One of the many decisions a business owner must make during the first year of operating is what accounting method is most appropriate for the company. While the Internal Revenue Service (IRS) requires that some taxpayers use the accrual method, for example, retail companies, some business taxpayers can elect to use either the cash or accrual method. If the taxpayer uses an improper method of accounting, the IRS can force the taxpayer to change his or her method of accounting.
In general, a “change in method of accounting” occurs when a taxpayer changes his or her overall method of accounting, changes treatment of a “material” item, or fails to properly account for “material” items. “Material” items include any item that involves the proper time for the inclusion of the item in income or the taking of a deduction, such as inventory. Treas. Reg. § 1.446-1(e)(2)(ii)(a).
Section 446 of the Internal Revenue Code (Code) allows the IRS to change a taxpayer's method of accounting when the taxpayer's overall method of accounting or treatment of a material item does not clearly reflect its income. The IRS has broad discretion in determining a new method.
The key feature of any change in method of accounting is the IRS's ability to force the taxpayer to recognize income omitted in previous years. Code Section 481 allows the IRS to make an adjustment to account for any omissions or duplications of income or deductions in the years in which the taxpayer used the improper method of accounting. The Section 481 adjustment is generally taken into account entirely in the “year of change,” which is usually the year in which the change in method of accounting occurred.
To calculate a Section 481 adjustment, the IRS will first look at the taxpayer's income as reported under the “old” method of accounting. Then, the IRS will impose its “new” method of accounting and recalculate the taxpayer's income for each year in which the old method was used. The cumulative amount of any omitted income for all corrected years is taken into account, in general, entirely in the year of change. This can result in an addition to income in the year of change (positive Section 481 adjustment) or reduced income in the year of change (negative Section 481 adjustment).
The most crippling feature of a Section 481 adjustment is the IRS's ability to look back to any series of consecutive years prior to the year of change in which the taxpayer used an improper method of accounting. Unlike the statute of limitations for assessment, where the IRS generally can look back up to 3 years to calculate an adjustment to income, there is no limit to how many years the IRS can look back when the taxpayer used an improper accounting method. The effects of 10 or 15 years of omitted income, all taken into account in one year, can be devastating to the business.
An IRS change in accounting method has a strong presumption of correctness. This means that the most important time to contact a tax practitioner when the IRS proposes a change in method of accounting is during the audit. If the practitioner is involved in the early stages, he or she may be able to convince the auditor that no change in method of accounting is appropriate, or, work with the auditor to minimize the impact of a Section 481 adjustment before any presumption is in place.