Three-month Window Period for Filing Accounting Method Changes Opened July 15

Taxpayers and tax return preparers frequently identify impermissible accounting methods as part of the tax return compliance process. The new accounting method change procedures issued earlier this year provide opportunities to remediate impermissible accounting methods with back-year audit protection prior to filing the current-year tax return. Not under examination? There is no reason to wait until the tax return is being filed to file your accounting method change. Restrictions on filing will apply immediately once a taxpayer is contacted for examination. Still procrastinating on the adoption of the final tangible property regulations? Transition guidance allows taxpayers to continue to file changes to adopt the final tangible property regulations (including UNICAP changes) for 2014 under the old accounting method procedure, which provides a waiver of the scope limitations.

New three-month window period

When an impermissible accounting method is identified, the taxpayer must obtain consent to change to a proper method of accounting, generally by filing Form 3115. If the taxpayer continues to use the impermissible method, the taxpayer may be required to disclose the impermissible method on a Form 8275R and/or Form UTP. In prior years, when issues were identified in the tax compliance process for a taxpayer that was under IRS examination, it was often too late to make a change in accounting method for the current year because the 90-day window period, which opens on the first day of the taxable year, had already closed. Rev. Proc. 2015-13 made significant modifications to the rules for filing Form 3115 when under IRS examination. The new rules provide that a taxpayer under IRS examination may voluntarily file accounting method changes for impermissible methods with unfavorable (positive) Sec. 481(a) adjustments with a four-year spread period and secure audit protection during the three month window period. The three-month window period is generally available for taxpayers that have been under examination for at least 12 consecutive months. The three-month window period begins on the 15th day of the taxpayer’s 7th month and ends on the 15th day of the taxpayer’s 10th month. Under the new rules, if a taxpayer is under examination and not within a window period (either three-month or 120-day window period), the spread period for an unfavorable adjustment is two years, as opposed to four, and the taxpayer does not receive back-year audit protection immediately.

The new three-month window allows a taxpayer to file the Form 3115 to correct an impermissible method of accounting that is not an issue under consideration prior to filing the current year tax return. The taxpayer gains back-year protection upon the filing of Form 3115, which prevents IRS from raising the same issue in an earlier year. Taxpayers also should consider the impact of securing audit protection under the new accounting method change procedures on their assessment of uncertain tax positions in quarterly and year-end tax provisions.

Action point: As part of the tax return preparation process, consider areas of exposure or potential opportunities to accelerate deductions and save cash taxes by filing a Form 3115. Calendar-year taxpayers that are under IRS examination should evaluate their current methods of accounting and file Form 3115 to remediate impermissible methods in the three-month window that is available from July 15 to October 15, 2015. An automatic method change filed in this window period generally can be applied either to the 2014 tax year or the 2015 tax year. 

Common accounting method changes

The following list contains common accounting method changes from impermissible methods, which typically result in positive Sec. 481(a) adjustments that taxpayers may want to consider filing in the upcoming three-month window, assuming the issue is not yet under consideration.

Capital improvements vs. repair and maintenance costs. The final tangible property regulations that are effective for tax years beginning on or after January 1, 2014, provide that a taxpayer must capitalize under Sec. 263(a) costs that result in a betterment or restoration of a unit of property (UOP), or adapt a UOP to a new or different use. IRS has provided numerous automatic accounting method changes to comply with the final tangible property regulations. If the automatic method change is made effective for 2014, there are no restrictions for taxpayers under IRS examination to make the method changes and obtain audit protection and a four-year spread of any positive Sec. 481(a) adjustment.

Uniform capitalization under Sec. 263A. Due to the complexity of the uniform capitalization rules, taxpayers may find that they are using an improper method of accounting that results in undercapitalization of additional Sec. 263A costs. An automatic accounting method change to properly apply Sec. 263A can be filed on the same Form 3115 with a change to adopt the final tangible property regulations in 2014 with no restrictions for taxpayers under IRS examination.

Depreciation. There are many automatic accounting method changes related to fixed assets. The most common of these changes from impermissible methods provide taxpayers with the ability to change depreciation methods (such as GDS to ADS), recovery periods (such as from a five- or seven-year life to a 39-year life), or conventions.

Advance payments. Taxpayers that receive advance payments related to certain goods, services, the use of intellectual property, computer software, or guaranty or warranty contracts and follow book to recognize income for federal income tax purposes may need to change to the proper deferral method in accordance with Rev. Proc. 2004-34.

Inventory valuation. Taxpayers that follow books with respect to the treatment of inventory reserves may need to change to a proper inventory valuation method for tax purposes. Proper tax inventory valuation methods allow write-downs in appropriate circumstances for subnormal goods, inventory shrinkage, or lower-of-cost-or-market adjustments. Most changes to proper inventory valuation methods are eligible for automatic consent.

Rebates and allowances. Taxpayers that provide rebates and allowances to their customers and accrue such rebates consistent with their book method may need to change to properly apply the recurring-item exception under Sec. 461.

Employee bonuses. In many cases, a taxpayer can file an automatic method change to properly accrue compensation, including employee bonuses.

Losses, expenses, and interest between related parties. Taxpayers that have transactions with related parties and are not following the matching rule in Sec. 267 may be taking deductions into account too soon. Taxpayers in this situation may be able to file an automatic accounting method change to properly apply the provisions of Sec. 267 and the regulations.

State income taxes. Taxpayers that deduct their current state tax accrual on their federal tax return and include the true up between the current accrual and actual payments in the subsequent tax year, or that do not deduct the California franchise taxes on the lag method, may benefit from an automatic accounting method change to properly take state income taxes (and California franchise taxes) into account.