IRS Eases Rules for Accounting-Method Changes

The IRS released Rev. Proc. 2002-19, which makes two significant modifications to Rev. Procs. 2002-9 and 97-27. Taxpayers receive much more favorable terms and conditions for changing an accounting method, and the rules governing taxpayers under examination, before an Appeals office or a Federal court are liberalized. Taxpayers may now deduct the entire amount of negative Sec. 481(a) adjustments (i.e., favorable adjustments that reduce taxable income) in one tax year, while previously they generally had to spread all their Sec. 481(a) adjustments over four tax years.

The IRS still permits taxpayers to spread positive Sec. 481(a) adjustments (i.e., unfavorable adjustments that increase taxable income) ratably over four tax years. Also, taxpayers currently under examination, before an Appeals office or a Federal court, that have an "issue pending" can now make accounting-method changes, but only on a prospective basis and without any audit protection. Pursuant to Rev. Proc. 2002-19, an issue is pending if the IRS has given the taxpayer written notification that an adjustment is being made or that an adjustment will be processed, even though the IRS has not yet determined the amount of the adjustment.

Effective Date

Rev. Proc. 2002-19 generally is effective for tax years ending on or after Dec. 31, 2001. However, for changes involving the elimination of the scope restrictions for pending issues, the revenue procedure is effective for tax years ending on or after March 14, 2002, if the change is made under Rev. Proc. 97-27's nonautomatic procedures.

To the credit of the IRS National Office, the IRS is expected to publish a notice clarifying that a taxpayer that has a Form 3115, Application for Change in Accounting Method, for a favorable method change pending on March 14, 2002, which was filed under Rev. Proc. 97-27 (but not under Rev. Proc. 99-49) for a tax year that ended prior to Dec. 31, 2001, will be permitted to "roll" the year of change forward so it may benefit from the one-year spread of the Sec. 481(a) adjustment provided in Rev. Proc. 2002-19. To obtain this treatment, it is expected that a taxpayer would merely need to notify the IRS individual processing the taxpayer's Form 3115 that it wants to roll forward the year of change.

In addition, it is expected that the IRS notice will permit a taxpayer that filed a Form 3115 for a favorable method change under Rev. Proc. 97-27 (but not under Rev. Proc. 99-49) for a tax year that ended on or after Dec. 31, 2001, to take the entire amount of the negative Sec. 481(a) adjustment in one year, even if the IRS consent letter has already been issued to the taxpayer. It is expected that despite the four-year-spread period provided for in the ruling granting the method change, the taxpayer would simply take the entire amount of the Sec. 481(a) adjustment into account on its return for the year of change.

Background

Rev. Procs. 2002-9 and 97-27, respectively, provide automatic and nonautomatic procedures by which taxpayers make voluntary accounting-method changes. Under these revenue procedures, generally all positive and negative Sec. 481(a ) adjustments that result from accounting-method changes were required to be spread over four tax years. Additionally, taxpayers under examination, before an Appeals office or a Federal court, were generally not permitted to change an accounting method for a pending issue.

One-Year-Spread Transition Rules

When a taxpayer has already filed Form 3115 with the IRS National Office, filed its return for the year of change or both, it must satisfy certain requirements to benefit from the one year-spread period for a net negative Sec. 481(a) adjustment:

Form 3115 already filed under Rev. Proc. 2002-9/return filed before April 15, 2002. A taxpayer that has filed a Form 3115 with its return for a tax year ending on or after Dec. 31, 2001, that resulted in a net negative Sec. 481(a) adjustment, had to, on or before April 15, 2002:

1. Complete and file a revised Form 3115 in duplicate, reflecting the one-year Sec. 481(a) adjustment period;

2. Attach the original form to the amended return, which must be filed no later than Sept. 10, 2002;

3. File the copy of the revised Form 3115 with the IRS National Office no later than when it files the amended return; and

4. Label both the original Form 3115 (attached to the amended return) and the copy (filed with the IRS National Office) with "Substitute Application under Rev. Proc. 2002-19."

If the taxpayer does not file a revised Form 3115, the four-year adjustment period will apply to the net negative Sec. 481(a) adjustment.

Form 3115 filed under Rev. Proc. 2002-9/return not yet filed. A taxpayer that has filed a Form 3115 with the IRS National Office for a tax year ending on or after Dec. 31, 2001, that resulted in a net negative Sec. 481(a) adjustment, and had not filed its return by April 15, 2002, must:

1. Complete and file a revised Form 3115 in duplicate, reflecting the one-year Sec. 481(a) adjustment period;

2. Attach the revised original Form 3115 to its timely filed original return for the year of change;

3. File the copy of the revised Form 3115 with the IRS National Office no later than when it files its original return; and

4. Label the copy of the revised Form 3115 filed with the IRS National Office with "Substitute Application under Rev. Proc. 2002-19."

If the taxpayer does not file a revised Form 3115, the four-year adjustment period will apply to the net negative Sec. 481(a) adjustment.

