SECTION 2. BACKGROUND AND — Internal Revenue Bulletin 2002-3

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 taxpayer’s lifetime income. If the practice does not permanently affect the taxpayer’s lifetime income, but does or could change the taxable year in which income is reported, it involves timing and is therefore a method of accounting. See Rev. Proc. 91–31 (1991–1 C.B. 566).

(2) Although a method of accounting may exist under this definition without a pattern of consistent treatment of an item, a method of accounting is not adopted in most instances without consistent treatment. The treatment of a material item in the same way in determining the gross income or deductions in two or more consecutively filed tax returns (without regard to any change in status of the method as permissible or impermissible) represents consistent treatment of that item for purposes of § 1.446– 1(e)(2)(ii)( a ). If a taxpayer treats an item properly in the first return that reflects the item, however, it is not necessary for the taxpayer to treat the item consistently in two or more consecutive tax returns to have adopted a method of accounting. If a taxpayer has adopted a method of accounting under these rules, the taxpayer

may not change the method by amending its prior income tax return(s). See Rev. Rul. 90–38 (1990–1 C.B. 57).

(3) A change in the characterization of an item may also constitute a change in method of accounting if the change has the effect of shifting income from one period to another. For example, a change from treating an item as income to treating the item as a deposit is a change in method of accounting. See Rev. Proc. 91–31. (4) A change in method of accounting does not include correction of mathematical or posting errors, or errors in the computation of tax liability (such as errors in computation of the foreign tax credit, net operating loss, percentage depletion, or investment credit). See § 1.446– 1(e)(2)(ii)( b ). .02 Securing permission to make a method change . Sections 446(e) and 1.446–1(e) state that, except as otherwise provided, a taxpayer must secure the consent of the Commissioner before changing a method of accounting for federal income tax purposes. Section 1.446– 1(e)(3)(i) requires that, in order to obtain the Commissioner’s consent to a method change, a taxpayer must file a Form 3115, Application for Change in Accounting Method, during the taxable year in which the taxpayer wants to make the proposed change.

.03 Terms and conditions of a method change . Section 1.446–1(e)(3)(ii) authorizes the Commissioner to prescribe administrative procedures setting forth the limitations, terms, and conditions deemed necessary to permit a taxpayer to obtain consent to change a method of accounting in accordance with § 446(e). The terms and conditions the Commissioner may prescribe include the year of change, whether the change is to be made with a § 481(a) adjustment or on a cut-off basis, and the § 481(a) adjustment period.

.04 No retroactive method change . Unless specifically authorized by the Commissioner, a taxpayer may not request, or otherwise make, a retroactive change in method of accounting, regardless of whether the change is from a permissible or an impermissible method. See generally Rev. Rul. 90–38.

.05 Method change with § 481(a) adjustment.

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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, sections 1.01 and 7A.01 of the APPENDIX of this revenue procedure. 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.

.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, addition to the tax, or additional amount 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, additions to the tax, or additional amounts 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 director. A change resulting in a positive § 481(a) adjustment will ordinarily be made in the earliest taxable year under examination with a oneyear § 481(a) adjustment period.

.11 Significant changes . Significant changes to Rev. Proc. 99–49 include:

(1) The term “applicable provisions” is now defined in new section 3.02.

(2) The term “director” as defined in section 3.11 of this revenue procedure replaces the term “district director” as defined in section 3.11 of Rev. Proc. 99–49. (3) The scope exclusion in section 4.02(7), relating to a taxpayer engaging in transactions to which § 381(a) applies, has been narrowed to exclude certain transactions under § 381(a).

(4) The consent provisions of section 6.01 have been clarified. (5) A new section 6.02(1), clarifying the form and content of applications, has been added.

(6) The instructions in section 6.02(6)(c) for hand delivery of applications to the national office have been modified.

(7) A new section 6.02(9) has been added, which provides that where a particular change waives the scope limitations of section 4.02 of this revenue procedure, a taxpayer making such a change that is under examination, before an appeals office, or before a federal court is required to provide a copy of its application to the examining agent(s), appeals officer(s), or counsel(s) for the government, as appropriate. This requirement was repeated throughout the APPENDIX of Rev. Proc. 99–49 in each of the various changes that waived the scope limitations of section 4.02. The addition of new section 6.02(9) consolidates these various

requirements into a single uniform provision, and allows the requirements to be removed throughout the APPENDIX.

(8) A new section 6.03(5) has been added, permitting a taxpayer under examination to change its method of accounting under this revenue procedure if the APPENDIX of this revenue procedure provides that the audit protection provisions of section 7 of this revenue procedure do not apply to the change made by the taxpayer.

