A change in method of accounting generally requires an adjustment under IRC section 481(a). IRC 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 IRC section 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 IRC section 481(a) adjustment is computed as of the beginning of the taxable year for which the method is being changed (year of change). Simply stated, the adjustment represents the cumulative difference (without regard to the statute of limitations) between the present and proposed methods. The IRC section 481(a) adjustment may increase income (positive adjustment) or decrease income (negative adjustment). In addition to the following example, see Exhibit (1) for a more detailed example of computing an adjustment under IRC section 481(a).

A net positive IRC section 481(a) adjustment increases income and may be referred to as a "taxpayer-unfavorable" adjustment. A net negative IRC section 481(a) adjustment decreases income and may be referred to as a "taxpayer-favorable" adjustment. When a taxpayer uses a voluntary method change procedure (e.g., Rev. Proc. 97-27) or a regulation provision, generally a net negative IRC section 481(a) adjustment is taken into account in the year of change (pursuant to Rev. Proc. 2002-19 effective for years ending on or after December 31, 2001). A net positive IRC section 481(a) adjustment is taken into account over four years starting with the year of change. When the Service imposes a method change (involuntary method change) as a result of an examination, in general the entire net positive or negative IRC section 481(a) adjustment is taken into account in the year of change. See Rev. Proc. 2002-18 for involuntary method change procedures.

When the Service imposes a method change (involuntary method change) as a result of an examination and there is a net positive IRC section 481(a) adjustment in excess of $3,000, it is mandatory that IRC section 481(b) be applied. IRC section 481(b) provides a limitation on the tax under Chapter 1 of the Internal Revenue Code for the taxable year of change that is attributable to the adjustments required under IRC section 481(a) and Treas. Reg. section 1.481-1 if the entire amount of the adjustment is taken into account in the year of change. See Exhibit (2) for an example of tax computation under IRC section 481(b).

The Commissioner may determine that certain changes in method of accounting will be made without an IRC section 481(a) adjustment using a " cut-off" method. Under a cut-off method, 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, IRC section 263A (which generally applies to costs incurred after December 31, 1986, for non-inventory property), IRC section 461(h) (which generally applies to amounts incurred on or after July 18, 1984), and IRC section 1.446-3 (which applies to notional principal contracts entered into on or after December 13, 1993). Because no items are duplicated or omitted from income when a cut-off method is used to effect a change in accounting method, no IRC section 481(a) adjustment is necessary. The cut-off may be used in a taxpayer-initiated method change only where specifically allowed or required by statute, regulation or by the Commissioner in published guidance.

Normally, a taxpayer uses the general automatic consent procedures (Rev. Proc. 2002-9 and successors) or the general advance consent procedures (Rev. Proc. 97-27 and successors) to request consent to change its method of accounting. In some instances, however, a statute, regulation or IRS publication may establish unique procedures, terms and conditions for obtaining consent to change a method of accounting. For example see IRC sections 174, 263A, 448, and 460 and the related treasury regulations. Thus, it is important that the examiner determine the authority being used to support the change in method of accounting.

Rev. Proc. 97-27 contains procedures for obtaining advance consent to change a method of accounting. In general, these procedures apply to all accounting method changes initiated by a taxpayer, except those accounting method changes that must be made under the automatic consent procedures (Rev. Proc. 2002-9 or successors) or special procedures established by statutes, regulations or IRS publications.

The "advance consent" Revenue Procedure 97-27:

Rev. Proc. 2002-9 contains general procedures for obtaining automatic consent to change certain methods of accounting which are described in the Appendix of Rev. Proc. 2002-9 or subsequent pronouncements. These procedures are the exclusive procedures for obtaining consent to make any of these specific accounting method changes.

The "automatic consent" Revenue Procedure 2002-9:

In determining whether an automatic method change was properly made, the examiner should first consider the automatic change revenue procedure in effect for the year the taxpayer made the change to verify the specific method change is included in the Appendix of the procedure. If not, the examiner should then check to see if the change was addressed in any subsequent pronouncement that modified the automatic consent procedure. Finally, the examiner should verify the taxpayer properly followed the terms and conditions for that specific change in the applicable procedures.

Most accounting method changes are granted with audit protection, which means that the Service will not require the taxpayer to change its method of accounting for the same item for a taxable year prior to the year of change. For example, a taxpayer has been using an impermissible method of accounting for several years for certain items. In 2003, the taxpayer files an application under Rev. Proc. 2002-9 to change to a proper method of accounting for such items. If the change is made with audit protection, the Service would not be able to propose an adjustment for the improper method of accounting for such items in an examination of an earlier taxable year. Rev. Proc. 97-27 section 9; Rev. Proc. 2002-9 section 7.

