MLR

Changing accounting methods has tax impact

Categories:

Owners of an automobile dealership recently found out the hard way that automatic consent from the commissioner of the Internal Revenue Service is not always required to make a change in accounting method.

There is a lot of case law on this topic, and the law is very clear. If a taxpayer changes the method of accounting used in computing taxable income without first requesting the tax commissioner’s consent, the commissioner has two choices:

  • Require the taxpayer to abandon the new method of accounting and report taxable income using the old method
  • Accept the change of accounting method and require the taxpayer to make any adjustments necessary to prevent amounts from being duplicated or omitted

In this case (James H. Hawse and Cynthia L. Hawse v. Commissioner, T.C. Memo 2015-99, May 27, 2015), the commissioner chose the second option and accepted the change in accounting method despite the fact that automatic consent had not been given.

JHH Motor Cars, Inc., lost its case for a refund in U.S. Tax Court. The case dealt with whether JHH had made a change in accounting method from the last in, first out (LIFO) method to the specific identification method.

Because it did not fully comply with all of the provisions of Revenue Procedure 99-49, JHH felt that it did not receive automatic consent from the Internal Revenue Service to switch methods. The U.S. Tax Court felt differently and ruled in favor of the IRS. In effect, the specific identification method became the accounting method.

JHH Motor Cars, Inc., had elected to use the LIFO method of accounting for vehicle inventory in 1985. In early 2001, James Hawse, the owner of JHH, wanted to change from the LIFO method of accounting for inventory to the specific identification method. He was trying to sell the dealership and felt that this change would help.

Because an unrecaptured LIFO reserve has to be brought into income upon the sale or liquidation of a business, a prospective buyer of the dealership could suffer a large tax consequence because of the dealership’s use of the LIFO method. The reserve would increase a prospective buyer’s income by approximately $1 million.

JHH filed a Form 3115 with the IRS stating that it wanted permission to change its methods of accounting for its vehicle inventory. JHH did everything required under Form 3115 except for attaching a statement explaining how its proposed new method of identifying and valuing its vehicle inventory was consistent with the requirements of Section 1.472-6 of the U.S. Treasury regulations.

Form 3115 also requires that business owners value all of their inventory items under the same inventory method. JHH did not do that, using different methods to value its vehicles and parts inventory. The only way to tell that JHH was using different inventory methods for vehicles and parts was by reading the financial statement footnotes.

JHH had tried to amend corporate income tax returns for years 2002-2007. The specific identification method had been used during these years. The 2001 return was beyond the statute of limitations and could not be amended.

Although the Tax Court ruled that JHH had not received automatic consent back in 2001 to use the specific identification method, the court ruled that JHH’s filing of the tax returns for those periods constituted a new method of accounting and therefore was a change in method of accounting.

The regulations and case law emphasize that it is the consistent treatment of an item involving a question of timing that establishes such treatment as a method of accounting. For that reason, a short-lived deviation from an already established method of accounting need not be viewed as establishing a new method of accounting. Case law has suggested that a two-year period can establish a new method of accounting.

Because JHH used the specific identification method for seven years, the court deemed this to be a change of accounting method and would not allow JHH to change back to its original LIFO method of valuing inventory. The IRS was entitled to reject JHH’s amended returns and deny the refund claim.