PROCEDURES ARE OUTLINED FOR CASH METHOD TAXPAYERS WHO ARE REQUIRED TO USE INVENTORIES TO CHANGE TO THE ACCRUAL METHOD

Rev. Proc. 85-36

SECTION 1. PURPOSE

The purpose of this revenue procedure is to provide a procedure whereby certain taxpayers who are required to use inventories in order to clearly determine income may obtain expeditious consent to change their overall method of accounting from the cash receipts and disbursements method to the accrual method. Taxpayers complying with this revenue procedure will be deemed to have obtained the consent of the Commissioner of Internal Revenue to change their method of accounting.

SEC. 2 BACKGROUND

01 Section 471 of the Internal Revenue Code requires the use of inventories when in the opinion of the Commissioner it is necessary in order clearly to determine income. Section 1.471-1 of the Income Tax Regulations provides that in order clearly to determine income, inventories at the beginning and end of each tax year are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing factor.

02 Section 1.446-1(c)(2) of the regulations provides that when taxpayers are required to use inventories in order to clearly determine income they must use the accrual method of accounting with regard to purchases and sales.

03 Section 446(e) of the Code and section 1.446-1(e) of the regulations state that, except as otherwise provided, in order to change a method of accounting for federal income tax purposes a taxpayer must obtain the consent of the Commissioner. Section 1.446-1(e)(3)(i) requires that in order to obtain this consent, generally an application, Form 3115, Application for Change in Accounting Method, must be filed within 180 days after the beginning of the tax year in which the proposed change is to be made. Section 1.446-1(e)(3)(ii) authorizes the Commissioner to prescribe administrative procedures setting forth the limitations, terms, and conditions deemed necessary to permit a taxpayer to obtain consent to a change in its method of accounting in accordance with section 446(e).

04 Section 481(a) of the Code requires that those adjustments necessary to prevent amounts from being duplicated or omitted 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 tax year. Section 481(c) and section 1.481-5 of the regulations provide that the adjustments required by section 481(a) may be taken into account in determining taxable income in the manner and subject to the conditions agreed to by the Commissioner and the taxpayer.

05 Section 6.02 of Rev. Proc. 84-74, 1984-2 C.B. 736 defines a Category A method of accounting that is specifically not permitted to be used by the taxpayer by the Code, regulations, or a decision of the Supreme Court of the United States, or a method that is clearly erroneous. The overall use of the cash receipts and disbursements method of accounting when inventories are required in order to clearly determine income constitutes the use of a Category A method of accounting.

SEC. 3 SCOPE

01 Except as provided in section 3.02 below, this revenue procedure applies to taxpayers who (1) employ the cash receipts and disbursements method of accounting as their overall method of accounting, (2) are required to use inventories in order to clearly determine income, and (3) desire to change their overall method of accounting to the accrual method.

02 This revenue procedure does not apply to:

(1) Financial institutions;

(2) Farmers;

(3) Cooperatives;

(4) Manufacturers and producers required to use the full absorption method for inventory costing (See section 1.471-11 of the regulations);

(5) Taxpayers who desire to change to the overall accrual method of accounting and to a special method of accounting, such as a long-term contract method or the method of accounting for prepaid subscription income provided in section 455 of the Code;

(6) Taxpayers under examination by the Service when the year or years under examination encompass the tax year in which the cash receipts and disbursements method was first employed by the taxpayer;

(7) Taxpayers who have been contacted in any manner by a representative of the Service for the purpose of scheduling an examination of their federal income tax return(s) for any year and such examination has not been completed;

(8) Taxpayers who at the time of filing Form 3115 are:

(a) Before an appeals office of the Service with respect to an examination of their federal income tax return(s) for any year, unless the taxpayer has obtained an agreement from the appeals officer that there is no objection to the proposed change in method of accounting, or

(b) Before any federal court with respect to an income tax issue arising in any year, unless the taxpayer has obtained an agreement from counsel for the Government that there is no objection to the proposed change in method of accounting;

(9) Taxpayers who are the subject of a criminal investigation or proceeding concerning, (a) directly or indirectly the taxpayer's federal tax liability for any year, or (b) the possibility of false or fraudulent statements made by the taxpayer with respect to any issue relating to its federal tax liability for any year.

03 Taxpayers to whom this revenue procedure does not apply and who desire to change their overall method of accounting to the accrual method should file an application (Form 3115) with the Commissioner in accordance with the requirements of section 1.446-1(e)(3) of the regulations and Rev. Proc. 84-74.