Form 3115 filed under Rev. Proc. 97-27. A taxpayer that filed a Form 3115 with the IRS National Office for a tax year ending on or after Dec. 31, 2001, which resulted in a net negative Sec. 481(a) adjustment that is still pending on March 14, 2002, must:

1. Take the entire net negative Sec. 481(a) adjustment into account in the year of change, unless it notifies the IRS National Office before the later of April 30, 2002, or the IRS's issuance of a letter ruling granting consent to the method change; and

2. Make appropriate modifications to the Form 3115 application to comply with Rev. Proc. 2002-19.

Prospective Change Transition Rules

Form 3115 not yet filed under Rev. Proc. 2002-9/return filed. A taxpayer under examination, before an Appeals office or a Federal court, that has filed its return on or before April 15, 2002, for a tax year ending on or after Dec. 31, 2001, that wants to change its accounting method for a pending issue must:

1 Complete and file a Form 3115 in duplicate;

2. Attach the original Form 3115 to its amended return for the year of change, which it must file no later than Sept. 10, 2002; and

3. File the copy of Form 3115 with the IRS National Office no later than when it files its amended return.

Observations.

Transition rule for 90-day or 120-day window filers or taxpayers subsequently contacted for examination: Rev. Proc. 2002-19 does not expressly address a situation in which a taxpayer filed Form 3115 either in a 90-day or 120-day window period and the taxpayer is not in a window period when it files a revised Form 3115 under the transition rules of Rev. Proc. 2002-19. Since the procedure does not expressly require the taxpayer to be in a window period when it files the revised Form 3115, it implicitly allows the taxpayer to file the form without regard to the taxpayer's current status, as long as the taxpayer was in a window period when it filed the original.

Similarly, the procedure does not expressly address the situation in which the taxpayer was not under examination when it originally filed Form 3115, but has since been contacted for examination. As such, the procedure implicitly allows the taxpayer to file a revised Form 3115 without regard to the taxpayer's current status, as long as the taxpayer was not under examination when it filed the original.

Estimated tax payments: Because Rev. Proc. 2002-19 permits taxpayers to take net negative Sec. 481(a) adjustments into account in one tax year, a taxpayer that reduces its 2001 taxable income on account of the Sec. 481(a) one-year-spread-period adjustment may have overpaid its 2001 estimated taxes. The time for filing expedited estimated tax refunds has expired for calendar-year taxpayers; taxpayers had to have filed the claim no later than March 15, 2002 (the return's original due date (without extensions)). However, taxpayers with fiscal years ending in 2002 are still eligible to file for an expedited refund of estimated taxes if the original due date of the return (without extensions) has not yet passed.

In addition, as a result of the new one-year spread for net negative Sec. 481(a) adjustments, calendar-year taxpayers that filed an extension for their 2001 returns had only until March 15, 2002, to adjust any payment of tax due for 2001. These taxpayers may have overpaid, and Rev. Proc. 2002-19 does not appear to provide any relief for them.

Other considerations: Taxpayers with a tax year that ended before Dec. 31, 2001 and that filed a Form 3115 under Rev. Proc. 97-27's nonautomatic procedures for a favorable method change that (1) received the ruling letter before March 14, 2002 and (2) have not yet filed their return, should consider postponing the year in which they make the change to their first tax year ending on or after Dec. 31, 2001. Taxpayers may receive more net-time-value benefit by making the change in the later tax year because of the ability to deduct the entire Sec. 481(a) adjustment in the year of change, rather than spreading it over a four-year period beginning one tax year earlier. Because a method change is not effective unless the taxpayer actually makes the change on its return, taxpayers in this situation can file their return for the year of change under the "old" method, and then file a new Form 3115 for their first tax year ending on or after Dec. 31, 2001. Arguably, taxpayers that have already filed their return for the year of change that are still within the period for timely filing the return (including extensions) could also timely file a substitute original return without making the method change. Taxpayers who receive a consent letter that do not make the change may have to show unusual or compelling reasons why the IRS should consider granting the request for the later tax year. There is no guarantee that the IRS National Office will agree; however, it would appear that the expected IRS notice clarifying the transition rules and scope requirements of Rev. Proc. 2002-19 may resolve this issue.

Taxpayers with a tax year that ended before Dec. 31, 2001, that were considering filing a Form 3115 under Rev. Proc. 99-49's automatic procedures for a favorable method change, but have not yet done so, should also consider making the change for the following year, to take advantage of the one-year Sec. 481(a) adjustment period. Taxpayers that have already filed a copy of the Form 3115 with the IRS National Office under Rev. Proc. 99-49 may also be able to postpone the year of change to their first tax year ending on or after Dec. 31, 2001 (provided the return's extended due date has not passed). However, taxpayers in this situation would have to file Form 3115 under the Rev. Proc. 97-27 nonautomatic procedures and may have to show unusual or compelling reasons why the IRS should consider granting the request for the later tax year. There is no guarantee that the IRS National Office will agree; however, it would appear that the expected IRS notice clarifying the transition rules and scope requirements of Rev. Proc. 2002-19 may resolve this issue. Arguably, taxpayers in this situation will not be using hindsight, because they have not yet filed a return and should not be put in a less favorable position than similarly situated taxpayers that have not yet filed a copy of Form 3115 with the IRS National Office.

Taxpayers currently under examination that merely have an issue under consideration (as defined in Rev. Procs. 2002-9 and 97-27) now appear to be in a less favorable position than taxpayers that have an issue pending, and would not be permitted to make accounting-method changes on a prospective basis without any audit protection under Rev. Proc. 2002-19. Again, the expected IRS notice clarifying the transition rules and scope requirements of Rev. Proc. 2002-19 may resolve this incongruous result.

From Paul K. Gibbs, CPA, and Carolyn Ossen, J.D., Washington, DC