(9) A new section 9.02, relating to taxpayers that have made a change in method of accounting without complying with all the applicable provisions of this revenue procedure, has been added.

(10) Section 10.02(2) has been expanded to clarify the procedures applicable to a taxpayer that does not qualify for automatic consent procedures of this revenue procedure because the taxpayer has failed to provide on a timely basis the additional information requested by the national office.

(11) Section 10.04(1) has been expanded to clarify that in no event will an application under this revenue procedure be treated as an application under Rev. Proc. 97–27 (or any successor).

(12) The first sentence of section 13.02, relating to the transition rules, has been rephrased to express more clearly the intended scope of the rule.

(13) Section 4.01 of the APPENDIX is modified to include certain additional uniform capitalization (UNICAP) changes by resellers.

(14) Section 5.01 of the APPENDIX is modified to allow certain taxpayers producing real or tangible personal property to change from the cash receipts and disbursements method or a hybrid method to an overall accrual method (or to the overall accrual method in conjunction with the recurring item exception under § 461(h)(3)).

(15) Section 8.01 is modified by the removal of provisions relating to bonuses, which are transferred to section 4B.02 of the APPENDIX.

(16) Section 8.02 of the APPENDIX is modified to include personal property taxes and state income taxes.

(17) Section 13.02 of the APPENDIX is modified to be applicable to all cash method banks.

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(18) The following changes in method of accounting have been added to the APPENDIX of this revenue procedure:

(a) Section 1 of the APPENDIX, relating to Commodity Credit Corporation loans.

(b) Section 1A.03 of the APPENDIX, relating to aircraft maintenance costs.

(d) Section 1A.05 of the APPENDIX, relating to railroad track structure expenditures.

(e) Section 1A.06 of the APPENDIX, relating to restaurant smallwares.

(f) Section 1B.01 of the APPENDIX, relating to bad debts.

(g) Section 2.04 of the APPENDIX, relating to golf course greens.

(h) Section 2B of the APPENDIX, relating to computer software expenditures.

(i) Section 3.03 of the APPENDIX, relating to costs of retiring or removing depreciable assets.

(j) Section 4.02 of the APPENDIX, relating to uniform capitalization (UNICAP) changes by producers of real or tangible personal property.

(k) Section 4.03 of the APPENDIX, relating to uniform capitalization (UNICAP) changes by taxpayers engaged in a farming business.

(l) Section 4.04 of the APPENDIX, relating to capitalization of research and experimental expenditures into inventory under uniform capitalization (UNICAP).

(m) Section 4A.01 of the APPENDIX, relating to the disallowance or deferral under § 267 of certain deductions attributable to transactions between related taxpayers.

(n) Section 4B.02 of the APPENDIX, relating to bonuses and vacation pay.

(o) Section 5.05 of the APPENDIX, relating to the use of the cash and disbursements method of accounting by certain small taxpayers.

(p) Section 5.06 of the APPENDIX, relating to the nonaccrual experience method.

(q) Section 5A.02 of the APPENDIX, relating to cash advances of insurance commissions.

(r) Section 5A.03 of the APPENDIX, relating to advance rentals.

(s) Sections 7A.01 and 7A.02 of the APPENDIX, relating to long-term contracts.

(t) Section 8.06 of the APPENDIX, relating to distribution fees of open-end regulated investment companies.

(u) Section 9.03 of the APPENDIX, relating to an exemption for certain small taxpayers from the requirement to maintain inventories.

(v) Section 9.04 of the APPENDIX, relating to payments made or received on “floor stocks.”

(w) Section 9.05 of the APPENDIX, relating to volume related trade discounts.

(x) Section 9.06 of the APPENDIX, relating to certain impermissible methods of inventory valuation.

(y) Section 10.04 of the APPENDIX, relating to the used vehicle alternative LIFO method.

(z) Section 10.06 of the APPENDIX, relating to changes to the inventory price index computation (IPIC) method.

(aa) Section 10.07 of the APPENDIX, relating to changes within the inventory price index computation (IPIC) method.

(bb) Section 11A.01 of the APPENDIX, relating to transactions involving computer programs.

(cc) Section 11B.01 of the APPENDIX, relating to functional currency changes.

(19) The following changes in method of accounting have been removed from the APPENDIX of this revenue procedure:

(a) Section 8A of the APPENDIX of Rev. Proc. 99–49, relating to rental agreements.

(b) Section 10A.01 of the APPENDIX of Rev. Proc. 99–49, relating to mark-to-market accounting for nonfinancial customer paper.