Source: https://www.currentfederaltaxdevelopments.com/blog/2018/12/6/irs-fails-to-show-taxpayers-action-was-a-change-of-accounting-method
Timestamp: 2019-04-20 04:40:13+00:00

Document:
In the case of Thrasys, Inc. v. Commissioner, TC Memo 2018-199, the Tax Court found that the IRS was not entitled to summary judgment on the agency’s argument that the taxpayer had engaged in a prohibited change of accounting method.
A taxpayer generally “may adopt any permissible method of accounting” when filing his first return. Id. para. (e)(1); see Pac. Nat'l Co. v. Welch, 304 U.S. 191, 194 (1938). But 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.” Sec. 446(e); see Silver Queen Motel v. Commissioner, 55 T.C. 1101, 1105 (1971) (“[T]he notion of changes in accounting method necessarily implies that a new accounting method is being substituted for a previously regularly used accounting method.”).
Accounting methods generally affect the timing, but not the ultimate amount, of an item of income or deduction. An accounting method adopted by the taxpayer, for which permission must be granted by the IRS to change, includes a method that clearly is prohibited by the IRC. But merely making an error on the first return is different from adopting an accounting method. To distinguish the two, the key factor is that a method is consistently applied.
“A change in method of accounting does not include correction of mathematical or posting errors, or errors in the computation of tax liability.” Sec. 1.446-1(e)(2)(ii)(b), Income Tax Regs. “The line between a change in accounting method and mere error (or its correction) is a fine one.” Hawse v. Commissioner, T.C. Memo. 2015-99, 109 T.C.M. (CCH) 1511, 1518. In discerning that line courts have “emphasized the primacy of consistency and timing in establishing a method of accounting.” Huffman, 126 T.C. at 350 n.16 (citing Diebold, Inc. v. United States, 16 Cl. Ct. 193, 204 n.9 (1989), aff'd, 891 F.2d 1579 (Fed. Cir. 1989)); see Firetag v. Commissioner, T.C. Memo. 1999-355, 78 T.C.M. (CCH) 645, 651 (finding a change of accounting method where the “case involve[d] the systematic, consistent treatment of a significant item”), aff'd, 232 F.3d 887 (4th Cir. 2000). “A change in the method of accounting also does not include a change in treatment resulting from a change in underlying facts.” Sec. 1.446-1(e)(2)(ii)(b), Income Tax Regs.
That revenue procedure allows taxpayers to choose from two permissible methods of accounting for deferred (i.e., unearned) revenues arising from (among other things) “the sale, lease, or license of computer software.” Rev. Proc. 2004-34, sec. 4.01(3)(e), 2004-1 C.B. at 992. A taxpayer may elect the full inclusion method, which requires that advance payments be fully included in gross income in the year of receipt. Id. sec. 5.01, 2004-1 C.B. at 992. Alternatively, the taxpayer may elect the (usually more desirable) deferral method, which generally allows recognition of advance payments to be deferred for one year for Federal income tax purposes unless those payments, appropriately accounted for, are currently “recognized in revenues in * * * [the taxpayer's] applicable financial statement.” Id. sec. 5.02(3)(a)(i), 2004-1 C.B. at 993.
Entries appearing on petitioner's 2005-2008 tax returns and financial statements provide evidence to support Mr. Balakrishnan's averment that Thrasys elected the deferral method in 2005 or previously. With the exception of the $15 million payment received in 2008, Thrasys appears to have treated all advance payments on its financial statements as “deferred revenues” or “unearned revenues.”6 As the deferral method directs, petitioner generally appears to have deferred recognition of these unearned revenues, for Federal income tax purposes, until the year following the year of receipt.
Petitioner agrees that its accounting deviated from the deferral method on at least one occasion. The deferral method prohibits the deferral of revenues beyond the next full taxable year after the year of receipt. Id. sec. 5.02(1)(a)(ii), (2), 2004-1 C.B. at 992-993. In 2007 Thrasys neglected to include in gross income the $958,000 of advance payments it had received during 2006, and it thus deferred that $958,000 for two years rather than one. Mr. Balakrishnan described this mistake as a one-time error. If so, the erroneous treatment would appear to lack the consistency necessary to constitute a method of accounting. See sec. 446(e); Huffman, 126 T.C. at 354 (“[A] short-lived deviation from an already established method of accounting need not be viewed as establishing a new method of accounting.”); Silver Queen Motel, 55 T.C. at 1105.
In the following year (2009), when the technical breach was corrected, the amount was reflected in the financial statements as deferred revenue. In accordance with Revenue Procedure 2004-34 which the company now believed first applied, the amount was not reported as income in that year either. The amount was not reported in income until the taxpayer’s 2010 income tax return.
On exam the taxpayer conceded that the “deposit” treatment was inappropriate for tax purposes. The IRS argued that the taxpayer had adopted an improper deposit method of accounting in 2008, effectively “undoing” the deferral method for advance payments. The IRS argued that since the taxpayer was now using a new method, the IRS was now free to place the taxpayer onto an acceptable method of the agency’s choice which would be to report such advance payments as income when received (the second method allowed by Revenue Procedure 2004-34).
The Tax Court, noting the IRS was moving for summary judgment at this point, found that there were material issues of fact remaining to be decided. That is, merely having reported as the company admitted did for this transaction did not necessarily mean that a change of accounting had occurred.
First, as far as the record reveals, Thrasys treated only one customer payment — the $15 million payment it received from Siemens in 2008 — as a “deposit” for book or Federal income tax purposes. That treatment appeared on only one tax return, namely, petitioner's Form 1120 for 2008. (On its Form 1120S for 2009 Thrasys shifted the $15 million from the “deposit” category into the “deferred revenue” category.) A question of material fact exists as to whether petitioner's “deposit” treatment displayed the consistency required to constitute a method of accounting on the basis of which Thrasys “regularly compute[d]” its income. See sec. 446(a), (e).
Without consistency, this would look more like an “error” that would allow the company to correct the error and report the income in 2009 rather than 2010 as the IRS wanted.
Thrasys now seems to agree that this treatment was mistaken (for Federal income tax purposes anyway) and that the $15 million payment should have been treated as an advance payment in 2008 under the principles of Rev. Proc. 2004-34, supra. But Thrasys and its auditor may reasonably have believed that treating the $15 million payment as a deposit was a required “change in treatment resulting from a change in underlying facts.” Sec. 1.446-1(e)(2)(ii)(b), Income Tax Regs.; cf. Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203, 210 (1990) (describing “[t]he key” to distinguishing an advance payment from a deposit as “whether the taxpayer has some guarantee that he will be allowed to keep the money”).
In sum, viewing all facts and inferences from the facts in the light most favorable to petitioner as the nonmoving party, we find that there exist genuine disputes of material fact as to whether Thrasys in 2008 adopted the “deposit” method as a method of accounting for customer payments. We will accordingly deny respondent's motion for summary judgment.

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