SECTION 10. EXAMPLES.

The following examples illustrate how the provisions of this revenue procedure apply to the resolution of accounting method issues in various circumstances. These examples include explanations of the resolution of an accounting method issue previously resolved by Appeals on a nonaccounting-method-change basis in the event that Examination resolves such issue in a subsequent taxable year by changing the taxpayer’s method of accounting. Note, however, that where the resolution of an accounting method issue is imposed by Appeals, an examining agent addressing such issue in a subsequent taxable year may resolve it consistently with the prior resolution by Appeals ( see Delegation Order 236).

.01 Examination-imposed Change .

(1) Facts . A taxpayer that is a corporation deducted costs that the Service determines should have been capitalized to real property that was placed in service in 2000. The taxpayer incurred and deducted $1,000,000 of the costs in 1996, $2,000,000 in each of 1997 and 1998, and $5,000,000 in each of 1999 and 2000. The taxpayer is examined for the 1997 and 1998 taxable years (1997 is the earliest open year). The examining agent

determines that the treatment of the costs is an accounting method issue, and that the taxpayer’s deduction of the costs is an impermissible method of accounting. The examining agent therefore proposes an adjustment.

(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. The examining agent imposes the change in 1997, the earliest open taxable year. The examining agent will provide the notice required by section 7.01 of this revenue procedure. The examining agent imposes a § 481(a) adjustment of $1,000,000 (representing the $1,000,000 of the costs deducted in 1996), the entire amount of which will be taken into account in computing taxable income in 1997. The examining agent also disallows the deductions of $2,000,000 in each of 1997 and 1998. The taxpayer’s basis in the property as of the beginning of 1998 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 1997 and 1998). The method change (once final) is effective for 1997. Thus, the taxpayer is required to capitalize the costs in 1997 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 Accounting Method 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 that hazards of litigation exist with respect to the Service’s position. The appeals officer and the taxpayer agree to resolve the accounting method issue by changing the taxpayer’s method of accounting for the costs, but with compromise terms and conditions to reflect the hazards of litigation.

(2) Effect . Under section 6.02(2) of this revenue procedure, when the appeals officer changes the taxpayer’s method of accounting, the appeals officer is required to properly apply the law to the facts and

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period. The appeals officer will impose a § 481(a) adjustment of $3,000,000 (representing the $1,000,000 of costs deducted in 1996 and the $2,000,000 of costs deducted in 1997), one-half of which will be taken into account in computing taxable income in each of 1998 and 1999. The appeals officer will disallow the deduction of $2,000,000 in 1998. The taxpayer’s basis in the property as of the beginning of 1998 will be increased by $5,000,000 (representing the $3,000,000 § 481(a) adjustment and the disallowance of the $2,000,000 of deductions in 1998). The method change (once final) is effective for 1998. Thus, the taxpayer is required to capitalize the costs in 1998 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.

.03 Appeals Resolution of Accounting Method Issue on an Alternative-timing Basis .

(1) Facts . The facts are the same as in section 10.02 of this revenue procedure, except that the appeals officer and the taxpayer agree to resolve the issue on an alternative-timing basis as described in section 6.02(3) of this revenue procedure and they enter into a closing agreement as required by section 8.01 of this revenue procedure. The accounting method issue is resolved by providing in the closing agreement that the taxpayer will deduct 50% of the costs incurred in 1997 and 1998 and capitalize the other 50% of the costs incurred in those years.

(2) Effect . The appeals officer will disallow $1,000,000 of the deductions in each of 1997 and 1998. The taxpayer’s basis in the property as of the beginning of 1998 is increased by $2,000,000 (representing the disallowance of the $1,000,000 of deductions in each of 1997 and 1998). The taxpayer’s current method of accounting for the costs is not changed. Thus, the taxpayer is required to continue to deduct the costs not covered by the agreement (that is, the costs incurred in 1996 and the costs incurred in 1999 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. If the Service changes the taxpayer’s

method in 1999, the Service will compute a § 481(a) adjustment of $1,000,000 (including the amount of the costs deducted in 1996, which are not covered by the agreement, and excluding the amount of those costs deducted in 1997 and 1998 because the costs are covered by the agreement). The Service will also disallow the deduction of $5,000,000 in 1999. The taxpayer’s basis in the property as of the beginning of 1999 will be increased by an additional $6,000,000 (representing the $1,000,000 § 481(a) adjustment and the disallowance of the $5,000,000 deduction in 1999). The method change (once final) is effective for 1999. Thus, the taxpayer is required to capitalize the costs in 1999 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.

