SECTION 2. BACKGROUND

.01 Method of accounting . (1) The term “method of accounting” includes (a) an overall plan of accounting, such as for gross income and deductions, and (b) 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, or both. See § 1.446–1(e)(2)(ii)(a). 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 taxable income. If the practice does not permanently affect the taxpayer’s lifetime taxable income, but does or could change the taxable year(s) in which the item is taken into account, 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 federal income tax returns, without regard to any change in characterization 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 federal income tax return that reflects the item, however, 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. Once a taxpayer has adopted a method of accounting, the taxpayer has established a method of accounting. An established method of accounting includes a finalized Internal Revenue Service (IRS) imposed method of accounting under Rev. Proc. 2002–18, 2002–1 C.B. 678.

(3) The regulations under § 446 provide that no method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income. To clearly reflect income, the method must, for example, be used consistently from one taxable year to another. See

§§ 1.446–1(a)(2), 1.446–1(c)(1)(ii)(C), and 1.446–1(c)(2)(ii).

(4) Section 446(a) and § 1.446–1(a)(1) provide that taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes income in keeping the taxpayer’s books (§ 446 book-tax conformity requirement). Section 1.446–1(a)(4) requires each taxpayer to maintain accounting records that will enable the taxpayer to file a correct return and states that accounting records include the taxpayer’s regular books of account and other records and data as may be necessary to support the entries on the taxpayer’s books of account and on the taxpayer’s return, as for example, a reconciliation of any differences between such books and his return. Thus, a taxpayer satisfies the § 446 book-tax conformity requirement if the taxpayer reconciles the results obtained under the method of accounting used in keeping its records and accounts and the method used for federal income tax purposes and maintains sufficient records to support that reconciliation.

.02 Changing a method of accounting . (1) A change in method of accounting occurs when the method of accounting to be used by the taxpayer for an item (or that would be used if the taxpayer had the item in the year of change) in computing its taxable income for the year of change is different than the taxpayer’s established method of accounting used (or that would have been used if the taxpayer had the item in the immediately preceding year) to compute the taxpayer’s taxable income for the immediately preceding taxable year.

(2) 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).

.03 Securing consent for a change in method of accounting .

(1) 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 any item for federal income tax purposes. Unless specifically authorized by the Commissioner

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changes in method of accounting. This revenue procedure, in conjunction with the List of Automatic Changes, provides the current procedures for automatic changes and non-automatic changes.

.04 Terms and conditions of a change in method of accounting . Section 1.446– 1(e)(3)(ii) provides that the Commissioner may prescribe administrative procedures setting forth the terms and conditions deemed necessary to permit a taxpayer to obtain consent to change a method of accounting under § 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.

.05 No retroactive change in method of accounting . Unless specifically authorized by the Commissioner or by statute, a taxpayer may not request, or otherwise make, a retroactive change in method of accounting. See generally Rev. Rul. 90–38.

.06 Change in method of accounting with a § 481(a) adjustment .

(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 of accounting 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, taxable income for the taxable year preceding the year of change must be determined under the method of accounting that was then employed, and taxable income for the year of change and the following taxable years must be determined under the method of accounting for which consent is granted as if that method of accounting 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 taxable years (closed years) in which the events giving rise to the need for an adjustment occurred.

When the Commissioner grants consent to a taxpayer to change its method of accounting, § 481(c) and §§ 1.446– 1(e)(3)(ii) and 1.481–4 provide that the taxpayer may take the adjustment required by § 481(a) into account in determining

taxable income only in the manner and subject to the conditions agreed to by the Commissioner and the taxpayer.

(2) Effect on earnings and profits . A corporation takes any § 481(a) adjustment resulting from a change in method of accounting into account in computing its earnings and profits. See § 1.312–6 and Rev. Proc. 79–47, 1979–2 C.B. 528.

.07 Change in method of accounting using a cut-off basis . The IRS may determine that certain changes in methods of accounting must be made without a § 481(a) adjustment. When a change in method of accounting is made without a § 481(a) adjustment (for example, 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 method of accounting for which consent is granted. 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 ex- ample, § 263A (which generally applies to costs incurred after December 31, 1986, for non-inventory property), § 461(h) (which generally applies to amounts incurred on or after July 18, 1984), and sections 2.01, 5.01, and 22.02 of the List of Automatic Changes. When a change in method of accounting is made on a cut-off basis, no amounts are duplicated or omitted, and therefore, a § 481(a) adjustment is not necessary or permitted.

.08 Separate trades or businesses . (1) 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 will be considered separate and distinct unless the taxpayer keeps a complete and separable set of books and records for that trade or business. See § 1.446–1(d)(2).

(2) 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 taxpayer’s trades or businesses will not be considered to be separate and distinct. See § 1.446–1(d)(3).

.09 Change made as part of an exam- ination . 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 IRS may change the taxpayer’s method of accounting to one that, in the opinion of the IRS, does clearly reflect income. In that case, a change in method of accounting resulting in a positive § 481(a) adjustment ordinarily will be made in the earliest taxable year under examination with a oneyear § 481(a) adjustment period. See Rev. Proc. 2002–18. But see SECTION 8 regarding audit protection.