The Service has provided specific exceptions to audit protection in some pronouncements. See, for example, the automatic consent procedures (Rev. Proc. 2002-9) which indicate that audit protection is not granted for specified method changes. Examiners should determine what method change was made and determine if audit protection was granted for that specific method change.

In general - The scope limitations are the rules within a voluntary method change procedure that indicate when (in what circumstances) the taxpayer may or may not use such guidance to request a voluntary method change. For example, a scope limitation generally prohibits taxpayers from requesting consent for a method change once they have been contacted for examination. This scope limitation is subject to several exceptions, as discussed in (3), below.

Waiver of scope limitations - In some instances, the scope limitations that would otherwise apply to a voluntary method change request may be waived by statute, regulation, or IRS publication. A scope limitation waiver may be limited to certain circumstances or to certain taxable years. For example, some procedures may indicate that scope limitations are waived unless the accounting method to be changed is an "issue under consideration," while other procedures may indicate that scope limitations are waived only for a certain taxable year or years. Accordingly, examiners need to review carefully the applicable guidance to determine the nature and extent of scope limitations applicable to a given voluntary method change request. See, for example, Treas. Reg. section 1.263(a)-4(p)(2); section 1.263(a)-5(n)(2); and Rev. Proc. 2004-23 section 4.01(1).

Taxpayers under examination - The general rule (scope limitation) is that a taxpayer may not request a voluntary method change while under examination for any year. However, this general rule has the following exceptions:

"Issue under consideration" is a relevant concept when a taxpayer desires to make a voluntary method change and use the 90-day or 120-day windows found in the scope limitations of Rev. Proc. 97-27 or Rev. Proc. 2002-9. A taxpayer's method of accounting for an item is an issue under consideration for the taxable years under examination if the taxpayer receives written notification (for example, by examination plan, information document request (IDR), or notification of proposed adjustments or income tax examination changes) from the examining agent(s) specifically citing the treatment of the item as an issue under consideration. See Rev. Proc. 97-27 or Rev. Proc. 2002-9 for examples of what is an issue under consideration.

Nature of "director consent." The "director consent" provision allows a taxpayer under examination to file a Form 3115 (by obtaining "director consent" for such filing) when the taxpayer would otherwise be prohibited from filing a Form 3115.

When should the "Consent" be granted? The "Consent" should be granted in the following circumstances:

How is a request for director consent processed? An examiner faced with a request for director consent from a taxpayer should do the following:

Who should sign the "letter" ? In response to a taxpayer's request for "consent of director" , the Service will provide a written letter of "objection" or "non-objection" to the filing of a Form 3115. Each Area may establish its own procedure as to who may sign the letter. The team/group manager has been delegated authority to sign the letter as follows:

What is the physical flow of the response letter to the taxpayer? Each Area may establish its own procedure as to the physical flow of the letter to the taxpayer. The following is a recommended procedure:

What should the examiner do about closing the current years? The request for "consent of director" to file a Form 3115 in the current year should have no impact on the conduct of the examination of the selected filed returns.

What happens if the examination function objects? If the examination function properly objects to a request, the change in method of accounting may not be made under either Rev. Proc. 97-27 or Rev. Proc. 2002-9.

What if there are concerns with the requested change? After review of the Form 3115, the examiner may have questions or concerns with the request, such as:

The examiner should advise the taxpayer of the concern and document the fact that the taxpayer was advised of the concern. If a non-objection letter is otherwise appropriate, issue the non-objection letter.

Circumstances which may occur relative to a request for "Consent" :

Responsibilities for Pre-filing - An examiner has the following responsibilities with respect to a request from a taxpayer under examination that desires to file a Form 3115 to make a voluntary change in accounting method in a year not yet filed.
(a) Ascertain:

(b) The Examiner may coordinate with Chief Counsel regarding:

Responsibilities for Post-filing - An examiner should consider the following as potential areas of inquiry when examining a tax return in which a taxpayer has implemented a change in accounting method under a voluntary method change procedure.
(a) Rev. Proc. 97-27 filing:

(b) Rev. Proc. 2002-9 filing:

Revenue procedure 2002-18 sets forth procedures for Examination, Appeals, and Counsel for the government to resolve accounting method issues. It does not alter Examination's authority to examine the returns of a taxpayer. It provides parameters for Examination to resolve accounting method issues, but does not limit or expand Examination's authority to resolve any issues under any applicable Delegation Order (e.g., Delegation Order No. 236, Application of Appeals Settlement to Coordinated Examination Program Taxpayers, and Delegation Order No. 247, Authority of Examination Case Managers to Accept Settlement Offers and Execute Closing Agreements on Industry Specialization Program and International Field Assistance Program Issues). This revenue procedure also does not alter or limit the authority of Appeals or Counsel for the government to resolve or settle any issues.

