Adjustments Required by Changes in Method of Accounting

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[IA-42-93]

RIN 1545-AS93

Adjustments Required by Changes in Method of Accounting

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

-----------------------------------------------------------------------

SUMMARY: This document contains proposed amendments to the regulations

under sections 446(e) and 481 of the Internal Revenue Code of 1986

relating to the requirements for changes in a taxpayer's method of

accounting. The proposed amendments conform existing regulations to the

IRS's long-standing administrative procedures and practices for

changing a taxpayer's method of accounting. The proposed amendments

would affect taxpayers subject to sections 446(e) and 481.

DATES: Written comments must be received by February 27, 1995. Requests

to appear and outlines of oral comments to be presented at the public

hearing scheduled for March 10, 1995, at 10 a.m. must be received by

February 17, 1995.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R:(IA-42-93), Room 5228,

Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,

D.C. 20044. In the alternative, submissions may be hand delivered

between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R(IA-42-93),

Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue,

N.W., Washington, D.C. The public hearing scheduled for March 10, 1995,

will be held in the IRS Auditorium, 7th floor, 1111 Constitution

Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Rosemary

DeLeone, 202-622-4930; concerning submissions and the hearing,

Christina Vasquez, 202-622-6803. These are not toll-free numbers.

SUPPLEMENTARY INFORMATION:

Background

This document contains proposed amendments to the Income Tax

Regulations (26 CFR part 1) to clarify rules under sections 446(e) and

481 regarding changes in method of accounting.

Explanation of Provisions

Section 446(e) states that, except as otherwise expressly provided,

a taxpayer must secure the Commissioner's consent prior to computing

its taxable income under a new method of accounting. Section 446(e) was

enacted as part of the Internal Revenue Code of 1954, Pub. L. 591, 68A

Stat. 1, to codify then-existing regulations that authorized the

Commissioner to impose terms and conditions on voluntary changes in

method of accounting (i.e., changes initiated by the taxpayer).

Section 481 was also enacted as part of the Internal Revenue Code

of 1954, Pub. L. 591, 68A Stat. 1. Section 481(a) generally provides

that in computing a taxpayer's taxable income for the year of a change

in method of accounting, there shall be taken into account those

adjustments which are determined to be necessary, solely by reason of

the change, in order to prevent amounts from being duplicated or

omitted. Under section 481(c), however, a section 481(a) adjustment may

be taken into account in such manner and subject to such conditions as

prescribed by the Commissioner.

As originally enacted, section 481 provided that the portion of the

adjustment attributable to pre-1954 Code years was excluded from the

required adjustment, regardless of whether the change was voluntary or

involuntary. This exclusion enabled taxpayers to change from one

permissible method to another permissible method or from an

impermissible method to a permissible method without accounting for any

duplication or omission of amounts that were attributable to pre-1954

Code years. When it became apparent that this provision was being

abused, Congress amended section 481 in the Technical Amendments Act of

1958, Pub. L. 85-866, 72 Stat. 1606, Title 1, to provide that the

section 481(a) adjustment would include amounts attributable to pre-

1954 Code years if the change was voluntary, but would exclude such

amounts if the change was required by the Commissioner.

Under the authority of sections 446(e) and 481(c), the IRS's long-

standing administrative practice has been to provide specific

adjustment periods under section 481(a) for voluntary changes in method

of accounting. These adjustment periods are intended to achieve an

appropriate balance between the goals of mitigating distortions of

income that would otherwise occur by taking the section 481(a)

adjustment into account entirely in the year of change and providing

appropriate incentives for voluntary compliance. See, for example, Rev.

Proc. 92-20, 1992-1 C.B. 685; Rev. Proc. 84-74, 1984-2 C.B. 736; Rev.

Proc. 80-51, 1980-2 C.B. 818; and Rev. Proc. 70-27, 1970-2 C.B. 509,

clarified, Rev. Proc. 75-18, 1975-1 C.B. 687. With respect to

involuntary changes in method of accounting, the IRS's long-standing

administrative practice generally has been to require that the section

481(a) adjustments be taken into account in computing taxable income

entirely in the year of change.

In order to conform existing regulations with the IRS's long-

standing administrative practice regarding section 481(a) adjustments,

certain amendments are provided in this notice of proposed rulemaking.

