Exploring Accounting Method Changes

On November 6, 2009, Congress enacted the Worker, Homeownership, and Business Act of 2009 (“the Act”) that allows all businesses a five-year period for carrying back net operating losses.

In 2008 and 2009, IRS issued two revenue procedures (Rev. Proc. 2008-52 and Rev. Proc. 2009-39) that add to an already lengthy list of automatic tax accounting method changes. What do these two disparate developments have to do with one another? In short, a great deal. Because many of the automatic tax accounting method changes would typically increase tax deductions, they may provide opportunities to create or increase a net operating loss in 2009 that may now be carried back up to five years to create a cash refund opportunity.

The Act provides taxpayers an election to carryback an applicable net operating loss for either (but not both) 2008 or 2009 for a period of three, four, or five years. The Act expands legislation enacted earlier in 2009 in the American Recovery and Reinvestment Tax Act that permits an eligible small business to carryback a 2008 applicable net operating loss for a period of three, four, or five years. The Act also eliminates the 90 percent limitation that applies for alternative minimum tax purposes to the use of a net operating loss for which the Election was made. Consequently, a net operating loss sustained in 2008 or 2009 is potentially more valuable than a loss sustained in other years.

Careful analysis is necessary to determine whether a five-year carryback of a 2008 or 2009 loss provides the greatest refund opportunity. Taxpayers who might create or increase a 2009 net operating loss through automatic accounting method changes made in 2009 should consider the impact of those potential accounting method changes when deciding whether to carryback a 2008 or 2009 loss. Revenue Procedure 2009-39 is particularly relevant to this analysis because it permits taxpayers to deduct repair and maintenance costs that were previously capitalized as well as abandoned property—two method changes that may produce substantial tax deductions for capital intensive enterprises.

In addition to increasing a net operating loss, automatic accounting method changes may also reduce current-year estimated tax payments, affect the tax provision and disclosures in financial statements, and provide back-year audit protection against potential penalties and interest for erroneous tax positions. These other aspects must be weighed in determining whether to change a tax accounting method.

An automatic accounting method change may be taken into account for purposes of determining estimated tax payments as soon as the intent is formed to file the application to change method (Form 3115). The application does not actually have to be filed for the benefit to be taken into account. For purposes of determining estimated tax payments, a taxpayer generally treats the “catch-up adjustment” (Sec. 481(a) adjustment) as an extraordinary item arising on the first day of the tax year in which the item is taken into account in determining taxable income. Alternatively, the taxpayer may choose to treat a Sec. 481(a) adjustment as an extraordinary item arising on the date the application to change a method is filed with the IRS National Office.

Realization of the impact of an accounting method change for financial statement purposes varies depending on whether the method change is automatic or non-automatic and whether the present method is proper. A taxpayer may be permitted to realize the financial statement impact of an automatic accounting method change from a permissible method to another permissible method at the time the decision is made to file the application, assuming the taxpayer is qualified to make the change. However, if the change is a non-automatic change, the impact would not be reflected in the financial statements until it is approved by the IRS. If the present method is an improper method, the financial statement impact is reflected in the financial statements when the improper method is identified, and the potential for interest or penalties would need to be considered.    If substantial favorable method changes are being filed, or improper methods are identified, careful consideration should be given to the financial reporting impact on tax uncertainties and disclosures. 

A taxpayer is eligible for back-year audit protection with respect to an erroneous method once the Form 3115 is properly filed with the IRS National Office. The IRS National Office copy of the automatic method-change application can be filed as late as the due date of the tax return for the year of change; however, there is no need to delay this filing until the return is filed – the application may be filed anytime during the year of change. Often these applications are filed as soon as possible to ensure that the taxpayer is not contacted by IRS to schedule an examination before the Form 3115 is filed.

A few of the often overlooked favorable accounting method changes that are now automatic include those for: rental income or expense; overhead capitalized under Sec. 263A to inventory or construction; repair and maintenance costs; abandonments; materials and supplies; trade discounts; vendor allowances; the tax treatment of workers’ compensation; prepaids, and other intangibles, including capitalized marketing expenses. Almost every taxpayer can reduce taxable income or increase a tax loss through appropriate tax accounting method planning focused solely on method changes that are automatic and that can still be made for the 2009 tax year.

In light of the enhanced carryback provision, taxpayers should take a close look at the availability of opportunities to change accounting methods.