Alternatively, the accounting method issue may be resolved by providing in the closing agreement that the taxpayer will capitalize $1,000,000 of the costs incurred in each of 1997 and 1998 (and the agreement is silent as to the manner in which the other $1,000,000 of costs incurred in each of 1997 and 1998 are to be accounted for). The results for 1997 and 1998 will be the same as under the closing agreement in the original facts described in section 10.03(1) of this revenue procedure. That is, the appeals officer will disallow $1,000,000 of the deduction in each of 1997 and 1998. The taxpayer’s basis in the property as of the beginning of 1998 is increased by $2,000,000 (representing the disallowance of the $1,000,000 of deductions in each of 1997 and 1998). Because the taxpayer’s current method of accounting for the costs is not changed, the taxpayer is required to continue to deduct the costs not covered by the closing agreement (that is, the costs incurred in 1996, the remaining $1,000,000 of costs incurred in each of 1997 and 1998, and the costs incurred in 1999 and all subsequent taxable years). However, if the Service changes the taxpayer’s method in 1999, the Service will compute a § 481(a) adjustment of $3,000,000 (including the $1,000,000 of the costs deducted in 1996 and the remaining $2,000,000 of the costs deducted in 1997 and 1998, because those

costs are not items covered by the closing agreement). The Service also will disallow the deduction of $5,000,000 in 1999. The taxpayer’s basis in the property as of the beginning of 1999 will be increased by an additional $8,000,000 (representing the $3,000,000 § 481(a) adjustment and the disallowance of the $5,000,000 deduction in 1999). The method change (once final) is effective for 1999. Thus, the taxpayer is required to capitalize the costs in 1999 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.

Assuming, in the alternative, that the accounting method issue is resolved by providing in the closing agreement that, for the costs incurred in 1996 through 1998, the taxpayer will deduct 50% of the costs and capitalize the other 50% of the costs, and will increase taxable income by $500,000 in 1997 (representing the disallowance of $500,000 of costs in 1996). The appeals officer will disallow $1,000,000 of the deductions in each of 1997 and 1998. The taxpayer’s basis in the property as of the beginning of 1998 is increased by $2,500,000 (representing the disallowance of the $500,000 of deductions in 1996 and the $1,000,000 of deductions in each of 1997 and 1998). The taxpayer’s current method of accounting for the costs is not changed. Thus, the taxpayer is required to continue to deduct the costs not covered by the closing agreement (that is, the costs incurred in 1999 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. If the Service changes the taxpayer’s method in 1999, the Service will compute a § 481(a) adjustment of $0 (excluding the amount of the costs deducted in 1996 through 1998, because the manner in which those costs are to be accounted for is specifically covered by the closing agreement). The Service also will disallow the deduction of $5,000,000 in 1999. The taxpayer’s basis in the property as of the beginning of 1999 will be increased by an additional $5,000,000 (representing the disallowance of the $5,000,000 deduction in 1999). The

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method change (once final) is effective for 1999. Thus, the taxpayer is required to capitalize the costs in 1999 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.

.04 Appeals Resolution of Accounting Method Issue on Time-value-of-money Basis .

(1) Facts . The facts are the same as section 10.02 of this revenue procedure, except that the appeals officer and the taxpayer agree to settle the issue on a time-value-of-money basis as described in section 6.02(4) of this revenue procedure. The taxpayer files its return on a calendar year basis. The appeals officer and the taxpayer agree to compute the specified amount using the sample computation described in section 6.02(4)(b)(ii) of the revenue procedure. The appeals officer believes that an appropriate factor to reflect the hazards of litigation is 25%. The taxpayer pays the specified amount on May 15, 2000. The highest marginal tax rate applicable to the taxpayer for 1997 and 1998 is 35% and the quarterly large corporation underpayment rates in effect for January 1, 1998, through June 30, 2000, are: 11%, 10%, 10%, 10%, 9%, 10%, 10%, 10%, 10%, and 11%. The specified amount under section 6.02(4) of this revenue procedure would be deductible under § 163(a) by the taxpayer if it were treated as interest expense arising from an underpayment of tax.

(2) Computation of specified amount . The hypothetical underpayment of tax for 1997 is $1,050,000, computed as follows: the net increase in taxable income of $3,000,000 (representing the § 481(a) adjustment of $1,000,000 and the disallowance of the deduction of $2,000,000 computed as if Examination had changed the taxpayer’s method in 1997) multiplied by the applicable tax rate of 35%. The hypothetical underpayment of tax for 1998 is $700,000, computed as follows: the net increase in taxable income of $2,000,000 (representing the disallowance of the deduction of $2,000,000 computed as if Examination had changed the taxpayer’s method in 1997) multiplied by the applicable tax rate of 35%.