Examiners will be faced with potential accounting method change issues in three situations:

Sections 446(b) and 1.446-1(b)(1) provide that if a taxpayer does not regularly employ a method of accounting that clearly reflects income, the computation of taxable income must be made in the manner that, in the opinion of the Commissioner, does clearly reflect income. The Commissioner has broad discretion in determining whether a taxpayer's method of accounting clearly reflects income, and the Commissioner's determination must be upheld unless it is clearly unlawful. Once the Commissioner has determined that a taxpayer's method of accounting does not clearly reflect income, the Commissioner has broad discretion in selecting a method of accounting which properly reflects income. The selection may be challenged only upon showing an abuse of discretion by the Commissioner. The Commissioner does not have discretion to require a taxpayer to change from a method of accounting that clearly reflects income to a method that, in the Commissioner's view, more clearly reflects income.

Accordingly, the first determination that the examiner must make is whether or not the accounting method being used (adopted) for an item by the taxpayer is permissible. The examiner must first make a concerted effort to understand what accounting method is being used by the taxpayer for the item(s) in question. This determination may entail having the taxpayer walk the examiner through transactions, journal entries, or other books and records. Generally, examples of journal entries shown by the taxpayer based upon hypothetical data should be verified with actual transactional data including actual journal entries that are contained in the books and records. After the examiner acquires an understanding of the taxpayer's transactions and accounting method for items, the examiner needs to ascertain what accounting treatment(s) is (are) permissible based upon Service position.

Generally, there are established Service positions as to what are proper methods of accounting for items. However, if the examiner is unable to ascertain Service position or if there is no official Service position and the examiner believes there is an accounting method issue, the examiner may consider seeking advice (formal or informal) from local field counsel, the Office of Chief Counsel, or LMSB Technical Advisors.

If the accounting method used for item(s) by the taxpayer is impermissible, the examiner may propose an adjustment with respect to that method only by changing the taxpayer's method of accounting pursuant to Rev. Proc. 2002-18, in order to place the taxpayer on a proper method of accounting for such item(s).

IRC section 446(e) provides 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. The Commissioner may require a taxpayer that has changed a method of accounting without the Commissioner's consent to change back to its former method. The commissioner may do so even when the taxpayer changed from an impermissible to a permissible method. The change back to the former method may be made in the taxable year the taxpayer changed without consent, or if that year is closed by the running of the period of limitations, in the earliest open year. For example, the Service may change a taxpayer back to its former impermissible method of accounting if the taxpayer changed to a permissible method of accounting without the Commissioner's consent and miscalculated the IRC section 481(a) adjustment, even where the statute of limitations has expired for the year of change. See Rev. Proc. 2002–18, section 2.06.

While the examiner may allow an unauthorized method change, such action should only be taken as an exception. The examiner, using professional judgement, should consider the following factors when applying the exception:

The examiner should fully explain in the workpapers the rationale for proposing or not proposing the unauthorized method change issue. If a change in method of accounting issue is not proposed, the examiner should document that all items are treated in a manner that prevents the duplication or omission of items of income or deduction. The examiner should contact the CAM Technical Advisors for assistance in addressing these arguments if necessary.

Error correction or retroactive accounting method change? Often, during the conduct of an examination, the examining agent will encounter a claim (formal or informal) requesting an adjustment. The examiner should carefully review such claim to determine whether the claim constitutes (i) the correction of an error in taxable year(s) under examination, or (ii) a request for a retroactive change in method of accounting for a year under examination.

When should examination impose a retroactive accounting method change proposed by the taxpayer?

Declining to impose a retroactive accounting method change requested by taxpayer. Generally, it is not appropriate for a taxpayer to obtain more advantageous terms and conditions by requesting a change in accounting method after being contacted for examination. In addition, routine consideration of taxpayer requests for retroactive method changes would consume substantial examination resources and thereby impede the Service's enforcement efforts. The Service's refusal to make taxpayer-requested retroactive method changes is consistent with equitable tax administration, since the taxpayer chooses the original method of accounting and may change from an impermissible method on a prospective basis by filing a Form 3115.

If questions exist, the examiner should contact the CAM Technical Advisor. If the examiner deems it necessary to decline to initiate an accounting method change, the examiner should recommend that the taxpayer request consent to make a voluntary method change pursuant to the appropriate administrative procedure. In addition, the examiner should coordinate with the taxpayer and provide the " director consent," if necessary, to facilitate the taxpayer's request.

