SECTION 2. BACKGROUND

.01 Change in method of accounting defined.

(1) Section 1.446–1(e)(2)(ii)( a ) 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

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it is not necessary for the taxpayer to treat the item consistently in two or more consecutive 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 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. Section 446(e) and § 1.446–1(e)(2)(i) 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 general, 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 for which the taxpayer wants to make the proposed change.

.03 Terms and conditions of a method change . Section 1.446–1(e)(3)(ii) provides that the Commissioner may 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 gener- ally Rev. Rul. 90–38. But see section 6.02(3)(d)(i) of this revenue procedure.

.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 employed, 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. The § 481(a) adjustment is computed notwithstanding that the period of limitations on assessment and collection of tax may have closed on the years (closed years) in which the events giving rise to the need for an adjustment occurred. See Superior Coach of Fla., Inc. v. Commissioner, 80 T.C. 895, 912 (1983). In computing the net § 481(a) adjustment, a taxpayer must take into account all relevant accounts. For example, the § 481(a) adjustment for a change in the proper time for deducting salary bonuses under § 461 reflects any necessary adjustments for amounts of salary bonuses capitalized to inventory under § 263A.

Example . A taxpayer that is not required to use inventories uses the overall cash receipts and disbursements 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) Adjustment period . Section 481(c) and §§ 1.446–1(e)(3)(ii) and 1.481–4 provide that the adjustment required 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 § 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 ba- sis . The Commissioner may determine that certain changes in methods of accounting will be made without a § 481(a) adjustment, using a cut-off basis. When a change in method of accounting is made on a cut-off basis, in general, 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, sections 2.01, 10.04 and 22.02 of the APPENDIX of this revenue procedure. Because no amounts are duplicated or omitted when a change in method of accounting is made on a cut-off basis, 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 Commissioner exercises 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, the taxpayer may use a different method of accounting 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 the taxpayer keeps a complete and separable set of books and records 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 taxpayer’s trades or businesses (for example, through inventory adjustments, sales, purchases, or expenses) so that the taxpayer’s income is not clearly reflected, the

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or submitting additional information) falls on a Saturday, Sunday, or legal holiday. The performance of any act is timely if the act is performed on the next succeeding day that is not a Saturday, Sunday, or legal holiday.

.06 Year of change . The year of change is the taxable year for which a change in method of accounting is effective, that is, the first taxable year the new method is to be used, even if no affected items are taken into account for that year.

.07 Section 481(a) adjustment period . The § 481(a) adjustment period is the applicable number of taxable years for taking into account the § 481(a) adjustment required as a result of the change in method of accounting. The year of change is the first taxable year in the adjustment period and the § 481(a) adjustment is taken into account ratably over the number of taxable years in the adjustment period. The applicable adjustment periods are set forth in section 5.04 of this revenue procedure.

.08 Under examination . (1) In general . (a) Except as provided in sections 3.08(2), 3.08(3) and 3.08(5) of this revenue procedure, an examination of a taxpayer with respect to a federal income tax return begins on the date the taxpayer is contacted in any manner by a representative of the Internal Revenue Service (Service) for the purpose of scheduling any type of examination of the return. Except as provided in sections 3.08(1)(b), 3.08(1)(c), 3.08(2), 3.08(3) and 3.08(4) of this revenue procedure, an examination ends:

(i) in a case in which the Service accepts the return as filed, on the date the “no change” letter is sent to the taxpayer;

(ii) in a fully agreed case, on the earliest of the date the taxpayer executes a waiver of restrictions on assessment or acceptance of overassessment (for example, Form 870, Waiver of Restrictions on Assess- ment and Collection of Deficiency in Tax and Acceptance of Overassessment, Form 4549, Income Tax Examination Changes, or Form 4605, Examination Changes — Partnerships, Fiduciaries, S Corporations, and Interest Charge Domestic Interna- tional Sales Corporations ), the date the taxpayer makes a payment of tax that equals or exceeds the proposed deficiency, or the date of the “closing” letter (for ex

taxpayer’s trades or businesses 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 examination . Section 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 director may make the change. A change resulting in a positive § 481(a) adjustment ordinarily will be made in the earliest taxable year under examination with a one-year § 481(a) adjustment period. See Rev. Proc. 2002–18, 2002–1 C.B. 678.