SECTION 5. EXAMINATION

DISCRETION TO RESOLVE TIMING ISSUES

.01 In general. Except as otherwise provided in published guidance (for example, Delegation Order No. 236), the discretion of an examining agent to resolve a timing issue is set forth in sections 5.02 through 5.05 of this revenue procedure. See section 10.01 of this revenue procedure for an example of the application of section 5 of this revenue procedure.

.02 Requirement to treat a timing issue as a method change. An examining agent proposing an adjustment with respect to a timing issue will treat the issue as a change in method of accounting.

.03 Requirement to apply the law to the facts. An examining agent changing a taxpayer’s method of accounting will properly apply the law to the facts without taking into account the hazards of litigation when determining the new method of accounting.

dinarily will not initiate an accounting method change if the change will place the taxpayer in a position more favorable than the taxpayer’s position would have been had the taxpayer not been contacted for examination. For example, an examining agent ordinarily will not initiate a change from an impermissible method that results in a negative § 481(a) adjustment. If the Service declines to initiate such an accounting method change, the district director will consent to the taxpayer requesting a voluntary change under Rev. Proc. 97–27. See section 6.01(4) of Rev. Proc. 97–27. .05 Method change with a § 481(a) ad- justment.

(1) Need for adjustment. Section 481(a) requires those adjustments necessary to prevent amounts from being duplicated or omitted to be taken into account when the taxpayer’s taxable income is computed under a method of accounting different from the method used to compute taxable income for the preceding taxable year. When there is a change in method of accounting to which § 481(a) is applied, income for the taxable year preceding the year of change must be determined under the method of accounting that was then used, and income for the year of change and the following taxable years must be determined under the new method of accounting as if the new method had always been used.

Example. A taxpayer, although not permitted to use the cash receipts and disbursements method of accounting by § 448, uses the overall cash method and changes to an overall accrual method. The taxpayer has $120,000 of income earned but not yet received (accounts receivable) and $100,000 of expenses incurred but not yet paid (accounts payable) as of the end of the taxable year preceding the year of change. A positive § 481(a) adjustment of $20,000 ($120,000 accounts receivable less $100,000 accounts payable) is required as a result of the change.

(2) Adjustments attributable to pre- 1954 years. Section 481(a)(2) and § 1.481–3 provide that if the adjustments required by § 481(a) are attributable to a change in method of accounting not initiated by the taxpayer, no portion of any adjustments which is attributable to pre1954 taxable years is taken into account in computing taxable income.

(3) Adjustment period. Section 481(c) and §§ 1.446–1(e)(3)(i) and 1.481–4 provide that the adjustment re

quired by § 481(a) may be taken into account in determining taxable income in the manner and subject to the conditions agreed to by the Commissioner and the taxpayer. Generally, in the absence of such an agreement, the § 481(a) adjustment is taken into account completely in the year of change, subject to § 481(b) which limits the amount of tax where the adjustment is substantial.

.06 Method change using a cut-off method. The Commissioner may determine that certain changes in method of accounting will be made without a § 481(a) adjustment, using a “cut-off method.” Under a cut-off method, only the items arising on or after the beginning of the year of change are accounted for under the new method of accounting. Any items arising before the year of change continue to be accounted for under the taxpayer’s former method of accounting. Because no items are duplicated or omitted from income when a cut-off method is used to effect a change in accounting method, no § 481(a) adjustment is necessary. .07 Previous method change without consent. The Commissioner may require a taxpayer that has changed a method of accounting without the Commissioner’s consent to change back to its former method. The Commissioner may do so even when the taxpayer changed from an impermissible to a permissible method. The change back to the former method may be made in the taxable year the taxpayer changed without consent, or if that year is closed by the running of the period of limitations, in the earliest open year. See Commissioner v. O. Liquidating Corp., 292 F.2d 225 (3rd Cir.), cert. de- nied, 368 U.S. 898 (1961); Handy Andy T.V. and Appliances, Inc., T.C. Memo. 1983–713. .08 Penalties. Any otherwise applicable penalty for the failure of a taxpayer to change its method of accounting (for example, the accuracy-related penalty under § 6662 or the fraud penalty under § 6663) may be imposed if the Service initiates an accounting method change. See § 446(f). Additionally, the taxpayer’s return preparer may also be subject to the preparer penalty under § 6694.