SEC. 4. APPLICATION

01 CONSENT. In accordance with section 1.446-1(e)(3)(ii) of the regulations, the 180-day period is waived, and under section 1.446-1(e)(2)(i), consent is hereby granted to taxpayers who (1) employ the cash receipts and disbursements method of accounting as their overall method of accounting, and (2) are required to use inventories in order clearly to determine income, to change their overall method of accounting to the accrual method. This consent is granted for the tax year for which a taxpayer requests a change (year of change) by filing a current Form 3115 in the manner described in section 6 of this revenue procedure and by otherwise complying with the provisions of this revenue procedure. See section 5 regarding compliance with conditions of this revenue procedure.

02 SECTION 481(a) ADJUSTMENT. Section 481 of the Code prescribes the rules to be followed in computing taxable income in cases in which the taxable income of a taxpayer is computed under a method of accounting different from the method used to compute the taxable income for the preceding tax year. An adjustment is required to prevent items from being duplicated or omitted when a change in method of accounting is made. The adjustment, referred to as the "section 481(a) adjustment," is the net amount of the adjustment required by section 481(a) of the Code. The "section 481(a) adjustment" takes into account inventories, accounts receivable, accounts payable, and any other item determined necessary in order to prevent items from being duplicated or omitted. The "section 481(a) adjustment" shall be taken into account in computing taxable income in the manner provided in section 4.03 below. Rev. Proc. 79-47, 1979-2 C.B. 528, sets forth the effect of the "section 481(a) adjustment" on corporate earnings and profits. The approved change shall be considered to be a change in method of accounting initiated by the taxpayer. An example of the computation of the "section 481(a) adjustment" is as follows:

EXAMPLE 1

As of December 31, 1984, A, a calendar year taxpayer who uses the overall cash method of accounting, has the following items of unreported income, undeducted expenses, and deducted inventoriable costs:

 Income, the right to which is fixed

 Income that was not included in gross

(1) The appropriate period ("adjustment period") for taking into account an adjustment, whether positive or negative, referred to in section 4.02 is generally determined as follows:

(a) For the two (2) tax year beginning after October 29, 1984, the taxpayer will be given an adjustment period determined in accordance with subdivisions (i), (ii), and (iii) below.

(i) When an entire net amount of an adjustment is attributable to the tax year immediately preceding the year of change (first preceding year), the total net adjustment is taken into account in computing taxable income for the year of change. The amount attributable to the tax year immediately preceding the year of change is the difference in the amount of the adjustment determined under section 481(a) of the Code for the year of change and the amount of the adjustment that would have been required under section 481(a) if the same change in method of accounting had been made in the preceding year.

(ii) When subdivision (i) of this section 4.03(1)(a) does not apply and 67 percent or more of the net amount of an adjustment is attributable to the 1-tax year period, 2-tax year period, or 3-tax year period immediately preceding the year of change, the highest percent attributable to the 1, 2, or 3-tax year period is to be taken into account ratably over a 3-tax year period beginning with the year of change. Any remaining balance is to be taken into account ratably over an additional period equal to the remainder of the number of tax years the taxpayer has used the method of accounting that is being changed. However, the total adjustment period shall not exceed 6 tax years. This section 4.03(1)(a)(ii) only applies if the taxpayer has used the method being changed for more than 3 tax years. If the method of accounting being changed has been used for no more than 4 tax years, 75 percent shall be substituted for 67 percent. An amount attributable to the 1, 2 or 3-tax year period is the difference in the amount of the adjustment determined under section 481(a) of the Code for the year of change and the amount that would have been required under section 481(a) if the same change had been made at the beginning of the preceding 1, 2, or 3-tax year period.

(iii) When there is a change in method of accounting that results in a negative net adjustment under section 481(a) of the Code, the entire negative net adjustment will be taken into account in computing taxable income in the year of change.

(b) When subparagraph (a) of this section 4.03(1) does not apply and the entire net amount of an adjustment is either negative or attributable to the tax year immediately preceding the year of change, the total net adjustment is to be taken into account in computing taxable income for the year of change. The amount attributable to the tax year immediately preceding the year of change is the difference in the amount of the adjustment determined under section 481(a) of the Code for the year of change and the amount of the adjustment that would have been required under section 481(a) if the same change in method of accounting had been made for such preceding year.

(c) When neither subparagraphs (a) nor (b) of this section 4.03(1) apply, the total net adjustment is to be taken into account ratably over the number of tax years (not to exceed 3) the taxpayer has used the method of accounting that is being changed.

(2) In applying section 4.03(1), if a taxpayer's books and records do not contain sufficient information to compute the section 481(a) adjustment attributable to the 1, 2 or 3-tax year period immediately preceding the year of change, the taxpayer may reasonably estimate these amounts and attach the computations upon which the estimates are based and attach and sign the following statement to the Form 3115:

Under penalties of perjury, I hereby certify that:

(a) The books and records of (name of the taxpayer) do not contain sufficient information to permit a computation of the section 481(a) adjustment attributable to the 1-tax year period, 2-tax year period, or 3-tax year period immediately preceding the year of change as required by section 4.03(1) of Rev. Proc. 85-36.

