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Examining Methods of Accounting and the IRS’s Broad Discretion to Change Them

The Practical Limits of IRC § 446(a)

A taxpayer must compute taxable income under the method of accounting it regularly uses in keeping its books.[1] The IRS has rather broad statutory discretion to change a taxpayer’s accounting method in certain circumstances.[2] If the method of accounting used by the taxpayer does not clearly reflect income, the IRS generally will see fit to change the taxpayer’s method of accounting to a method that, in its not so humble collective administrative opinion, more clearly reflects income.[3]

The IRS’s discretion in deciding whether to consent to a change of accounting method, though not limitless, has the breadth and girth of the average waistline of a Golden Corral patron.[4] The IRS’s determination with respect to a change in accounting methods may be challenged only upon a showing of abuse of discretion, which, in turn, depends upon whether the IRS’s determination is without sound basis in fact or law.[5] A taxpayer may change its accounting method too, but like Oliver Twist, the taxpayer must beg permission and forgiveness from the IRS, whose consent is necessary for the change.

The IRS, not content with being the arbiter of doling out porridge to orphans, which in my metaphor means controlling accounting methods, wanted to be able to retroactively adjust the orphans’ porridge allotment. (Ok, admittedly, this is where the metaphor quickly breaks down.)

The IRS, talking to Congress one day in 1954 over a cold Schlitz and a bowl of stale peanuts, raised the question of how it might be able to really stick it to a taxpayer whose methods of depreciation had been improper for years outside of the statute of limitations where, by its terms, IRC § 446 simply could not reach. Congress set its bottle quietly on the table, the condensation slowly pooling in a concentric circle around its base, patted the IRS on the shoulder as it walked away like John Wayne towards a casual gunfight, and said that it would make a few calls.

And that, dear reader, is how IRC § 481 was born.

IRC § 481(a) authorizes the IRS to adjust a taxpayer’s income for the year the taxpayer changes her method of accounting, whether initiated by the taxpayer or the IRS.[6] When the change in method of accounting is involuntary (i.e., not initiated by the taxpayer), the entire amount of the adjustment is included in the taxpayer’s income in the first taxable year in which taxable income is computed under a method of accounting that is different from the method that was used in the prior year.[7]

As the IRS noted above, IRC § 446 does not apply to retroactive adjustments to a taxpayer’s liability for a year preceding the year of change. Further, the period of limitations may prevent the IRS from examining prior years to make adjustments that directly relate to an accounting method change made for the current year.[8]

Principals of Consistency, Retroactive Adjustments, and Application to Years at Issue

The principal behind IRC § 481 is consistency. The IRS likes many things, like macaroni salad and collated copies of just about anything.  However, the IRS does not like change.

There was, of course, the infamous Swingline to Bostich stapler schism of 1985 that quietly reverberates in the very corners of the IRS to this day. Nevertheless, to the victor go the spoils, and there are very few who were around during the Swingline embargo who remember the anger, fear, and palpable tension of those times.

Congress has mandated through its enactment of IRC § 481 that an adjustment under that section generally must be made to remove the threat of a double benefit or omission whenever there is a change in a method of accounting.[9] The threat of removing Swinglines in the night from those holdovers caused more than one revenue-agent-qua-Swingline-patriot to sleep under his desk with his stapler in one hand and a crudely sharpened letter opener in the other.  Those were tense times.

Similarly, when the taxpayer computes income in Year 2 under a different accounting method than it used in Year 1, the IRS has an institutional flashback to the hostilities of 1985 and clutches at IRC § 481(a)(2) like a security blanket, because that section permits the IRS to take into accounts any adjustments determined to be necessary in Year 1 because of the change in accounting method in Year 2. Practically, this look-back prevents amounts from being counted twice or omitted completely.

