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Is a Change in
Characterization an Accounting-Method Change?
Taxpayers periodically assess the
validity of their tax positions. Financial Accounting Standards Board
Interpretation No. 48, Accounting for
Uncertainty in Income Taxes, has made this assessment even more detailed,
and the questions have become more probing. This increased awareness has many
companies in a quandary as to how to address uncertain tax positions. While the
issue is not new, taxpayers still are asking: Is a change in characterization an accounting-method change?
Effect of Classification Whether
the treatment of an item is classified as an accounting method is pivotal,
because such classification dictates how changes in the method can be made. If
the treatment is deemed an accounting method, the taxpayer must seek IRS
permission before computing taxable income under a new method; see Sec. 446(e).
The Service automatically grants consent for certain method changes, but Form
3115, Application for Change in Accounting Method, generally still must be
filed to request the change; see Rev. Proc. 2002-9. In
determining whether to file Form 3115, a taxpayer should consider the
likelihood that the request will be approved. Also, taxpayers under audit
might, depending on the circumstances, be restricted by the rules applicable to
method changes while under audit. Another issue is whether the company can take
a financial statement benefit for a position. There are many strategic issues
to consider; at the forefront is whether a method change exists. The
uncertainty as to whether treatment of an item is an accounting method is
particularly problematic if the treatment is erroneous. If the treatment is an
accounting method, the taxpayer, by filing Form 3115 at the appropriate time,
can secure audit protection with a current year of change and a spread of the
unfavorable Sec. 481(a) adjustment; see Rev. Proc.
2002-9. However, if a taxpayer files Form 3115 and the IRS determines that the
treatment is not an accounting method, it generally will adjust taxable income
in prior open years. In light of this risk, the taxpayer needs to undertake
prudent analysis and consideration of the potential positions.
What Is an Accounting Method? Accounting
methods often are thought of as the overall method of accounting employed
(e.g., the overall accrual accounting method). But an accounting method can be
any method that affects the timing of income or deductions. Strictly speaking,
a change in accounting method includes a change in the treatment of any
material item used in the overall plan of accounting for gross income or
deductions. A material item is any item that involves the proper time for the
inclusion of the item in income or the taking of a deduction. The
courts have concluded that if the treatment of an item does not affect a
company’s lifetime income, the treatment
of the item is a timing issue and is classified as an accounting method; see,
e.g., Wayne Bolt & Nut Co., 93 TC
500 (1989). Conversely, the treatment of an item that does affect a company’s
lifetime income has been held not to be an accounting method; see, e.g., Schuster’s Express, Inc., 66 TC 588
(1976). One broad class of items affecting a company’s lifetime income is a
change in characterization, such as a change from treating an item as taxable
income to treating it as excluded income with a basis reduction. The
characterization issue has triggered significant disagreement between tax
practitioners and the government. The Service disagrees with the assertion that
a change of characterization is not a change of accounting method, arguing that
such a position would allow many taxpayers to change how they treat material
items without requesting IRS permission. Case law is divided on whether a
change in character is a method change requiring approval; compare Florida Progress Corp., 156 FSupp2d 1265
(MD FL 1999), Underhill, 45 TC 489
(1966), and Coulter Electronics, Inc.,
TC Memo 1990-186, with Johnson, 108
TC 448 (1997), and Firetag, TC Memo 1999-355. One particularly
controversial change affects basis adjustments. Saline Sewer: In Saline Sewer Co., TC Memo 1992-236, the Tax Court considered
whether changing the treatment of fees received from nontaxable Sec. 118
contributions to capital, to taxable customer connection fees, was an
accounting-method change. The court concluded it was not a method change,
stating that the depreciation and income issues had to be analyzed separately
and not collapsed into one event when deciding whether timing was affected. The
court separated the issue into distinct items and did not consider the effect
of the characterization of the contributions on depreciation. The
taxpayer in Saline Sewer previously
had been treating fees received as nontaxable Sec. 118 contributions to capital
and had reduced the assets’ bases by the fees. Because of this treatment, the
taxpayer was forgoing the opportunity to depreciate the basis it had reduced.
Subsequently, the Service changed the taxpayer’s treatment, requiring that the
fees be included in taxable income when earned, rather than reducing basis.
Under this treatment, the taxpayer had a higher basis in the property that was
depreciated over the property’s depreciable life. The
Tax Court determined that the restoration of the depreciable basis was not a
timing issue, stating that “when the depreciable basis of assets is decreased,
a corresponding amount of depreciation expense is permanently forfeited.” With
that approach, the court refused to combine the two effects of the change
(i.e., inclusion of fees in income and increase in depreciable basis of
property purchased with the money). The
court concluded that neither the income nor the depreciation issues, when
looked at independently, involved timing. Specifically, it stated that the
failure to report the contributions as income did not involve a timing issue,
because the excluded income would never be reflected in the taxpayer’s lifetime
income. Accordingly, the court concluded the change was a change in
characterization, not an accounting-method change. While
Saline Sewer is not a new
development, reliance on the conclusions set forth therein continues to be a
contentious position. The Service informally has stated that it would like to
issue guidance on the subject, but it is uncertain when it may be published. In
Rev. Proc. 91-31, the IRS determined that a change in treatment of customer
deposits, from treating them as taxable when received to treating them as
nontaxable until applied against a future invoice, was
an accounting-method change. Utility companies often receive deposits from
customers to protect them from the risk of nonpayment. Before 1990, some
companies treated these deposits as taxable income. The Supreme Court, in Indianapolis Power & Light Co., 493 Rev.
Proc. 91-31 took the position that such change in treatment is an
accounting-method change and prescribed an automatic procedure for implementing
it. While Saline Sewer involved an
exclusion resulting in a basis reduction, no basis reduction was involved in
Rev. Proc. 91-31 and, thus, no depreciation was forgone. Rev.
Proc. 97-27 originally contained the following language:
After
criticism from commentators, this section was later deleted from the procedure.
The Service indicated that it agreed to delete this statement because it was
not directly relevant to the content of Rev. Proc. 97-27. While the IRS backed
off from the issue by removing the statement, it did not concede the issue, and
future guidance could be published.
Observations Several
cases have held that a change in characterization of a transaction is not an
accounting-method change, while other cases have held to the contrary. In light
of this potential conflict, it is very important to analyze carefully the
precise change of characterization at issue, and the surrounding context,
before deciding how to proceed in a particular situation.
From Jessica Rancher, CPA, |
