significant items, rather than focusing on short-term timing differences. In addition, the IRS' adoption of these proposals would ensure the stability of the consent requirement as a means of promoting the usage of proper accounting methods, while simultaneously reducing the administrative burden on the IRS and taxpayers of granting and securing consent to change its accounting method under these limited sets of circumstances.

V. MERITS OF THE PROPOSALS

The proposals are worthy of consideration by the IRS and Treasury.

The clarification of the automatic consent procedures will allow taxpayers to more easily adopt a permissible method of accounting enumerated in Rev. Proc. 2002-9 and the IRS to more readily monitor the change. The inclusion of the Rev. Rul. 58-74 fact pattern will reinforce the validity of that ruling.

The adoption of these proposals will encourage taxpayer compliance with permissible accounting methods.

These proposals provide reasonable solutions to common taxpayer problems. Many factors can lead to inadvertently adopting an impermissible method of accounting or erroneously excluding expenses or income from an adopted method of accounting. These proposals enable taxpayers to efficiently correct those errors and provide comfort to the IRS that taxpayers will correct the errors in a transparent and monitorable manner.

Lastly, these proposals are reasonable and administratively simple. The IRS' automatic consent procedure already exists, and its success is accepted by the IRS, taxpayers and practitioners. The proposed example merely documents clearly established principles.

VI. IMPORTANT COLLATERAL CONSEQUENCES

These proposed changes would not contravene the rules established in prior guidance. For instance, the first proposal simply proposes to clarify an automatic consent procedure for a taxpayer wishing to change from an impermissible accounting method to a permissible one listed in Rev. Proc. 2002-9.

With respect to proposal 2, the example would clearly identify a situation wherein the taxpayer has not adopted a method of accounting. As such, the example would not contravene existing guidance.

VII. PROPOSAL IS POLITICALLY & ECONOMICALLY FEASIBLE

The proposed changes should not result in a substantial decrease in federal tax revenue since the proposal simply: (a) recommends clarifying the automatic consent procedures for situations where a taxpayer wishes to change from any impermissible method of accounting to a specified permissible method of accounting; and (b) recommends including as an example of what is not a change in method of accounting a well-established and taxpayer relied-upon scenario. The proposed changes would limit controversy on these issues and allow the IRS to pursue more material substantive matters with its scare resources, instead of focusing on short-term timing issues.

² Although the participants on the project might have clients affected by the rules applicable to the subject matter of this paper and have advised such clients on applicable law, no such participant has been significantly engaged by a client to participate in this project.

³ The IRS and Treasury also included this issue on the 2005-2006 Priority Guidance Plan. All future references to Rev. Proc. 2002-9, unless otherwise stated, will also include the reference to any additional Revenue Procedures clarifying, modifying, and/or amplifying Rev. Proc. 2002-9.

⁴ The IRS and Treasury intend to issue an updated Revenue Procedure, which will consolidate and update, as necessary, the guidance on this issue. This paper proposes changes for the IRS and Treasury to consider in drafting the updated Revenue Procedure.

⁵ All references to the I.R.C. are to the Internal Revenue Code of 1986, as amended.

⁶ I.R.C. § 446(e) (2005).

⁷ Treas. Reg. § 1.446-1 (2005).

⁸ See Temp. Treas. Reg. § 1.446-1T(e)(2)(iii), Examples (1), (6), (7), (8), (11), (14).

⁹ See Rev. Rul. 90-38, 1990-1 C.B. 57 (April, 30, 1990). See also Diebold, Inc. v. U.S., 891 F.2d 1579 (Fed. Cir. 1989).

¹⁰ See Rev. Proc. 97-27, 1997-21 I.R.B. 11 (May 27, 1997). Generally, a method of accounting is adopted with consistent treatment i.e. the use of an impermissible method for 2 or more years; however, if a taxpayer treats an item correctly in the first return that reflects the item, it has adopted that accounting method despite the lack of consistent treatment for more than one year.

¹¹ Rev. Rul. 90-38, 1990-1 C.B. 57 (April 30, 1990).

¹² I.R.S. Notice 2005-97 (December 6, 2005).

¹³ Rev. Proc. 2002-9, 2002-1 C.B. 327 (January 8, 2002).

¹⁴ Office of Tax Policy and Internal Revenue Service, 2005-2006 Priority Guidance Plan, Tax Accounting, Item 11 (August 8, 2005).

¹⁵ The IRS adopted the first automatic consent revenue procedure, Rev. Proc. 97-37, in part as a means to solve the existing backlog and resource constraint problems at the IRS National Office. Rev. Proc. 97-37 sought to alleviate the administrative burden of approving Form 3115 for changes that would likely be routinely approved by the IRS. See Conjura, Carol and Zuber, Timothy. New Rev. Proc. for Automatic Accounting Method Changes Goes a Long Way Toward Simplification, Journal of Taxation (March 2002).

¹⁶ Deborah Nolan, Commissioner of the IRS Large and Midsize Business (LMSB) Division, noted that ",,, the LMSB's priorities for 2005 include increased audit coverage . . . [and] increased efficiency." See 2005 TNT 14-3 , Nolan Gives First Glimpse of LMSB Compliance Assurance Pilot Program (January 24, 2005). This proposal would aid the IRS in achieving both of these goals.

¹⁷ See Rev. Rul. 90-38, 1990-1 C.B. 57 (April 30, 1990). See also Rev. Proc. 2004-11, 2004-3 I.R.B. 311 (January 20, 2004).

¹⁸ Rev. Rul. 58-74, 1958-1 C.B. 148 (January 1958).

¹⁹ Once adopted, this treatment is binding, is inclusive of all such expenditures as to the projects involved, and cannot be changed without the prior consent of the IRS. See I.R.C. § 174(a)(3).

²⁰ The IRS has cited to Rev. Rul. 58-74 for this proposition. See, e.g., NSAR 010428, Vaughn #10428.

²¹ Some commentators have referred to this exception as the "Error-within-a-Method Exception," a version of the posting error exception in the Treasury Regulations. See Laughlin, Felix B. and Dale, Kathleen C., Accounting Methods -- Which Retroactive "Corrections" Require IRS Consent, 56 Tax Law. 101 (Fall 2002). In other words, the taxpayer has adopted a method of accounting, but has made classification errors within that method of accounting.

²²Gimbel Brothers, Inc. v. U.S, 210 Ct. Cl. 17 (1976).

²³ Id. at 20.

²⁴ Id.

²⁵ Id. at 30-34.

²⁶ Id.

²⁷ Tech. Adv. Mem. 94-21-003 (February 4, 1994).

²⁸ Pursuant to I.R.C. § 6110(k)(3), a technical advice memorandum may not be relied upon or cited to as precedent.

²⁹ The taxpayer estimated that this represented at least two-thirds of its software development costs. The IRS contended that this represented ninety percent of the software development costs.

³⁰ The ruling also reiterates the statement from Rev. Rul. 90-38 that the IRS will not follow Gimbel Brothers, Inc.