Not understanding and following proper procedures can come back to haunt taxpayers, even if they do something that they would have been allowed to do if they had followed the proper procedures.  In PLR 202223011[1] the IRS denied the taxpayer’s request to file a Form 3115 for an overall accounting method change from the cash to accrual basis it had made without asking for permission years earlier.

Accounting Method Rules

IRC 446 covers acceptable accounting methods to be used by the taxpayer for computing income and deductions under the IRC.  However, IRC §446(e) requires that anytime the taxpayer wishes to change an accounting method, the taxpayer must obtain the consent of the IRS:

(e) Requirement respecting change of accounting method. Except as otherwise expressly provided in this chapter, a taxpayer who changes the method of accounting on the basis of which he regularly computes his income in keeping his books shall, before computing his taxable income under the new method, secure the consent of the Secretary.

Note that the provision says nothing about not needing the consent of the IRS to change from an inappropriate method of accounting to an appropriate (or even required) one, nor that the consent is not necessary to change to a method that better reflects income.  Rather, all changes of an accounting method can only be made with the permission of the IRS.

Accounting methods are ways of recording and reporting transactions that affect only the timing, but not the eventual amount, of such items of income and deduction.  Such methods can be overall methods of accounting (such as the overall cash or accrual methods of accounting) or methods for computing a specific item of income or expense (such as the life over which assets are depreciated).

The IRS regularly updates a list of accounting method changes for which automatic consent can be obtained (currently found in Revenue Procedure 2021-34) by attaching a completed Form 3115 to the taxpayer’s timely filed original return for the year in question and by sending a copy to the IRS office designated on the Form 3115 (currently an address at the IRS Service Center in Ogden, Utah).  If a change is desired not found in the current list of automatic updates or additional automatic changes added in separate Revenue Procedures between the updates of the larger list, advance permission must be requested from the IRS.

In most cases, the taxpayer must determine the cumulative effect of the change by computing the difference in cumulative taxable income that was reported under the old method and what would have been reported under the new method, referred to as the IRC §481(a) adjustment since that provision requires such adjustments to be made.

One of the automatic changes involves a taxpayer changing their overall method of accounting from the cash basis to the accrual basis.  As is true with most such changes, the taxpayer must take into income the §481(a) adjustment. If the adjustment is positive (more income would have been recognized cumulatively under the new method than the old one), generally the difference is taken into income ratably over four years beginning with the year of change. If the adjustment is negative, it is all taken into account in the year of change.

The Taxpayer’s Situation

The PLR sets out the facts of the taxpayer’s request as follows:

Taxpayer is an S corporation that is a full-service production company for Activity. It currently uses an overall accrual method of accounting. In Year, it changed from the cash receipts and disbursements to its current accrual method without filing either of the two Forms 3115 that are required to be filed to obtain the Commissioner's consent to make this change in accounting method. Section 6.03(1)(a)(i) of Rev. Proc. 2013-15, 2015-51 I.R.B. 419. Taxpayer failed to take into account the adjustment required by § 481(a) of the Internal Revenue Code when it made its accounting method change in Year.[2]

Note that the taxpayer appears to have simply started reporting on the accrual basis but did not take into account the cumulative adjustment.  Although the PLR does not indicate exactly how many years ago this change took place, it does note the request took place “long after its unauthorized change in method of accounting.”[3]  Likely, this means the relief is being requested for a year for which the IRS is barred from collecting additional taxes due to the statute of limitations.

IRS Ruling

The IRS notes that generally a taxpayer will not be granted relief for the late filing of Form 3115:

Rev. Proc. 2015-13 provides the current procedures by which a taxpayer may obtain the Commissioner's consent to change its method of accounting. A taxpayer complying with all the applicable provisions of this revenue procedure has obtained the required permission to change its accounting method under § 446(e) and the Regulations thereunder.