Like the 1986 Treaty of the East Breakroom which formalized the stapler détente (to the satisfaction of no one, especially the loyalists), the courts have found that IRC § 481, in practice, leaves many questions unanswered. Indeed, the Fifth Circuit want so far as to refer to IRC § 481 as “codified confusion.”[10] What courts have settled on, however, is that IRC § 481 permits the IRS to adjust the amount of tax due in a year that a taxpayer changes its method of accounting, whether the change is voluntary or foisted upon the taxpayer by the IRS like a piece of broccoli on a picky toddler.[11]

Because the statute affects closed years, courts have permitted the IRS to allow adjustments in prior (even closed) years to affect adjustments in the year at issue.[12] Notwithstanding the fact that IRC § 481 applies to prior years, Congress did not intend it to be “a means to correct errors of past years.”[13]

Practically, this means that changes that the IRS makes to a taxpayer’s method of accounting in Year 5 may affect Years 1-4. If it does affect Years 1-4, adjustments may be made, even if the statute of limitations are closed on such years. If adjustments are made in Years 1-4, and such adjustments affect Year 5, then IRC § 481 permits additional adjustments in Year 5.

Heightened Scrutiny when IRS Invokes IRC § 481

Can a taxpayer ever sleep at night with the specter of IRC § 481 retroactively adjusting returns from years before “who let the dogs out” was an innocent, practical question? To pacify the worrywarts out there, the Tax Court assures that it very “carefully examines” each instance in which the IRS invokes IRC § 481. Further pushing the IRC § 418 bogeyman out of the dreams of taxpayers, the Tax Court “places a premium” on distinguishing between a permitted change in accounting method and an impermissible “correction of errors.”[14] Finally, if the Tax Court permits a change in accounting method, it is obligated to ensure that the IRC § 481 adjustment has been made to compensate only for that change.[15] Thus, the Tax Court makes clear that IRC § 481 does not give the IRS carte blanche to reach back to the Chumbawumba years.

The Symbiosis of IRC § 481 and IRC § 446

What the taxpayer and IRS must remember is that IRC § 481 has no teeth but for IRC § 466. Only when the taxpayer’s accounting method is changed in the year at issue by application of IRC § 466 may IRC § 481 then apply the new accounting method retroactively.[16]

Erroneous Treatment of “Material Item” Rising to Level of “Method of Accounting”

The Tax Court has adopted the position that the erroneous treatment of an item rises to the level of a “method of accounting” only if the item is consistently (albeit erroneously) treated for two or more years.”[17] Thus, a “change in accounting” includes a change in the treatment/reporting of an item (if such change is carried out in more than one year) from a previously adopted treatment.[18]

Thus, the Tax Court looks to periods of inconsistent treatment for “material items,” which are items that involve timing of inclusion of the item in income or the timing of taking a deduction with respect to that item.[19] In other words, an item is “material” if it concerns when, as opposed to whether, taxable income is affected.[20]

When an accounting practice postpones the reporting of income, rather than permanently avoiding the reporting of income over the taxpayer’s lifetime, like depreciation, it involves the proper time for reporting income.[21] A change in method of accounting, however, does not include correction of mathematical or posting errors, or errors in the computation of tax liability.”[22] Neither does a change in the method of accounting include a change in treatment resulting from a change in underlying facts.[23]

Case Study: “Materiality” in Pinkston v. Commissioner

In 2020, the Tax Court explored (at some length) the materiality element in changes of accounting methods in the Memorandum Opinion of Pinkston v. Commissioner.[24]  Both sets of adjustments to petitioners’ depreciation methods involve “material items” under the general principles of the regulations, because the depreciation methods at issue involve the proper time for taking a depreciation deduction.[25] Similarly, the reallocation of basis from depreciable property to non-depreciable land affects timing of deductions, though a bit less directly.

Because under the petitioners’ method of accounting (that is, their adopted depreciation schedules) they would take large annual depreciation deductions very quickly, rather than under the IRS’s proposed method which would spread out the deductions over a longer period of depreciation, even though the change in accounting method affects the value of the deductions, it also affects the timing of the deductions, and this is enough to implicate IRC § 446 (and in turn IRC § 481).

