Section 481 provides that where a taxpayer’s taxable income for a tax year is computed under a method of accounting different from that previously used, an adjustment will be made to prevent amounts from being duplicated or omitted solely by reason of the change in accounting method.[i] Section 481 applies regardless of whether the change in accounting method is initiated by the taxpayer or by the IRS, and regardless of whether the prior accounting method was a correct or incorrect method of accounting.
If the requirements of Section 481 are met, the section allows an adjustment for amounts that would have been reported in prior years if the new method of accounting had been consistently used, even if adjustments for those earlier years are otherwise barred by the statute of limitations. As a result, it is important to have an understanding of what changes are considered to be a change in accounting method, and what changes do not fall under Section 481.
Definition of a Change in Accounting Method. Section 481 and the regulations thereunder do not include a definition of “accounting method” or explain what constitutes a change in an accounting method—the terms are defined only by reference to Section 446 (“General rule for methods of accounting”).[ii] Section 481 applies to a change in a taxpayer’s over-all method of accounting for gross income or deductions, such as a change from the cash method of accounting to the accrual method of accounting, as well as to any change in the “treatment of a material item.”[iii] The regulations define “material item” as “any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.”[iv]
Section 481 Applies Only to Changes in Timing. Any change that does not relate to the proper time for the inclusion of an item in income or the proper time for the taking of a deduction is not a change in accounting method under Section 481. Treasury Regulation Section 1.446-1(e)(2)(ii)(b) provides that a change in accounting method does not include any “adjustment of any item of income or deduction that does not involve the proper time for the inclusion of the item of income or the taking of a deduction.”[v] The test that courts generally use to determine whether an adjustment involves the timing of an item of income or deduction is whether the change permanently distorts the taxpayer’s lifetime taxable income (that is, the taxpayer’s cumulative taxable income for all taxable periods of its existence).[vi]
The regulation provides two examples to illustrate this rule: (1) corrections of items that are deducted as interest or salary, but that are in fact payments of dividends, are not changes in method of accounting; and (2) corrections of items that are deducted as business expenses, but that are in fact personal expenses, are not changes in method of accounting.[vii] In both instances, a corporation’s overall taxable income is permanently changed as a result of the disallowed deductions—the changes disallow the deduction instead of merely deferring the deduction.
For example, in Pelton & Gunther P.C., TC Memo 1999-339, the Tax Court held that Section 481 was not applicable where the IRS determined that a law firm’s practice of deducting litigation expenses that it advanced on behalf of clients was erroneous, recharacterizing those amounts instead as non-deductible loans. The Tax Court concluded that it was not a timing question even though the law firm had been including the reimbursed amounts into income in the year the reimbursements were received, because the IRS determined that the item was not deductible ab initio, finding that the petitioner’s payments of litigation costs were non-deductible loans to its clients. Because the deductions were disallowed entirely, the Tax Court determined there was not a change in method of accounting.
However, in Humphrey, Farrington & McClain, TC Memo 2013-23, another Tax Court case involving advanced litigation expenses, the Tax Court found there to be a change in accounting method where the IRS had disallowed an ordinary and necessary business deduction for such expenses but instead allowed a bad debt deduction for the unreimbursed expenses in a later tax year, because the amount of the net deduction was the same under both the taxpayer’s treatment of the expenses and under the IRS’ treatment of the expenses.
Section 481 Does Not Apply to Mathematical and Posting Errors. The regulations specify that a change in accounting method does not include a correction of a mathematical or posting error.[viii] In Korn Industries, Inc. v. United States, 532 F.2d 1352 (Ct. Cl. 1976), the Court of Claims considered whether a taxpayer’s omission of three items of inventory in prior years was a “change in method of accounting” when those errors were corrected in a subsequent year. The taxpayer’s income tax return for the tax year at issue reported a beginning inventories amount that was greater than the company’s closing inventories amount for the prior year, as a result of including the value of these additional amounts in inventory. The taxpayer had conceded that the error resulted in an understatement in the year of the omission, so the only issue was whether an adjustment for those prior years was barred by the statute of limitations. The IRS argued that the adjustment in the taxpayer’s beginning inventory was a “change in method of accounting” necessitating an adjustment under Section 481, but the Court of Claims held there to be no change in method of accounting. Even though the change affected a balance sheet item in the current tax year, the court held that the taxpayer did not change its method of accounting because the taxpayer had simply made an error analogous to a mathematical or posting error—there was no change to the taxpayer’s method of valuing inventories.
Section 481 Does Not Apply to a Change Caused by a Change in the Underlying Facts. There is no change in accounting method if the change in treatment of an item results from a change in the underlying facts.[ix] For example, a change in the tax year that a taxpayer accrues a liability for a vacation pay plan is not a change in the method of accounting if the change results from a change the company made in the type of vacation pay plan.[x] Similarly, in an IRS National Office Technical Advice Memorandum dated June 3, 2010, the IRS concluded that a change in the treatment of a loss from an entity from active to passive pursuant to Section 469 is not a change in a method of accounting for purposes of Sections 446(e) and 481(a).[xi] In the Technical Advice Memorandum, the IRS states: “We do not believe that a determination of whether a taxpayer materially participates in an activity is a method of accounting.”[xii]
It is important to keep these concepts in mind during the course of an audit, as the IRS may take the position that an adjustment affecting the timing of an item of income or deduction triggers the application of Section 481, giving rise to an adjustment for the item not only in the year under audit, but also for each prior year relating to the item. Having an understanding of what is and is not an accounting method change will assist practitioners in evaluating any potential Section 481 issue. In addition to the above concepts, the detailed regulations in Section 1.446-1(e) provide specific rules and illustrate several examples of how the Section 481 rules apply to various situations.
LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is a senior tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. She routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue domestic civil tax examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise, and in defending criminal tax fraud investigations and prosecutions. She has considerable expertise in handling matters arising from the U.S. government’s ongoing civil and criminal tax enforcement efforts, including various methods of participating in a timely voluntary disclosure to minimize potential exposure to civil tax penalties and avoiding a criminal tax prosecution referral. Additional information is available at http://www.taxlitigator.com.
[i] IRC § 481(a).
[ii] Treas. Reg. § 1.481-1(a)(1) (“For rules relating to changes in methods of accounting, see section 446(e) and paragraph (e) of § 1.446-1.”).
[iii] Treas. Reg. § 1.481-1(a)(1); 1.446-1(e)(2)(ii)(a).
[iv] Treas. Reg. § 1.446-1(e)(2)(ii)(a).
[v] Treas. Reg. § 1.446-1(e)(2)(ii)(b).
[vi] See, e.g., Schuster’s Express, Inc. v. Commissioner, 66 TC 588 (1976).
[vii] Treas. Reg. § 1.446-1(e)(2)(ii)(b).
[viii] Treas. Reg. § 1.446-1(e)(2)(ii)(b).
[ix] Treas. Reg. § 1.446-1(e)(2)(ii)(b).
[x] See Treas. Reg. § 1.446-1(e)(2)(iii) Examples (3) & (4).
[xi] TAM 201035016, June 3, 2010.