The applicable time-value rate for 1997 is 6.565%, which is computed as follows: The applicable period for 1997 is March 15, 1998 (the due date of the return) to May 15, 2000 (the date the specified amount is paid). The underpayment rates in effect for the applicable period are 11%, 10%, 10%, 10%, 9%, 10%, 10%, 10%, 10%, and 11%. The average underpayment rate in effect for the applicable period is 10.1%

[(11+10+10+10+9+10+10+10+10+11)/ 10]. The applicable after-tax time-value rate is 6.565%, computed by multiplying the average underpayment rate by one minus the applicable tax rate [10.1% (1-.35)].

The applicable time-value rate for 1998 is 6.5%, which is computed as follows: The applicable period for 1998 is March 15, 1999 (the due date of the return) to May 15, 2000 (the date the specified amount is paid). The underpayment rates in effect for the applicable period are 9%, 10%, 10%, 10%, 10%, and 11%. The average underpayment rate in effect for the applicable period is 10.00% [(9+10+10+10+10+11)/6]. The applicable after-tax time-value rate is 6.5%, computed by multiplying the average underpayment rate by one minus the applicable tax rate [10.00% - (1-.35)].

The time-value-of-money benefit for each taxable year is computed by using the following formula:

U - {[1+(r/365)] ⁿ -1} where U = hypothetical underpay

ment for the taxable year r = the applicable time-value

rate n = the number of days in the

accounting for the costs for 1997 and 1998. The taxpayer’s basis in the property as of the beginning of 1998 is not changed. The taxpayer’s current method of accounting for the costs is not changed. Thus, the taxpayer is required to continue to deduct the costs in 1999 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. If the Service changes the taxpayer’s method in 1999, the Service will compute a § 481(a) adjustment of $5,000,000 (representing the $1,000,000 of the costs deducted in 1996 and the $2,000,000 of costs deducted in each of 1997 and 1998). The Service will also disallow the deduction of $5,000,000 in 1999. The taxpayer’s basis in the property as of the beginning of 1999 will be increased by $10,000,000 (representing the $5,000,000 § 481(a) adjustment and the disallowance of the $5,000,000 deduction in 1999). The method change (once final) is effective for 1999. Thus, the taxpayer is required to capitalize the costs in 1999 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.

The interest on the taxpayer’s deficiency (which reflects the inclusion of the $5,000,000 § 481(a) adjustment in taxable income) for 1999 is $100,000. A portion of the $100,000 of interest will be treated as paid to the extent necessary to prevent duplicate payment of the time-value-ofmoney benefit relating to the § 481(a) adjustment. The interest on the deficiency for 1999 includes the time-value-ofmoney benefit attributable to the § 481(a) adjustment for the period March 15, 2000, through the date of payment of the deficiency. The taxpayer previously paid the Service the time-value-of-money benefit attributable to $3,000,000 of the § 481(a) adjustment for the period March 15, 1998, through May 15, 2000, and $2,000,000 of disallowed deduction for the period March 15, 1999, through May 15, 2000. The interest on the deficiency for 1999 attributable to the overlap period of March 15, 2000, through May 15, 2000, is $19,112, computed as follows:

applicable period The time-value-of-money benefit for 1997 is $160,519, computed as follows: $1,050,000 * {[1+(.06565/365)] ⁷⁹¹ -1. The time-value-of-money benefit for 1998 is $55,165, computed as follows: $700,000

• [1+(.065/365)] ⁴²⁶ -1{ }. The specified amount is the sum of the time-value-of-money benefit for 1997 and 1998 reduced by 25% to reflect the hazards of litigation. The specified amount is $161,763 computed as follows: ($160,519+$55,165)*(1-.25).

(3) Effect . The Service will not propose any adjustments to taxable income with respect to the taxpayer’s method of

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A * t - {[1+(r/365)] ⁿ -1} where A = the § 481(a) adjustment

and the $2,000,000 of the costs deducted in each of 1997 and 1998 because the costs were accounted for in the prior adjustments). The Service will also disallow the deduction of $5,000,000 in 1999. The taxpayer’s basis in the property as of the beginning of 1999 will be increased by an additional $5,000,000 (representing the disallowance of the $5,000,000 deduction in 1999). The method change (once final) is effective for 1999. Thus, the taxpayer is required to capitalize the costs in 1999 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.