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Accounting change to reflect tangible property regs brings prior year audit protection

Chief Counsel Advice 201614037

In emailed Chief Counsel Advice, IRS has concluded that a taxpayer that makes an accounting method change to reflect the 2013 tangible property regs rule regarding non-incidental materials and supplies, and does so via the “limited Code Sec. 481(a) adjustment,” is protected from IRS auditors making a prior year change to its accounting for those materials and supplies.

Background on tangible property regs. In September of 2013, IRS issued final regs providing guidance on the application of Code Sec. 162(a) and Code Sec. 263(a) to amounts paid to acquire, produce, or improve tangible property. Under those regs, with exceptions not relevant here, amounts paid to acquire or produce non-incidental materials and supplies are deductible in the tax year in which the materials and supplies are first used in the taxpayer’s operations or are consumed in the taxpayer’s operations. (Reg. § 1.162-3(a)(1)) (For a series of articles on the final regs, see Weekly Alert ¶  22  09/19/2013, Weekly Alert ¶  23  09/19/2013, Weekly Alert ¶  42  09/19/2013, and Weekly Alert ¶  27  09/19/2013.)

Background on accounting method changes. Except as otherwise expressly provided by the Code or regs, Code Sec. 446(e) and Reg. § 1.446-1(e)(2) require a taxpayer to secure IRS’s consent before changing an accounting method for federal income tax purposes. Reg. § 1.446-1(e)(3)(ii) authorizes IRS to prescribe administrative procedures setting out the terms and conditions necessary for a taxpayer to obtain consent to change an accounting method.

A Code Sec. 481(a) adjustment is an adjustment made in any year in which the taxpayer computes taxable income under a different accounting method from that used in the preceding year; the purpose of the adjustment is to prevent items from being duplicated or omitted.

Rev Proc 2015-13, 2015-5 IRS 419, provides procedures by which a taxpayer may obtain IRS’s automatic consent to change to certain accounting methods. Rev Proc 2015-14, 2015-5 IRB 450 provides a list of automatic changes to which the automatic change procedures in Rev Proc 2015-13 (or a successor) apply. Rev Proc 2015-14, Sec. 10.11 provides for automatic consent procedures for accounting method changes to conform to the above-mentioned tangible property regs.

Except as provided in the next sentence, a taxpayer changing to a method of accounting provided in Rev Proc 2015-14, Sec. 10.11 must apply Code Sec. 481(a) and take into account any applicable Code Sec. 481(a) adjustment under the standard Code Sec. 481(a) rules. (Rev Proc 2015-14, Sec. 10.11(6)(a))

However, with exceptions not relevant here, a taxpayer changing to a method of accounting under Reg. § 1.162-3 is required to calculate a Code Sec. 481(a) adjustment as of the first day of the taxpayer’s tax year of change that takes into account only amounts paid or incurred in tax years beginning on or after Jan. 1, 2014. Optionally, a taxpayer may take into account amounts paid or incurred in tax years beginning on or after Jan. 1, 2012. (Rev Proc 2015-14, Sec. 10.11(6)(b)(i)) This rule is referred to as “the limited Code Sec. 481(a) adjustment” rule.

Facts. Taxpayer made an automatic change for its tax year beginning Jan. 1, 2014 under Rev Proc 2015-14, Sec. 10.11, to deduct non-incidental materials and supplies in the tax year they are used or consumed in accordance with Reg. § 1.162-3(a)(1). Under Rev Proc 2015-14, Sec. 10.11(6)(b)(i), the taxpayer calculated its Code Sec. 481(a) adjustment taking into account only amounts paid or incurred in tax years beginning on or after Jan. 1, 2014.

Issue. For costs paid or incurred by the taxpayer in tax years beginning prior to Jan. 1, 2014, whether IRS auditors can examine or change the taxpayer’s method of accounting for non-incidental materials and supplies that were deducted when paid or incurred by the taxpayer, to the correct method, i.e., deducting those items when they were used or consumed in the taxpayer’s operations.

Taxpayer has audit protection. IRS concluded that the taxpayer has audit protection for the costs of non-incidental materials and supplies paid or incurred prior to Jan. 1, 2014.

Rev Proc 2015-13, Sec. 8.01, provides that, except as otherwise provided in Rev Proc 2015-13, Sec. 8.02, or under any guidance provided in the I.R.B., when a taxpayer timely files a Form 3115, IRS will not require the taxpayer to change its method of accounting for the same item for a tax year prior to the requested year of change. Rev Proc 2015-14, Sec. 10.11, does not specifically address audit protection for taxpayers that file method changes under its general provisions or its provisions for automatic changes made with a limited adjustment.

Therefore, the general rule under Rev Proc 2015-13, Sec. 8.01, should apply to these changes. As a result, if the taxpayer timely filed a Form 3115 (Application for Change in Accounting Method) for 2014 to change its method of accounting for non-incidental materials and supplies pursuant to Rev Proc 2015-14, Sec. 10.11, and properly included the limited Code Sec. 481(a) adjustment, then IRS cannot require the taxpayer to change its method of accounting for its non-incidental materials and supplies costs incurred prior to the year of change.

IRS also said that, for the same reasons, if a taxpayer made an automatic change in method of accounting to utilize the final tangible regs pursuant to Rev Proc 2015-14, Sec. 10.11, and that change was made with the limited Code Sec. 481(a) adjustment, that taxpayer cannot request a subsequent or additional method change for the same item, for costs paid or incurred in tax years that begin before Jan. 1, 2014.

References: For accounting method changes, see FTC 2d/FIN ¶  G-2100  et seq.; United States Tax Reporter ¶  4464.21  et seq.; TaxDesk ¶  442,400  et seq.; TG ¶  6300  et seq.