SECTION 2. BACKGROUND AND

CHANGES

. 01 Change in method of accounting defined.

(1) Section 1.446–1(e)(2)(ii)(a) of the Income Tax Regulations provides that a change in method of accounting includes a change in the overall plan of accounting for gross income or deductions, or a change in the treatment of any material item. A material item is any item that involves the proper time for the inclusion of the item in income or the taking of the item as a deduction. In determining whether a taxpayer’s accounting practice for an item involves timing, generally the relevant question is whether the practice permanently changes the amount of the

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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 § 481(a) adjustment is substantial. However, under the Commissioner’s authority in § 1.446–1(e)(3)(ii) to prescribe terms and conditions for changes in methods of accounting, this revenue procedure provides specific adjustment periods that are intended to achieve an appropriate balance between the goals of mitigating distortions of income that result from accounting method changes and providing appropriate incentives for voluntary compliance.

.06 Method change using a cut-off method. The Commissioner may determine that certain changes in methods 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 (or other operative date) are accounted for under the new method of accounting. Any items arising before the year of change (or other operative date) continue to be accounted for under the taxpayer’s former method of accounting. See, for example, § 263A (which generally applies to costs incurred after December 31, 1986, for noninventory property), § 461(h) (which generally applies to amounts incurred on or after July 18, 1984), and § 1.446–3 (which applies to notional principal contracts entered into on or after December 13, 1993). 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 Consistency and clear reflection of income. Methods of accounting should clearly reflect income on a continuing basis, and the Internal Revenue Service exercises its discretion under §§ 446(e) and 481(c) in a manner that generally minimizes distortions of income across taxable years and on an annual basis.

pated future changes in the organizational structure of the Internal Revenue Service.

(2) Section 4.02 is modified by the addition of section 4.02(8), which provides that this revenue procedure does not apply if the taxpayer would be required to accelerate the § 481(a) adjustment in the year of change. This scope limitation does not apply to changes of accounting method under sections 2.01 and 2.02 of the APPENDIX of this revenue procedure.

(3) The additional statement required by section 6.02(5) of Rev. Proc. 98–60 has been discontinued. Elimination of this statement does not otherwise change the responsibility of a taxpayer seeking automatic consent to comply with all the applicable provisions of this revenue procedure. See sections 5.01, 6.01, 6.06 and 10.04(1) of this revenue procedure. (4) Section 6.03(4) clarifies that the office conducting the examination gives consent to the filing of the application, rather than to the change itself. This is consistent with the current authority of such office, upon examination, to deny the change if the taxpayer fails to comply with all the applicable provisions of this revenue procedure. See section 6.06 of this revenue procedure.

(5) Sections 2.01 and 2.02 of the APPENDIX are modified to include certain changes in method of accounting for depreciation or amortization for purposes of computing alternative minimum taxable income and adjusted current earnings under § 56.

(6) Section 5.01 of the APPENDIX is modified to permit a taxpayer required to use an inventory method of accounting to change to an overall accrual method, provided the taxpayer uses a proper inventory method and either is a small reseller or is eligible to use the simplified resale method;

(7) Section 5.01 of the APPENDIX is modified to provide that the change does not apply to a taxpayer with two or more trades or businesses, unless the taxpayer uses or adopts the same overall accrual method for each such trade or business.

(8) Section 8.04 of the APPENDIX is modified to include changes in the method of accounting for state unemployment taxes and railroad retirement taxes.

(9) The following changes in methods of accounting have been added to the

.08 Separate trades or businesses.

(1) Sections 1.446–1(d)(1) and (2) provide that when a taxpayer has two or more separate and distinct trades or businesses, a different method of accounting

may be used for each trade or business provided the method of accounting used for each trade or business clearly reflects the overall income of the taxpayer as well as that of each particular trade or business. No trade or business is separate and distinct unless a complete and separable set of books and records is kept for that trade or business.

(2) Section 1.446–1(d)(3) provides that if, by reason of maintaining different methods of accounting, there is a creation or shifting of profits or losses between the trades or businesses of the taxpayer (for example, through inventory adjustments, sales, purchases, or expenses) so that income of the taxpayer is not clearly reflected, the trades or businesses of the taxpayer are not separate and distinct.

.09 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 taxpayer does not timely file a request to change a method of accounting. See § 446(f). Additionally, the taxpayer’s return preparer may also be subject to the preparer penalty under § 6694. However, penalties will not be imposed when a taxpayer changes from an impermissible method of accounting to a permissible one by complying with all applicable provisions of this revenue procedure.

.10 Change made as part of an exami- nation . Sections 446(b) and 1.446–1(b)(1) provide that if a taxpayer does not regularly employ a method of accounting that clearly reflects its income, the computation of taxable income must be made in a manner that, in the opinion of the Commissioner, does clearly reflect income. If a taxpayer under examination is not eligible to change a method of accounting under this revenue procedure, the change may be made by the district director. A change resulting in a positive § 481(a) adjustment will ordinarily be made in the earliest taxable year under examination with a one-year § 481(a) adjustment period.

.11 Significant changes. Significant changes to Rev. Proc. 98–60 include:

(1) The term “district director” is now defined in new section 3.11 to include the district director or other appropriate examining office or official. This change was made to accommodate antici

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APPENDIX of this revenue procedure:

(a) Section 1A.01 of the APPENDIX regarding the revocation of a § 171(c) election; (b) Section 4A.01 of the APPENDIX regarding deferred compensation;

(c) Section 5A.01 of the APPENDIX regarding accrual of interest on nonperforming loans;

(d) Sections 8A.01, 8A.02, and 8A.03 of the APPENDIX regarding § 467 rental agreements;

(e) Section 10A.02 regarding elections to use the mark-to-market method of accounting under § 475(e) or (f).

(f) Section 12A.01 of the APPENDIX regarding the revocation of a § 1278(b) election.