| Historical Service Position |
| In general, it has been
the long-standing position of the Service that, in the year an asset
is placed in service, an accounting method is adopted relative to
the depreciation method, recovery period, or convention for the
depreciable property.
In any subsequent year after the
placed-in-service year, a change in depreciation method, recovery
period, or convention resulting from a reclassification of such
property, results in a change in method of accounting. Such a change
requires the consent of the Commissioner (i.e., the taxpayer must
generally file Form 3115, Application for Change in Accounting
Method), and the adjustment to income is made pursuant to IRC §
481(a).
If a taxpayer has adopted a method of accounting, the
taxpayer may not change the method by amending its prior income tax
returns. See Rev. Rul. 90-38, 1990-1 C.B. 57. Accordingly, amended
returns or claims for adjustment, based on a cost segregation study
performed after the original return was filed (for the
placed-in-service year), should generally be disallowed on the basis
that the taxpayer is attempting to make a retroactive method change.
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Accounting Method
Gregory J. Cook, EA, CPA, Accredited Tax Advisor
An accounting method is a set of rules used
to determine when and how income and expenses are reported.
You choose an accounting method for your
business when you file your first income tax return. There are two basic
accounting methods.
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Cash method. Under the cash method, you report income in the tax year you receive it. You usually deduct or capitalize expenses in the tax year you pay them.
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Accrual method. Under an accrual method, you generally report income in the tax year you earn it, even though you may receive payment in a later year. You deduct or capitalize expenses in the tax year you incur them, whether or not you pay them that year.
For other methods, see
Publication 538.
If you need inventories to show income correctly, you must generally use an accrual method of accounting for purchases and sales. Inventories include goods held for sale in the normal course of business. They also include raw materials and supplies that
will physically become a part of merchandise intended for sale. Inventories are explained in Publication 538.
Certain small business taxpayers may be eligible to adopt or change to the cash method of accounting and may not be required to account for inventories. For more information, see Publication 538.
You must use the same accounting method to figure your taxable income and to keep your books. Also, you must use an accounting method that clearly shows your income. In general, any accounting method that consistently uses accounting principles suitable for your trade or business
clearly shows income. An accounting method clearly shows income only if it treats all items of gross income and expense the same from year to year.
More than one business. When you own more than one business, you can use a different accounting method for each business if the method you use for each clearly shows your income. You must keep a complete and separate set of books and records for each business.
Changing your method of accounting. Once you have set up your accounting method, you must get IRS approval before you can change to another method. A change in accounting method not only includes a change in your overall system of accounting, but also a change in the
treatment of any material item. For examples of changes that require approval and information on how to get approval for the change, see Publication 538.
Historically, a taxpayer
has been required to use an accrual accounting method with regard to
purchases and sales of merchandise whenever the taxpayer was required to
account for inventories. In Revenue Procedure 2001–10, 2001–1 C.B. 272
and Revenue Procedure 2002–28, 2002–1 C.B. 815, the Commissioner has
exempted some qualifying taxpayers from having to use an accrual
accounting method and from having to account for inventories.
Revenue Procedure 2001–10 is available for use by "qualifying
taxpayers." A qualifying taxpayer is a taxpayer (1) who has average
annual gross receipts of $1,000,000 or less and (2) who is not a tax
shelter within the meaning of Internal Revenue Code Section 448(a)(3).
Revenue Procedure 2001–10 provides detailed procedures for determining
whether you satisfy the average annual gross receipts test. Review
section 5 of Revenue Procedure 2001–10 for these procedures.
Revenue Procedure 2002–28, exempts "qualifying small business taxpayers"
from the requirements to use the accrual accounting method and permits
treatment of inventorial items as materials and supplies that are not
incidental. You are a qualifying small business taxpayer if your average
annual gross receipts are in excess of $1,000,000 but are not more than
$10,000,000, and your principle business activity is an eligible
business. Review Sections 3 and 4 of Revenue Procedure 2002–28 for the
qualification requirements.
If you are a qualifying taxpayer under Revenue Procedure 2001–10 or a
qualifying small business taxpayer under Revenue Procedure 2002–28 you
may choose to:
Use the cash accounting method and treat your inventoriable items as
inventory within the meaning of IRC Section 471,
Use the cash accounting method and treat your inventoriable items as
materials and supplies that are not incidental within the meaning of
Treasury Regulation Section 1.162–3, or
Use an accrual accounting method and treat your inventoriable items as
materials and supplies that are not incidental within the meaning of
Treasury Regulation Section 1.162–3.