Section 1.481-1(c) is amended to clarify that, generally, any section

481(a) adjustments attributable to a voluntary or involuntary change in

method of accounting are taken into account in the taxable year of the

change, regardless of whether the adjustments increase or decrease

taxable income. However, sections 1.446-1(e)(3) and 1.481-5 are also

amended to clarify the Commissioner's authority to prescribe terms and

conditions for effecting a change in method of accounting, including

the taxable year or years in which any adjustment that is necessary to

prevent amounts from being duplicated or omitted is taken into account.

The terms and conditions that may be prescribed by the Commissioner may

include terms and conditions that require the change in method of

accounting to be effected on a cut-off basis.

Finally, because the Tax Reform Act of 1986, Pub. L. 99-514, 100

Stat. 2085, redesignated the Internal Revenue Code of 1954 as the

Internal Revenue Code of 1986, certain references to the Internal

Revenue Code of 1954 contained in Secs. 1.481-1, 1.481-2, 1.481-3, and

1.481-5 are revised to reflect the redesignation. In addition,

Secs. 1.481-1, 1.481-2, 1.481-3, 1.481-4, 1.481-5, and 1.481-6 are

revised to remove certain obsolete provisions.

Effective Date

These regulations are proposed to be effective for Consent

Agreements signed on or after December 27, 1994.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It has also been determined

that section 553(b) of the Administrative Procedure Act (5 U.S.C.

chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do

not apply to these regulations and, therefore, a Regulatory Flexibility

Analysis is not required. Pursuant to section 7805(f) of the Internal

Revenue Code, these regulations will be submitted to the Chief Counsel

for Advocacy of the Small Business Administration for comment on their

impact on small businesses.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (a signed original

and eight copies) that are submitted timely to the IRS. All comments

will be available for public inspection and copying.

A public hearing has been scheduled for Friday, March 10, 1995, at

10 a.m., in the IRS Auditorium, 7th floor, 1111 Constitution Avenue,

N.W., Washington, DC. Because of access restrictions, visitors will not

be admitted beyond the Internal Revenue Building lobby more than 15

minutes before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons that wish to present oral comments at the hearing must

submit written comments by February 27, 1995 and submit an outline (a

signed original and eight copies) of the topics to be discussed and the

time to be devoted to each topic by February 17, 1995. A period of 10

minutes will be allotted to each person for making comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these regulations is Rosemary DeLeone,

Office of the Assistant Chief Counsel (Income Tax and Accounting),

Internal Revenue Service. However, personnel from other offices of the

IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by

revising the entry for section 1.446-1 and by adding the following

citations:

Authority: 26 U.S.C. 7805. * * *

Section 1.446-1 also issued under 26 U.S.C. 446 and 461(h). * * *

Section 1.481-1 also issued under 26 U.S.C. 481.

Section 1.481-2 also issued under 26 U.S.C. 481.

Section 1.481-3 also issued under 26 U.S.C. 481.

Section 1.481-4 also issued under 26 U.S.C. 481.

Section 1.481-5 also issued under 26 U.S.C. 481.

Par. 2. Section 1.446-1 is amended as follows:

1. Paragraph (e)(3) is revised to read as follows:

Sec. 1.446-1 General rule for methods of accounting.

* * * * *

(e) * * *

(3)(i) Except as otherwise provided under the authority of

paragraph (e)(3)(ii) of this section, to secure the Commissioner's

consent to a taxpayer's change in method of accounting the taxpayer

must file an application on Form 3115 with the Commissioner within 180

days after the beginning of the taxable year in which the taxpayer

desires to make the change in method of accounting. To the extent

applicable, the taxpayer must furnish all information requested on the

Form 3115. This information includes all classes of items that would be

treated differently under the new method of accounting, any amounts

that would be duplicated or omitted as a result of the proposed change,

and the taxpayer's computation of any adjustments necessary to prevent

such duplications or omissions. The Commissioner may require such other

information as may be necessary to determine whether the proposed

change will be permitted. Permission to change a taxpayer's method of

accounting will not be granted unless the taxpayer agrees to the

Commissioner's prescribed terms and conditions for effecting the

change, including the taxable year or years in which any adjustment

necessary to prevent amounts from being duplicated or omitted is to be

taken into account. See section 481 and the regulations thereunder,

relating to certain adjustments resulting from accounting method

changes and section 472 and the regulations thereunder, relating to

adjustments for changes to and from the last-in, first-out inventory

method.

(ii) Notwithstanding the provisions of paragraph (e)(3)(i) of this

section, the Commissioner may prescribe administrative procedures under

which taxpayers will be permitted to change their method of accounting.