(b) Based on the information that is contained in such records, to the best of my knowledge and belief, the entire amount of the section 481(a) adjustment for the year of change (indicate either "is" or "is not," as the case may be) attributable to the tax year immediately preceding the year of change, and 67 percent (or "75 percent", in applicable cases) or more of the section 481(a) adjustment for the year of change (indicate "is" or "is not", as the case may be) attributable to the 1-tax year period, 2-tax year period, or 3-tax year period immediately preceding the year of change.

(3) For examples of the application of the rules prescribed in section 4.03(1) with respect to the appropriate period for taking into account the section 481(a) adjustment, see examples in section 5.14 of Rev. Proc. 84-74.

04 ACCOUNTS RECEIVABLE

(1) The section 481(a) adjustment shall not include any account receivable that was worthless or partially worthless as of the last day of the year preceding the year of change. See section 1.166-3 of the regulations.

(2) If, during the adjustment period (see section 4.03), any portion of the accounts receivable included in the section 481(a) adjustment becomes worthless or partially worthless, such portion, not previously included in gross income, shall be included in income in the tax year it becomes worthless. This condition will apply regardless of whether the section 481(a) adjustment is positive or negative. This condition is illustrated by the following example.

EXAMPLE 2

A, the taxpayer in example 1, section 4.02, has determined that the section 481(a) adjustment is to be taken into account ratably over six tax years.

In 1986, $30,000 of the $120,000 accounts receivable were determined to be worthless. In 1986, A, will not have included in gross income $150,000 of the section 481(a) adjustment ($180,000 less $30,000 included in gross income in 1985). In 1986, A must include in gross income the remaining portion of the accounts receivable determined to be worthless but not previously included in gross income, of $25,000 ($30,000 less the $5,000 portion included in gross income in 1985) plus one-fifth of the remaining balance of the section 481(a) adjustment, $25,000. A total of $50,000 will be included in gross income in 1986.

 Section 481(a) adjustment                              $180,000

05 INVENTORY.

(1) If, during the adjustment period (see section 4.03), the inventory as of the last day of any tax year is reduced by more than 33 1/3 percent of the inventory balance at the beginning of the year of change, and remains reduced for a period of one tax year, then the remaining portion of the section 481(a) adjustment attributable to the inventory not previously deducted shall be included in income at the end of the year succeeding the year of the reduction. This condition would apply whether the section 481(a) adjustment is positive or negative. If the value of the inventory does not remain reduced for one tax year, the reduction is not considered permanent and the provisions of this paragraph do not apply. In applying this section 4.05(1), the 33 1/3 percent rule applies only to the inventory to which the section 481(a) adjustment relates. For an illustration of the kind of computations required by the above rule see the example in section 5.08(1) of Rev. Proc. 84-74.

(2) Section 4.05(1) shall not apply if the taxpayer has shown to the satisfaction of the Commissioner that such reduction is attributable to a strike, involuntary conversion, or involuntary interruption of the availability of goods. This section 4.05(2) shall apply only if the taxpayer has obtained the consent of the Commissioner. The consent must be requested no later than 90 days after the end of the tax year in which section 4.05(1) would otherwise apply.

06 BAD DEBTS. As part of the change to the accrual method, a taxpayer may adopt the reserve method for bad debts. The initial reserve for bad debts at the beginning of the year of change is included in the section 481(a) adjustment. The amount established as the initial reserve must be considered in determining the amount of subsequent additions to such reserve, even though the entire amount of the reserve may not have been accounted for because of a spread of the section 481(a) adjustment (see section 4.03). The amount of the bad debt deduction for the year of change and for tax years thereafter will consist of a reasonable addition to the reserve for bad debts as provided by section 166(c) of the Code. In computing the reserve for bad debts, the taxpayer will not include notes receivable sold without recourse or to be sold in the immediate future without recourse. See sections 5.02(2), 5.02(3), and 5.06 of Rev. Proc. 85-8, 1985-6 I.R.B. 41.

07 CEASING TO ENGAGE IN THE TRADE OR BUSINESS.

(1) With respect to a corporation:

If the corporation ceases to engage in the trade or business to which the adjustment (section 4.02) relates at any time prior to the expiration of the adjustment period referred to in section 4.03, the taxpayer shall take into account in that year the balance of the adjustment not previously taken into account in computing taxable income. See Rev. Rul. 80-39, 1980-1 C.B. 112, which holds that if a division of a corporation, for which a change in method of accounting had been granted, ceases to operate the trade or business for which the change in method was granted, the remaining portion of the section 481(a) adjustment applicable to the business conducted by that division of the corporation must be taken into account in computing income in the year the corporation ceases to engage in that trade or business. For purposes of this condition, the taxpayer is not considered to have ceased operation of the trade or business if its assets have been acquired by another corporation in a transaction to which section 381 of the Code applies, but in such case the acquiring corporation shall continue to be subject to this revenue procedure as though it were the acquired corporation.