Change in Service's position. Where the Service has changed its position with respect to a particular method of accounting (i.e., it recognizes the permissibility of a method which it previously viewed as impermissible), a taxpayer may request that the examiner allow a change to the previously controverted method in the years under examination via formal or informal claim. Whether to allow a retroactive change based on a change in position is a determination that is appropriately made at the National Office Chief Counsel level. In at least one "unique and extraordinary " circumstance, retroactive change has been allowed within a specified time period. See Rev. Proc. 91-31 (allowed retroactive change in reaction to the decision in Indianapolis Power & Light, 493 U.S. 203 (1990)). The determination as to whether and when such changes should be allowed should not be made by the examiner, as such a practice would result in disparate treatment (differing determinations and differing terms of change) among taxpayers under examination and disparate treatment between taxpayers under examination and those not under examination. Examiners may contact the CAM Technical Advisor and submit a request for technical advice if warranted.

Correction of an error. Where an examiner determines that an error correction is necessary and it is not a method change issue, the examiner should make such error correction for the years under examination regardless if the adjustment is positive or negative.

Using professional judgment in accordance with auditing standards, an examining agent will make findings of fact and apply Service position on issues of law to determine whether an issue is an accounting method issue and whether the taxpayer's method of accounting is permissible. The term "accounting method issue" means an issue regarding whether the taxpayer's accounting treatment of an item is proper, but only if changing the taxpayer's treatment of such item could constitute a change in method of accounting. See Treas. Reg. 1.446-1(e)(2) and Rev. Proc. 2002–18, sections 2.01 and 3.01.

An examining agent who determines that a taxpayer's method of accounting is impermissible, or that a taxpayer changed its method of accounting without obtaining the consent of the Commissioner may propose an adjustment with respect to that method only by changing the taxpayer's method of accounting. Failure to recognize and properly treat an accounting method issue as a change in method of accounting can result in a permanent overstatement or understatement of a taxpayer's lifetime taxable income. See Rev. Proc. 2002-18, section 5.02

An examining agent changing a taxpayer's method of accounting will select a new method of accounting by properly applying the law to the facts determined by the agent. The method selected must be a proper method of accounting and will not be a method contrived to reflect the hazards of litigation. See Rev. Proc. 2002-18, section 5.03

An examining agent changing a taxpayer's method of accounting will make the change in a year under examination. Ordinarily, the change will be made in the earliest taxable year under examination, or, if later, the first taxable year the method is considered to be impermissible. However, in appropriate circumstances, an examining agent may defer the year of change to a later taxable year. See Rev. Proc. 2002-18 section 5.04(1).

An examining agent changing a taxpayer's method of accounting ordinarily will impose a 481(a) adjustment, subject to a computation of tax under IRC section 481(b) (if applicable). See Exhibits (1, 2). However, an examining agent should use a cut-off method to make a change (other than a change within the LIFO inventory method as defined in Rev. Proc. 97-27 section 3.09, or a change in method of accounting for intercompany transactions (see Treas. Reg. 1.1502-13) when a statute, regulation or administrative pronouncement of the Service effective for the year of change directs that the change be made using a cut-off method. See, e.g., IRC section 174. In addition, an examining agent may use a cut-off method to make a change in appropriate circumstances. See Rev. Proc. 2002-18 section 5.04(2).

The IRC section 481(a) adjustment, whether positive or negative, will be taken into account entirely in the year of change. See Rev. Proc. 2002–18, section 5.04(3).

An examining agent changing a taxpayer's method of accounting will provide written notice that an accounting method issue is being treated as an accounting method change. Resolution of an accounting method issue without notice will not establish a new method of accounting. Written notice is a statement in the RAR that a method change is being proposed pursuant to IRC section 446 and 481. To implement a Service-imposed method change, it is recommended that the taxpayer and the Service execute a closing agreement in which the taxpayer agrees to the change and the terms and conditions of the change. If the taxpayer and the Service execute a closing agreement finalizing the change, the notice will be provided in the closing agreement. Rev. Proc. 2002-18 provides a model closing agreement. Such closing agreement is not mandatory.

The written notice must include:

If the taxpayer and the Service execute a closing agreement, the change is final as of the date of the agreement (unless otherwise provided by a federal court). In the absence of such an agreement, a Service-imposed accounting method change is final only upon the expiration of the period of limitations for filing a claim for refund under 6511 for the year of change or the date of a final court order requiring the change.

The Service should make the adjustments necessary to effect a Service-imposed accounting method change to the taxpayer's returns for the taxable years under examination, before Appeals, or before a federal court. These adjustments include the adjustments to taxable income necessary to reflect the new method (including the IRC section 481(a) adjustment required as a result of the change), and any collateral adjustments to taxable income or tax liability resulting from the change.

If the taxpayer does not use the new method on any return filed prior to the date a Service-imposed change becomes final, and does not file amended returns to reflect the change, the Service should make the adjustments necessary to reflect the change for the affected taxable years if and when it examines those returns.