Sec. 263(a) 12-Month Rule and Economic Performance Accounting Method Changes

As has previously been discussed (see Tax Clinic, Fitzpatrick, “Rev. Proc. 2005-9 Extends Automatic Accounting-Method Changes Relating to Intangibles Capitalization,” TTA,  June 2005; Tax Clinic, Borrack and Fitzpatrick, “Guidance on Accounting Method Changes for Intangibles,” TTA, June 2004; and Tax Clinic, Jagdman, “Final Regs. on Capitalization of Intangibles, TTA, April 2004), the final regulations under Sec. 263(a) issued in January 2004 included a 12-month rule (Regs. Sec. 1.263(a)-4(f)), whereby taxpayers are not required to capitalize an expense if it is paid or incurred (see Regs. Sec. 1.263(a)-4(j)) to create a right or benefit that does not extend beyond the earlier of (1) 12 months after the first date of the right or benefit or (2) the end of the tax year following the tax year in which the expense was paid or incurred.

Regs. Sec. 1.263(a)-4(f)(6) makes it clear that, for an accrual-method taxpayer, the 12-month rule does not eliminate the other requirements for deduction—all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.

Example: Corporation X, an accrual-method taxpayer with a calendar tax year, made two prepayments in June 2005. One payment was for a fire and casualty insurance policy; the other was for equipment rental. Both payments covered the period July 1, 2005–June 30, 2006. X is not required to capitalize the portion of the insurance payment attributable to 2006 because of the 12-month rule, and the portion can be deducted in 2005 because the all-events test is met, the amount is determinable with reasonable accuracy, and economic performance was satisfied on payment. The portion of the rental payment attributable to 2006 does not have to be capitalized because of the 12-month rule and, with the all-events and determinable-with-reasonable-accuracy requirements met, it can be deducted in 2005 if the payment satisfies the requirements for the economic performance recurring-item exception under Regs. Sec. 1.461-5.

The Sec. 263(a) regulations provided that for the first tax year ending on or after Dec. 31, 2003, taxpayers wishing to change their accounting method to a method consistent with the regulations can make the change using the automatic consent procedure described in Rev. Proc. 2002-9. Accordingly, for example, a calendar-year taxpayer could make a change to apply the 12-month rule beginning with its tax year ended Dec. 31, 2003, by filing Form 3115, Application for Change in Accounting Method, by the due date (including extensions) of its 2003 return.

Rev. Proc. 2004-23 was issued later. It provided additional guidance for completing Form 3115 under the automatic consent procedure to change to an accounting method to conform to the Sec. 263(a) regulations for the first tax year ending on or after Dec. 31, 2003. Taxpayers could also use the procedure to correspondingly change their accounting methods to use the economic performance 3-month rule or recurring-item exception in conjunction with the items changed under the 12-month rule, by including this information on the same Form 3115. The availability of the automatic consent procedure to change to the 12-month rule and to use the 3-month rule or recurring-item exception was later extended by Rev. Proc. 2005-9 for taxpayers’ second tax year ending on or after Dec. 31, 2003.

Rev. Proc. 2006 -12 was issued on Dec. 21, 2005. It allows taxpayers to change, under the automatic consent procedure, to an accounting method provided under the Sec. 263(a) regulations beginning with tax years ending on or after Dec. 31, 2005. However, a major departure from Rev. Procs. 2004-23 and 2005-9 was made. Rev. Proc. 2006-12 only applies to taxpayers changing to an accounting method provided under the Sec. 263(a) regulations; it does not apply to taxpayers changing their method using the economic performance 3-month rule or recurring-item exception. Rev. Proc. 2006-12 states:

Thus, for a change in method of accounting utilizing the 3 month rule or the recurring-item exception in conjunction with a change to a method provided by the final regulations, a taxpayer must file two separate applications for a change in method of accounting—an application for a change in method of accounting under this revenue procedure to change to the method of accounting provided in the final regulations, and a separate application for a change in method of accounting under Rev. Proc. 97-27 for a change in method of accounting utilizing the 3 month rule or the recurring-item exception.

Accordingly, in the example above, to change to an accounting method under which X could deduct in 2005 the insurance premium and equipment rental payments attributable to 2006, X would have to file two Forms 3115—one under the automatic consent procedure by the due date of the 2005 return to change to the 12-month rule for both payments, and the other under the advance consent procedure, which would have to be filed by Dec. 31, 2005 to permit X to use the recurring-item exception to deduct its equipment rental payment.

It appears the IRS made this significant change due to its findings that change to the use of the 3-month rule or recurring-item exception when it is necessary to comply with the economic performance requirement in conjunction with a change to the 12-month rule was often not being made, and when made the exception may not have been applied correctly. It also appears that the IRS is proposing to modify Rev. Proc. 2006-12 to allow taxpayers in this situation to file one Form 3115 for both changes (instead of two) under the advance consent procedure.

From Lorin Luchs, J.D., LL.M., CPA, Bethesda MD, Craig Rubin, CPA, MST, Melville NY, and Mark Blazek, CPA, MST, Beard Miller Company, LLP, Harrisburg PA