The administrative procedures shall prescribe those terms and

conditions necessary to obtain the Commissioner's consent to effect the

change and to prevent amounts from being duplicated or omitted. The

terms and conditions that may be prescribed by the Commissioner may

include terms and conditions that require the change in method of

accounting to be effected on a cut-off basis or by an adjustment under

section 481(a) to be taken into account in the taxable year or years

prescribed by the Commissioner.

(iii) This paragraph (e)(3) is effective for Consent Agreements

signed on or after February 27, 1995. For Consent Agreements signed

before December 27, 1994, see Sec. 1.446-1(e)(3) as contained in the 26

CFR Part 1 edition revised as of April 1, 1994.

Par. 3. Section 1.481-1 is amended as follows:

1. Paragraph (a)(2) is amended by adding the phrase ``(hereinafter

referred to as ``pre-1954 years'')'' to the end of the sentence.

2. The third sentence of paragraph (c)(1) is amended by removing

``pre-1954 Code years'' and replacing it with ``pre 1954 years''.

3. Paragraphs (c)(2), (3), and (4) are revised.

4. Paragraph (c)(6) is removed.

5. Paragraph (c)(7) is removed.

6. Paragraph (d) is revised.

7. Paragraph (e) is removed.

8. The revised paragraphs read as follows:

Sec. 1.481-1 Adjustments in general.

* * * * *

(c) * * *

(2) If a change in method of accounting is voluntary (i.e.,

initiated by the taxpayer), the entire amount of the adjustments

required by section 481(a) is generally taken into account in computing

taxable income in the taxable year of the change, regardless of whether

the adjustments increase or decrease taxable income. See, however,

Sec. 1.446-1(e)(3) and 1.481-4 which provide that the Commissioner may

prescribe the taxable year or years in which the adjustments are taken

into account.

(3) If the change in method of accounting is involuntary (i.e., not

initiated by the taxpayer), then only the amount of the adjustments

required by section 481(a) that is attributable to taxable years

beginning after December 31, 1953, and ending after August 16, 1954,

(hereinafter referred to as ``post-1953 years'') is taken into account.

This amount is generally taken into account in computing taxable income

in the taxable year of the change, regardless of whether the

adjustments increase or decrease-taxable income. See, however,

Secs. 1.446-1(e)(3) and 1.481-4 which provide that the Commissioner may

prescribe the taxable year or years in which the adjustments are taken

into account. See also Sec. 1.481-3 for rules relating to adjustments

attributable to pre-1954 years.

(4) For any adjustments attributable to post-1953 years that are

taken into account entirely in the year of change and that increase

taxable income by more than $3,000, the limitations on tax provided in

sections 481(b)(1) or (2) apply. See Sec. 1.481-2 for rules relating to

the limitations on tax provided by sections 481(b) (1) and (2).

* * * * *

(d) Any adjustments required under section 481(a) that are taken

into account during a taxable year must be properly taken into account

for purposes of computing gross income, adjusted gross income, or

taxable income in determining the amount of any item of gain, loss,

deduction, or credit that depends on gross income, adjusted gross

income, or taxable income.

Par. 4. Section 1.481-2 is amended as follows:

1. The first and second sentences of paragraph (a) are revised.

2. The first sentence of paragraph (b) introductory text is

revised.

3. The first sentence of paragraph (c)(1) is revised.

4. The first sentence of paragraph (c)(2) is amended by removing

``subparagraph (1) of this paragraph'' and replacing it with

``paragraph (c)(1) of this section''.

5. Paragraph (c)(3) introductory text is amended by removing

``subparagraph (1) of this paragraph'' and replacing it with

``paragraph (c)(1) of this section''.

6. Paragraph (c)(4) is revised.

7. Paragraph (c)(6) is amended by removing ``Internal Revenue Code

of 1954'' and replacing it with ``Internal Revenue Code of 1986''.

8. The second sentence of paragraph (d) is amended by removing

``Internal Revenue Code of 1954'' and replacing it with ``Internal

Revenue Code of 1986''.

9. Example (1) of paragraph (d) is amended by removing ``pre-1954

Code years'' and replacing it with ``pre-1954 years'' every place that

it appears.

10. The revised paragraphs read as follows:

Sec. 1.481-2 Limitation on tax.

