SECTION 10. EXAMPLES

.01 Examination-initiated change.

(1) Facts. A taxpayer that is a corporation deducted certain costs that, as a matter of law, should have been capitalized as part of the cost of a nondepreciable asset that was acquired in 1994. The taxpayer incurred and deducted $1,000,000 of the costs in 1994, $2,000,000 in each of 1995 and 1996, and $5,000,000 in each of 1997 and 1998. The taxpayer is examined for the 1995 and 1996 taxable years (1995 is the earliest open year) and the examining agent discovers the taxpayer’s impermissible method of accounting.

(2) Effect. Under section 5 of this revenue procedure, the examining agent is required to properly apply the law to the facts and change the taxpayer to the capitalization method of accounting for the costs for 1995. The examining agent will provide the notice required by section 7.01 of this revenue procedure. The examining agent will impose a § 481(a) adjustment of $1,000,000 (representing the $1,000,000 of the costs deducted in 1994) the entire amount of which will be taken into account in computing taxable income in 1995. The examining agent will also disallow the deductions of $2,000,000 in each of 1995 and 1996. The taxpayer’s basis in the property as of the end of 1996 is increased by $5,000,000 (representing the $1,000,000 § 481(a) adjustment and the disallowance of the $2,000,000 of deductions in each of 1995 and 1996). The method change (once final) is effective for 1995. Thus, the taxpayer is required to capitalize the costs in 1995 and all subsequent taxable years, unless the taxpayer obtains the consent of the Commissioner to change the method or the Service changes the taxpayer from the method on subsequent examination.

.02 Appeals resolution of timing issue as a method change with compromise terms and conditions.

(1) Facts. The facts are the same as in section 10.01 of this revenue procedure, except that the issue of whether the costs should be capitalized is referred to Appeals. The appeals officer believes there is substantial merit to the Service’s position that the costs must be capitalized as a matter of law, but believes there are

(2) Subsequent change.

(a) Resolution on an alternative- timing basis. If a timing issue is resolved on an alternative-timing basis, the Service is not precluded from changing the taxpayer’s method of accounting in any open taxable year for any item not covered by the closing agreement.

(b) Resolution on a time-value- of-money basis. If a timing issue is resolved on a time-value-of-money basis, the Service is not precluded from changing the taxpayer’s method of accounting in any open taxable year not covered by the closing agreement.

(3) Effect of subsequent change.

(a) Resolution on an alternative- timing basis. If a timing issue is resolved on an alternative-timing basis and the taxpayer’s method of accounting is changed (voluntarily or involuntarily) in a subsequent taxable year, the § 481(a) adjustment (if any) will be determined by reference to all items arising prior to the year of change, except those items covered by the closing agreement (that is, those items for which the closing agreement specifically provides the manner in which the items are to be accounted for).

(b) Resolution on a time-value- of-money basis. If a timing issue is resolved on a time-value-of-money basis and the taxpayer’s method of accounting is changed (voluntarily or involuntarily)

in a subsequent taxable year, the § 481(a) adjustment (if any) will be determined by reference to all items arising prior to the year of change. If the Service changes the taxpayer’s method of accounting in a subsequent taxable year and imposes a § 481(a) adjustment, the interest that is assessed on any underpayment or the interest that is due on any overpayment for the year of change will be treated as paid to the extent necessary to prevent the duplicate payment of the time-value-of- money benefit relating to the § 481(a) adjustment.