IRS Guidance on the Nonaccrual Experience Method of Accounting

In Notice 2003-12, the IRS provided interim guidance to taxpayers seeking to change to, or from, the nonaccrual experience (NAE) method of accounting under Sec. 448(d)(5). The NAE method permits certain service providers to exclude amounts from gross income that, based on experience, they do not expect to collect (based on a formula that takes into account the history of uncollected receivables relative to total receivables). The Service released Notice 2003-12 pending the issuance of final regulations. Taxpayers can rely on the notice until the Service issues final regulations, which will probably include the rules in the notice. Notice 2003-12 is effective for tax years ending after March 9, 2002.

Sec. 448(d)(5) provides that, in the case of any taxpayer using an accrual method for amounts received from performing services, it does not have to accrue any portion of such amounts, which, on the basis of its experience, it does not expect to collect (NAE method). Temporary regulations under Sec. 448 were promulgated in June 1987 and included various alternative methods for computing experience. These regulations (the original temporary regulations) were withdrawn and supplanted in April 1988 by temporary regulations (amended temporary regulations) currently in effect.

Six-year moving average. Temp. Regs. Sec. 1.448-2T(e)(2) replaced the methods permitted under the original temporary regulations in determining which amounts a taxpayer is not required to accrue under Sec. 448(d)(5), with a six-year moving-average formula method. Under this method, a taxpayer computes its uncollectible amount by multiplying its year-end accounts receivable balance by the ratio of the total bad debts of accounts receivable sustained during the current year and five preceding tax years (adjusted for recoveries of bad debts during the same period) to the sum of the accounts receivable earned (i.e., the total sales resulting in accounts receivable) during the same six-year period.

Black Motor formula. It soon became apparent, however, that the six-year moving-average formula often understated many taxpayers actual bad-debt experience. This problem was illustrated in Hospital Corp. of America (HCA), 107 TC 116 (1996), in which the taxpayer used a method known as the Black Motor formula (after Black Motor Co., 125 F2d 977 (6th Cir. 1942)), to compute its bad-debt experience for its 1987 and 1988 tax years.

Under this formula, a taxpayer computes its experience by multiplying its year-end accounts receivable balance by the ratio of total bad debts sustained during the current year and the five preceding tax years (less recoveries of bad debts during the same period) over the sum of the accounts receivable balance at year-end for the same six-year period.

The Black Motor formula was included in the original Sec. 448(d)(5) temporary regulations as a way to compute bad-debt experience, but was replaced in the amended temporary regulations with the generally less favorable six-year moving-average method (which requires a taxpayer to use total sales versus year-end accounts receivable in determining its uncollectible experience).

In response to the IRSs challenge of its use of the Black Motor formula to compute its bad debt for the years at issue as contrary to the regulations, the taxpayer asserted that the latter method was contrary to statutory intent and that the former method produced a more accurate reflection of its experience. Moreover, the taxpayer argued, the former method was the impetus behind the enactment of the NAE method. The court, however, ruled that the Services method was a reasonable interpretation of the statute and disallowed the taxpayers use of the Black Motor formula to determine its experience.

JCWAA. Section 403(a) of the Job Creation and Worker Assistance Act of 2002 (JCWAA) amended Sec. 448(d)(5) to limit the use of the NAE method to those engaged in the provision of services in the areas of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting. Sec. 448(d)(5)(A)(ii), however, permits any taxpayer meeting a $5 million gross receipts test under Sec. 448(c) for all prior tax years to use the NAE method for amounts received for the performance of services in fields other than those listed above. In addition, and significantly, the JCWAA acknowledges the limits of the six-year moving-average method as exemplified in HCA, by directing Treasury and the IRS in Sec. 448(d)(5)(C) to issue regulations permitting taxpayers to determine uncollectible amounts using alternative computations or formulas, including safe harbors that, based on experience, accurately reflect the income the taxpayer will not collect.

The statutory directive included in the JCWAA is addressed in Notice 2003-12; pending issuance of Sec. 448(d)(5) final regulations, a taxpayer eligible to use the NAE method may use:

• One of two safe harbors provided in the notice or

• An alternative NAE method, provided such method clearly reflects the taxpayers NAE and the taxpayer meets the self-testing requirements described in Section 3.03 of the notice.

The safe-harbor methods provided in the notice are presumed to clearly reflect the taxpayers NAE.

The first safe-harbor method is provided for in Temp. Regs. Sec. 1.448-2T(e)(2); the second is the actual-experience method. Under the second method, which is a variation of the Black Motor formula, a taxpayer can determine uncollectible NAE amounts by multiplying its year-end accounts receivable balance by a three-year moving-average percentage, reflecting its actual NAE as to its accounts receivable balance at the beginning of the current tax year and the two immediately preceding tax years. The actual-experience amount may be increased by 5% (adjusted NAE amount). The adjusted NAE amount may also be computed using the current-year NAE percentage for the first year this method is used; a two-year moving-average NAE percentage for the second year; and a three-year moving-average NAE percentage for the third and each succeeding tax year the method is used.

Under an alternative NAE method, a taxpayer can use any NAE method, provided such method clearly reflects the taxpayers actual NAE. The taxpayer also has to perform a self-test for its first tax year and every third tax year by comparing the NAE amount under the taxpayers alternative method with the adjusted NAE that would have resulted from use of the actual-experience method.

Use of the self-test ensures that the total NAE amount for each year of the test period is less than, or equal to, the total adjusted NAE amount computed under the actual-experience method. If such amount is more than the amount that would have resulted under the actual-experience method, the taxpayer must change its accounting method for uncollectible amounts to a method that will clearly reflect its NAE.

The JCWAA imposed additional limits on the types of taxpayers eligible to use the NAE method. As a result, many taxpayers that were using the NAE method before the JCWAA are no longer eligible to do so. A taxpayer discontinuing the use of the NAE method for its first tax year ending after March 9, 2002 because it no longer qualifies to use such method is treated as having initiated the change with the IRSs consent. The Sec. 481(a) adjustment is taken into account over four tax years and the taxpayer is not required to file Form 3115, Application for Change in Accounting Method, with the IRS National Office. The taxpayer, however, should file this form with its return for the change year and write Change of the nonaccrual experience method under Notice 2003-12 at the top of the form.

A change to a safe-harbor method is made automatically under the Rev. Proc. 2002-9 provisions, as is a voluntary change to, or from, another alternative NAE method. In addition, the scope limits provided in Rev. Proc. 2002-9, Section 4.02, generally do not apply. Finally, a required change from an alternative NAE method for the first tax year following the last tax year of the test period is also made under Rev. Proc. 2002-9, without application of the Section 4.02 scope limits.

Notice 2003-12 addresses a problem of which many taxpayers have long been awarethe current NAE formula provided in Sec. 448 often does not clearly reflect the taxpayers collection experience. The interim guidance, on the other hand, recognizes the variations between taxpayers businesses and makes great strides in allowing taxpayers to accurately reflect their individual collection experience.

Although the Service did not readopt the Black Motor formula in its original incarnation, the variation permitted by the notices safe-harbor method should prove more beneficial to many taxpayers than the lone method for determining experience under the existing regulations, albeit possibly at the expense of a substantial administrative burden (due to the receivables tracking requirement).

Alternatively, the taxpayer is free under the notice, within limits, to develop its own method to determine its experience. Thus, given the flexibility in determining experience under Notice 2003-12, an eligible taxpayer that has never used the NAE method may now want to consider it.

From Michael T. Smalley, CPA, and Carolyn Ossen, J.D., Washington, DC