An item is “material” when it affects the timing of reporting income or deductions, as opposed to the amount (how much income is reported), or whether a deduction would ever have been appropriate.[26] When an accounting practice postpones the reporting of income, rather than permanently avoiding the reporting of income over the taxpayer’s lifetime, it involves the proper time for reporting income.[27]

By changing petitioners’ treatment, the IRS has not altered their lifetime ability to recover the full cost of the beach house; it has changed the timing of when (and how) that cost recovery will occur. In determining whether an item postpones or accelerates the reporting of income, the courts have generally assumed that relevant future events (such as sale of the property) will ultimately occur.[28]

Although the petitioners argue that the change in accounting method is inappropriate because they involve only a recharacterization of the rental properties, the Tax Court is not persuaded. The Tax Court notes that in some situations the IRS’s recharacterization of an item may determine whether the item is taxable or deductible,[29] the changes proposed by the IRS change both the characterization of the properties (from land to rental real estate, for example), as well as the changes also change the timing of the cost recovery. Thus “it makes no difference” (for purposes of IRC § 446) whether the changes also implicate characterization. The Tax Court’s primary focus is on the change in timing.[30] There is a limited exception, but it only applies to IRC § 167 property (property used in trade or business or held for the production of income).


Footnotes:

[1] IRC § 446(a).

[2] IRC § 446(b).

[3] Id.

[4] Brown v. Helvering, 291 U.S. 193, 204 (1934).

[5] RACMP Enters. v. Commissioner, 114 T.C. 211, 218-219 (2000); see also Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532 (1979).

[6] See Suzy’s Zoo v. Commissioner, 273 F.3d 875, 883 (9th Cir. 2001), aff’g 114 T.C. 1 (2000); see also Treas. Reg. § 1.446-1(e)(2)(ii)(d)(5)(iii) (providing that a “change from an impermissible method of computing depreciation” to a permissible method “results in a IRC § 481 adjustment”).

[7] Treas. Reg. § 1.481-1(c)(3).

[8] See IRC § 6501; Suzy’s Zoo, 273 F.3d at 883.

[9] Wasco Real Props. I, LLC v. Commissioner, T.C. Memo. 2016-224, *50, aff’d, 744 F. App’x 534 (9th Cir. 2018); see also Suzy’s Zoo, 273 F.3d at 883.

[10] See Grogan v. United States, 475 F.2d 15, 16 (5th Cir. 1973).

[11] Suzy’s Zoo, 273 F.3d at 883.

[12] Graff Chevrolet Co. v. Campbell, 343 F.2d 568, 572 (5th Cir. 1965); see Suzy’s Zoo, 273 F.3d at 884; Rankin v. Commissioner, 138 F.3d 1286, 1288 (9th Cir. 1998), aff’g T.C. Memo. 1996-350; Huffman v. Commissioner, 126 T.C. 322, 341 (2006), aff’d, 518 F.3d 357 (6th Cir. 2008).

[13] German v. Commissioner, T.C. Memo. 1993-59, aff’d, 46 F.3d 1141 (9th Cir. 1995).

[14] See Huffman, 126 T.C. at 341-42.

[15] Rankin, 138 F.3d at 1288.

[16] German, T.C. Memo. 1993-59; Treas. Reg. § 1.481-1(a)(1); Treas. Reg. § 1.446-1(e).

[17] Thrasys, Inc. v. Commissioner, T.C. Memo. 2018-199, *12-*13.

[18] See Treas. Reg. § 1.446-1(e)(2)(ii)(a).

[19] See Treas. Reg. § 1.446-1(e)(2)(ii)(a).

[20] See Primo Pants Co. v. Commissioner, 78 T.C. 705, 722 (1982).

[21] Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 510 (1989); see also Rankin, 138 F.3d at 1288 (noting that an item is “material” when it affects the timing of reporting income or deductions, as opposed to “how much income is reported, or whether a deduction would ever have been appropriate”).

[22] Treas. Reg. § 1.446-1(e)(2)(ii)(b).

[23] Id.

[24] T.C. Memo. 2020-44.

[25] See Treas. Reg. § 1.446-1(e)(2)(ii)(a).

[26] Rankin, 138 F.3d at 1288; see Treas. Reg. § 1.446-1(e)(2)(ii)(a).

[27] Wayne Bolt & Nut, 93 T.C. at 510; see also Primo Pants, 78 T.C. at 722 (noting that materiality turns on whether the items affect timing).

[28] See, e.g., Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781, 799 (11th Cir. 1984).

[29] Underhill v. Commissioner, 45 T.C. 489, 496 (1966).

[30] See, e.g., Sunoco, Inc. & Subs. v. Commissioner, T.C. Memo. 2004-29.

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