(a) Three-year allocation. Section 481(b)(1) provides a limitation

on the tax under chapter 1 of the Internal Revenue Code for the taxable

year of change that is attributable to the adjustments required under

section 481(a) and Sec. 1.481-1 if the entire amount of the adjustments

is taken into account in the year of change. If such adjustments

increase the taxpayer's taxable income for the taxable year of the

change by more than $3,000, then the tax for such taxable year that is

attributable to the adjustments shall not exceed the lesser of the tax

attributable to taking such adjustments into account in computing

taxable income for the taxable year of the change under section 481(a)

and Sec. 1.481-1, or the aggregate of the increases in tax that would

result if the adjustments were included ratably in the taxable year of

the change and the two preceding taxable years. * * *

(b) Allocation under new method of accounting. Section 481(b)(2)

provides a second alternative limitation on the tax for the taxable

year of change under chapter 1 of the Internal Revenue Code that is

attributable to the adjustments required under section 481(a) and

Sec. 1.481-1 where such adjustments increase taxable income for the

taxable year of change by more than $3,000. * * *

(c) Rules for computation of tax. (1) The first step in determining

whether either of the limitations described in sections 481(b)(1) or

(2) applies is to compute the increase in tax for the taxable year of

the change that is attributable to the increase in taxable income for

such year resulting solely from the adjustments required under section

481(a) and Sec. 1.481-1.

* * * * *

(4) The tax for the taxable year of the change shall be the tax for

such year, computed without taking any of the adjustments referred to

in paragraph (c)(1) of this section into account, increased by the

smallest of the following amounts:

(i) The amount of tax for the taxable year of the change

attributable solely to taking into account the entire amount of the

adjustments required by section 481(a) and Sec. 1.481-1;

(ii) The sum of the increases in tax liability for the

(ii) The sum of the increases in tax liability for the taxable year

of the change and the two immediately preceding taxable years that

would have resulted solely from taking into account one-third of the

amount of such adjustments required for each of such years as though

such amounts had been properly attributable to such years (computed in

accordance with paragraph (c)(2) of this section); or

(iii) The net increase in tax attributable to allocating such

adjustments under the new method of accounting (computed in accordance

with paragraph (c)(3) of this section).

* * * * *

Par. 5. Section 1.481-3 is amended as follows:

1. Remove ``pre-1954 Code years'' and replace it with ``pre-1954

years'' from the section heading and every place it appears in the

section.

2. Remove the last sentence of the section which reads ``See

section 481(b)(4)(A).''.

Par. 6. Section 1.481-4 is removed.

Par. 7. Section 1.481-5 is redesignated as Sec. 1.481-4 and is

revised to read as follows:

Sec. 1.481-4 Adjustments taken into account with consent.

(a) In addition to the terms and conditions prescribed by the

Commissioner under Sec. 1.446-1(e)(3) for effecting a change in method

of accounting, including the taxable year or years in which the amount

of the adjustments required by section 481(a) is to be taken into

account, or the methods of allocation described in section 481(b), a

taxpayer may request approval of an alternative method of allocating

the amount of the adjustments under section 481. See section 481(c).

Requests for approval of an alternative method of allocation shall set

forth in detail the facts and circumstances upon which the taxpayer

bases its request. Permission will be granted only if the taxpayer and

the Commissioner agree to the terms and conditions under which the

allocation is to be effected. See Sec. 1.446-1(e) for the rules

regarding how to secure the Commissioner's consent to a change in

method of accounting.

(b) An agreement to the terms and conditions of a change in method

of accounting under Sec. 1.446-1(e)(3), including the taxable year or

years prescribed by the Commissioner under that section (or an

alternative method described in paragraph (a) of this section) for

taking the amount of the adjustments under section 481(a) into account,

shall be in writing and shall be signed by the Commissioner and the

taxpayer. It shall set forth the items to be adjusted, the amount of

the adjustments, the taxable year or years for which the adjustments

are to be taken into account, and the amount of the adjustments

allocable to each year. The agreement shall be binding on the parties

except upon a showing of fraud, malfeasance, or misrepresentation of

material fact.

Par. 7. A new section 1.481-5 is added to read as follows:

Sec. 1.481-5 Effective dates.

Sections 1.481-1, 1.481-2, 1.481-3, and 1.481-4 are effective for

Consent Agreements signed on or after December 27, 1994. For Consent

Agreements signed before December 27, 1994, see Secs. 1.481-1, 1.481-2,

1.481-3, and 1.481-4 as contained in the 26 CFR Part 1 edition revised

as of April 1, 1994.

Par. 8. Section 1.481-6 is removed.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 94-31531 Filed 12-27-94; 8:45 am]

BILLING CODE 4830-01-P