Section 6.03(4)(b) of Proc. 2015-13 provides that, except in unusual and compelling circumstances or as provided in section 6.03(4)(a) of Rev. Proc. 2015-13 (the 6-month automatic extension for filing a Form 3115), a taxpayer is not eligible for an extension of time to file a Form 3115.[4]

However, a taxpayer can attempt to argue that his or her case represents such “unusual and compelling” circumstances and obtain such relief:

However, § 301.9100-1(c) provides that the Commissioner has discretion to grant a reasonable extension of time under the rules set forth in §§ 301.9100-2 and 301.9100-3 to make certain regulatory elections.

Sections 301.9100-1 through 301.9100-3 provide the standards the Commissioner will use to determine whether to grant an extension of time to make an election. Section 301.9100-2 provides automatic extensions of time for making certain elections. Section 301.9100-3 provides extensions of time for making elections that do not meet the requirements of § 301.9100-2.[5]

The two automatic options in Section 301.9100-2 do not apply to this situation, as the request is being made more than six months after the original due date of the return and late elections for filing a request to change an accounting method is not in the very short list of elections that qualify for 12-month relief—as well as the simple problem that the request didn’t take place within 12 months of the extended due date of the return either.

This leaves a request under IRC §301.9100-3 for relief. The IRS explains this relief provision as follows:

Section 301.9100-3(a) provides that requests for an extension of time subject to § 301.9100-3 will be granted when the taxpayer provides evidence to establish to the satisfaction of the Commissioner that the taxpayer acted reasonably and in good faith and that the granting of the extension will not prejudice the interests of the Government.[6]

Initially this sounds promising, since the taxpayer likely believes they acted “reasonably and in good faith” and similarly may believe that the request is in the interests of the Government (after all, keeping citizens happy is in the interest of the Government and the law has generally expressed a preference for the use of the accrual basis of accounting).

But it turns out the regulations go into detail on each of these requirements, and those requirements make it seem far less likely this taxpayer will qualify.  First it outlines cases that will be deemed to show acting reasonably and in good faith:

Section 301.9100-3(b)(1) provides that a taxpayer is deemed to have acted reasonably and in good faith if the taxpayer:

(i) requests relief before the failure to make a regulatory election is discovered by the IRS;

(ii) failed to make the election because of intervening events beyond the taxpayer's control;

(iii) failed to make the election because, after exercising reasonable diligence, the taxpayer was unaware of the necessity of the election;

(iv) reasonably relied on written advice of the IRS; or

(v) reasonably relied on a qualified tax professional, including a tax professional employed by the taxpayer, and the tax professional failed to make, or advise the taxpayer to make, the election.[7]

The good news is that this list has an “or” clause in the next to last item in the list, so the taxpayer merely needs to show one of these to be deemed to have acted in good faith.  The bad news is that the client did not claim to meet any of these requirements or offer evidence of such facts.

Conversely, the regulation also provides cases where the taxpayer is deemed not to have acted reasonably and in good faith:

Section 301.9100-3(b)(3) provides that a taxpayer is deemed not to have acted reasonably and in good faith if the taxpayer:

(i) seeks to alter a return position for which an accuracy-related penalty has been or could be imposed under section 6662 at the time the taxpayer requests relief and the new position requires or permits a regulatory election for which relief is requested;

(ii) was informed in all material respects of the required election and related tax consequences and chose not to file the election; or

(iii) uses hindsight in requesting relief.

If specific facts have changed since the due date for making the election that make the election advantageous to the taxpayer, the IRS will grant relief only when the taxpayer provides strong proof that the taxpayer's decision to seek relief did not involve hindsight.[8]

Nothing in the ruling directly addresses these issues. It is possible that the taxpayer could have faced an accuracy related penalty for being on the cash basis of accounting when it was not allowed, but that is not mentioned in the letter or the IRS’s discussion of reasons for its decision.

Next the regulation moves on to look at the interests of the Government:

Section 301.9100-3(c)(1) provides that the Commissioner will grant a reasonable extension of time to make a regulatory election only when the interests of the Government will not be prejudiced by the granting of relief.

Section 301.9100(b)(c)(1)(ii) provides that the interests of the Government are ordinarily prejudiced if the taxable year in which the regulatory election should have been made or any taxable years that would have been affected by the election had it been timely made are closed by the period of limitations on assessment under section 6501(a) before the taxpayer's receipt of a ruling granting relief under this section.[9]

Given the IRS reference to the request being “long after” the taxpayer made the change without permission, it seems very possible the taxpayer’s request was doomed by this provision.