(2) With respect to a partnership:

In the event a partnership terminates or ceases to engage in the trade or business (within the meaning of section 708(b) of the Code) to which the adjustment (section 4.02) relates at any time prior to the expiration of the adjustment period referred to in section 4.03, the balance of the adjustment not previously taken into account in computing ordinary income shall be taken into account in that year. A partnership ceasing to engage in the trade or business includes the incorporation of the trade or business in a transaction to which section 351 of the Code applies (See Rev. Rul. 77-264, 1977-2 C.B. 187).

(3) With respect to a sole proprietor:

If the individual (sole proprietor) ceases to engage in the trade or business to which the adjustment (section 4.02) relates at any time prior to the expiration of the adjustment period referred to in section 4.03, the balance of the adjustment not previously taken into account in computing taxable income shall be taken into account in that year. A sole proprietor ceasing to engage in trade or business includes the incorporation of the trade or business in a transaction to which section 351 of the Code applies (See Rev. Rul. 77-264). A sole proprietorship does not cease to engage in that trade or business when the individual taxpayer sells a partial interest in the proprietorship and continues to be actively engaged in the management of the business that is subsequently operated as a partnership. The section 481(a) adjustment remaining at the time the partnership is formed is to be taken into account by the sole proprietor in computing his own taxable income as though there had been no change in ownership (See Rev. Rul. 66-206, 1966-2 C.B. 206).

SEC. 5. COMPLIANCE WITH CONDITIONS

Taxpayers making a change in their overall method of accounting from the cash receipts and disbursements method to the accrual method without complying with all the conditions of this revenue procedure will be deemed to have initiated the change in method of accounting without obtaining the permission of the Commissioner as required under section 446(e) of the Code.

SEC. 6. MANNER OF EFFECTING THE CHANGE

01 A taxpayer applying for a change in method of accounting pursuant to this revenue procedure must complete and file a current Form 3115 in duplicate. The original shall be attached to the taxpayer's timely filed federal income tax return for the year of change. A copy of the Form 3115 shall be filed with the National Office addressed to the Commissioner of Internal Revenue, Attention: CC:C:C:1, 1111 Constitution Avenue, N.W., Washington, D.C. 20224, no later than 270 days after the beginning of the year of change. In addition to including all of the information required on the Form 3115, the taxpayer must state: (1) that it agrees to all of the conditions of Rev. Proc. 85-36 and that it proposes to take the section 481(a) adjustment into account over the appropriate period required by section 4.03; and (2) the period over which the section 481(a) adjustment will be taken into account and the basis for such conclusion. If it is found that the taxpayer does not qualify for the change in method of accounting under this revenue procedure, the National Office or the district director will so advise the taxpayer.

02 In order to assist in the processing of these changes in method of accounting and to insure proper handling, reference to this revenue procedure shall be made a part of the Form 3115 by either typing or legibly printing the following statement at the top of page 1 of Form 3115: "FILED UNDER REV. PROC. 85-36."

03 The signature of the person requesting the change in method of accounting must appear in the space provided for it on the Form 3115. For example, an officer must sign on behalf of a corporation, a general partner on behalf of a partnership, a trustee on behalf of a trust, or a sole proprietor. See the signature requirements set forth in the General Instructions attached to a current Form 3115 for those who are to sign. If an agent is authorized to represent the taxpayer before the Service, to receive the original or a copy of correspondence concerning the request, or to perform any other act(s) regarding the application on behalf of the taxpayer, a power of attorney reflecting such authorization(s) must be attached to the application. Taxpayer's representatives without a power of attorney to represent the taxpayer as indicated in this subsection will not be given any information about the application.

04 If the taxpayer is a member of an affiliated group that has elected to file a consolidated federal income tax return, a Form 3115 submitted on behalf of the taxpayer must be signed by a duly authorized officer of the common parent. See section 1.1502-77 of the regulations.

SEC. 7. INQUIRIES

Inquiries regarding this revenue procedure may be addressed to the Commissioner of Internal Revenue, Attention: CC:C:C:1, 1111 Constitution Avenue, N.W., Washington, D.C. 20224.

SEC. 8. EFFECTIVE DATE

This revenue procedure is effective July 29, 1985, the date of its publication. Requests for change in methods that qualify under this revenue procedure and are received in the National Office after the effective date will be returned to the taxpayer. Taxpayers who have timely filed a Form 3115 with the National Office prior to the effective date of this revenue procedure may use the automatic provisions of this revenue procedure and will be notified to this effect by the National Office.