You can also follow the historic rule, that is, use an accrual
accounting method and treat your inventoriable items as inventory within
the meaning of IRC Section 471.
Be aware that Revenue Procedure 2001–10 & Revenue Procedure 2002–28
specifically state when you can deduct the costs for the inventoriable
items that are being treated as materials and supplies that are not
incidental within the meaning of Treasury Regulation 1.162–3. In the
case of a cash method taxpayer, the cost for these items cannot be
deducted until the year in which (1) you sell the items or (2) you pay
for them, whichever is later.
A taxpayer wishing to change to the cash method or to change its method
of accounting for inventory under the rules in Revenue Procedure 2001–10
or Revenue Procedure 2002–28 must follow the provisions of Revenue
Procedure 2002–9, 2002–1 C.B. 327, as modified and clarified by
Announcement 2002–17, 2002–1 C.B. 561, modified and amplified by Rev.
Proc. 2002–19, 2002–1 C.B. 696, and amplified, clarified, and modified
by Rev. Proc. 2002–54, 2002–2 C.B. 432.
NOTE: It is the
position of the Service that a change in recovery period is a change in
accounting method. Accordingly, a taxpayer is required to obtain the
consent of the Commissioner by filing a timely Form 3115. |
| Recent Litigation |
| In recent years, the historical position of the Service
was challenged in several court cases. The Fifth
Circuit, affirming the Tax Court, held that the
reclassification of gas station properties as 15-year
property for MACRS purposes was not a change in
accounting method requiring the Secretary's consent
[Brookshire Brothers Holding, Inc. & Subsidiaries v.
Commissioner, 320 F.3d 507 (5th Cir. 2003), aff’g T.C.
Memo. 2001-150, reh’g denied (March 31, 2003)]. The
Circuit Court agreed with the Tax Court that the
then-existing regulations were meant to allow taxpayers
to make temporal changes in their depreciation schedules
without the consent of the IRS. The Court also affirmed
that Brookshire's change in the classification of its
gas station properties from straight-line depreciation
of non-residential real estate to declining balance
depreciation of 15-year property was not a change in
Brookshire's method of accounting under IRC § 446.
The decision of the Fifth Circuit in Brookshire
conflicts with the opinion of the Tenth Circuit in
Kurzet v. Commissioner, 222 F.3d 830, 842-845 (10th Cir.
2000). In Kurzet, the taxpayer sought to change the
classification of a reservoir from nonresidential real
property to 15-year property under § 168, thereby
resulting in a change in recovery period from 31.5 years
to 15 years. The taxpayer did not change the method of
depreciation for the reservoir, which was the
straight-line method of depreciation. Although the Tenth
Circuit found "some persuasive value to the [taxpayer’s]
argument that a change in recovery period under MACRS
should be treated like a change in useful life," the
court concluded that the Commissioner’s interpretation
of § 1.446-1(e)(2)(ii) as requiring a taxpayer to obtain
permission for a change in recovery period is not
"plainly erroneous" or "inconsistent" with §
1.446-1(e)(2)(ii).
In addition, the Tax Court in Standard Oil Co. (Indiana)
v. Commissioner, 77 T.C. 349, 410-411 (1981), held that
a change in depreciation method resulting from a
reclassification of depreciable property from section
1250 property to section 1245 property is a change in
method of accounting. In reaching its decision, the
court cited to §§ 1.167(e)-1 and 1.446-1(e)(2)(ii)(a),
and explained "It is unquestioned that a change in the
method of computing depreciation is a change in method
of accounting." Id. at 410. (But see, Green Forest
Manufacturing Inc. v. Commissioner, T.C. Memo. 2003-75,
which followed Brookshire by holding that a change in
computing depreciation from the general depreciation
system in § 168(a) (GDS) to the alternative depreciation
system in § 168(g) (ADS) is not a change in method of
accounting, and O’Shaughnessy v. Commissioner, 332 F.3d
1125 (8th Cir. 2003), rev’g in part 2002-1 U.S.T.C. (CCH)
¶ 50,235 (D. Minn. 2001), which also followed Brookshire
by holding that a change in classification under MACRS
is not a change in method of accounting). |
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