Section 301.9100-3(c)(2) imposes special rules for accounting method regulatory elections. Section 301.9100-3(c)(2)(i) provides that the interests of the Government are deemed to be prejudiced except in unusual and compelling circumstances if the accounting method regulatory election for which the extension of time is requested is subject to the procedure described in § 1.446-1(e)(3)(i) (requiring the advance written consent of the Commissioner). Section 301.9100-3(c)(2)(ii) provides that the interests of the Government are deemed to be prejudiced except in unusual and compelling circumstances if the accounting method regulatory election for which the extension of time is requested requires a § 481(a) adjustment (or would require such an adjustment if the taxpayer changed to the method of accounting for which the extension is requested in a taxable year subsequent to the year in which the election should have been made).[10]

The facts noted that there was such a §481(a) adjustment required for this change.  As well, the ruling also notes that the adjustment was not taken into account by the taxpayer when it undertook a “just change it” approach without IRS permission.  This provision is certainly fatal to the request even if the statute problem wasn’t.

What are unusual and compelling circumstances must be decided on a case-by-case basis in light of all applicable facts and circumstances. Id. at 390.

Finally, this provision notes that even if the request doesn’t run afoul of the prior two presumptions, it’s still going to be determined by the IRS on a case-by-case basis.  Generally, taxpayers would have to show the IRS acted arbitrarily or capriciously to challenge an IRS finding that the interests of the Government would be prejudiced by granting relief.

As the IRS concludes in its analysis:

While the Commissioner has discretion to grant a reasonable extension of time under the rules set forth in §§ 301.9100-2 and 301.9100-3 to make certain regulatory elections, Taxpayer is seeking an extension of time to file the original and signed duplicate copy of its Form 3115 for Year, long after its unauthorized change in method of accounting. Barring unusual and compelling circumstances, Taxpayer is not entitled to an extension of time under § 301.9100-3 because the Government's interests are deemed prejudiced.[11]

The IRS therefore concludes:

Based on the facts and representations submitted, we conclude that Taxpayer has failed to demonstrate that the Government's interests are not prejudiced. Accordingly, no extension of time to file the missing two Forms 3115 for Year is granted.[12]

Why Was This Ruling Requested?

It’s interesting to consider what might have prompted this letter ruling request.  The IRS rarely raises this issue on exam and nothing in the ruling suggests the taxpayer was under exam at the time relief was requested.

Most likely some event (such as a prospective buyer doing a due diligence review of the business for potential contingent liabilities or a change in tax adviser) uncovered the rather informal change of accounting method by the taxpayer in the past. 

What’s even more interesting is this note early in the ruling:

After considering the information provided at the conference of right and the post-conference submission, as well as the earlier submitted information, we concluded that an extension of time to file the missing two Forms 3115 could not be granted. We notified Taxpayer's authorized representatives of this conclusion and the representatives requested an adverse letter ruling.[13]

That suggests that either the taxpayer wanted a formal ruling to document the IRS denial for an eventually (likely very difficult) court challenge or, more likely, some party wanted/required a formal ruling by the IRS that relief would not be available.

[1] PLR 202223011, June 10, 2022, https://www.taxnotes.com/research/federal/irs-private-rulings/letter-rulings-%26-technical-advice/extension-to-file-accounting-method-change-request-denied/7dkgy (retrieved June 11, 2022)

[2] PLR 202223011, June 10, 2022

[3] PLR 202223011, June 10, 2022

[4] PLR 202223011, June 10, 2022

[5] PLR 202223011, June 10, 2022

[6] PLR 202223011, June 10, 2022

[7] PLR 202223011, June 10, 2022

[8] PLR 202223011, June 10, 2022

[9] PLR 202223011, June 10, 2022

[10] PLR 202223011, June 10, 2022

[11] PLR 202223011, June 10, 2022

[12] PLR 202223011, June 10, 2022

[13] PLR 202223011, June 10, 2022