How to Make a Change in Accounting Methods With the IRS

An accounting method determines how a business reports its income and expenses. It is the framework used to track financial activity and is established when a company files its first tax return. Businesses may choose from several permissible methods, such as the cash or accrual basis, depending on their structure. Over time, a company’s circumstances can evolve, prompting a need to reconsider its established accounting practices. When this occurs, a business may decide to transition to a new method that better aligns with its operational needs.

What Constitutes a Change in Accounting Method

A change in accounting method is a change in the taxpayer’s overall plan for recognizing gross income or deductions. It also includes a change in the treatment of any “material item,” which is an item that affects the timing of when income is reported or an expense is taken. The defining characteristic of such a change is its effect on timing, not the permanent alteration of lifetime taxable income.

Common examples that qualify as a change in method include switching from the cash method to the accrual method, or the reverse. Another frequent change involves the way inventory is valued, such as moving from a First-In, First-Out (FIFO) to a Last-In, First-Out (LIFO) system. Adopting or discontinuing a specialized method, like a long-term contract method, also falls under this definition. Even if a business is using an improper method, switching to a proper one is still considered a change of method.

It is also important to understand what does not qualify as a change in accounting method. These actions include:

• The correction of a simple mathematical or posting error.
• Fixing an error in the calculation of your final tax liability.
• An adjustment that permanently alters income, rather than just its timing.
• A change in accounting treatment that results from a change in the underlying facts of a business operation.

Obtaining IRS Consent

A taxpayer is required to get permission from the IRS Commissioner before changing an accounting method for tax purposes. This consent requirement applies whether the taxpayer is switching from a permissible method or an impermissible one. The process for obtaining this consent follows one of two distinct paths: automatic consent or non-automatic consent.

The automatic consent procedure is available for a list of specific accounting method changes that the IRS has identified in published guidance. If a taxpayer’s desired change is on this list and they meet all stipulated conditions, consent is granted without having to file a request in advance.

If a desired accounting method change is not included on the automatic change list, the taxpayer must request permission through the non-automatic consent procedure. This process, also known as requesting advance consent, involves a formal application to the IRS national office, payment of a user fee, and a detailed review by the IRS before approval is granted.

Preparing Form 3115 and Calculating the Adjustment

The central document for requesting an accounting method change is Form 3115, Application for Change in Accounting Method. This form must be used for both automatic and non-automatic change requests. Completing Form 3115 requires gathering specific details, including the taxpayer’s identifying information and a description of the present and proposed accounting methods. A statement explaining the legal basis for the change is also required, which often involves citing a specific revenue procedure.

A significant part of the preparation is the calculation of the Section 481(a) adjustment. This calculation is designed to prevent items of income or deduction from being duplicated or omitted as a result of switching from one accounting method to another. The adjustment represents the cumulative difference between the income reported under the old method and what would have been reported had the new method always been in use.

To calculate the adjustment, one must determine the account balances at the beginning of the year of change as if the new method were already in place. For instance, a business changing from the cash method to the accrual method would calculate its accounts receivable and its accounts payable. The net Section 481(a) adjustment would be the accounts receivable minus the accounts payable. This calculated adjustment figure must be reported on the appropriate schedule within Form 3115, and supporting calculations should be retained as part of the taxpayer’s records.

Submitting the Application and Post-Filing Procedures

The submission process for Form 3115 differs depending on whether the change is automatic or non-automatic. For an automatic change, an unsigned copy of Form 3115 must be attached to the taxpayer’s timely filed federal income tax return for the year of the change. In addition, a separate, signed copy of the Form 3115 must be filed with the IRS National Office.

For a non-automatic change, the original, signed Form 3115 must be filed with the IRS national office during the tax year for which the change is requested. A copy of that same application must then be attached to the federal income tax return for that year when it is filed.

After submitting a non-automatic request, the IRS will review the application and may contact the taxpayer for additional information before issuing a letter ruling that either approves or denies the request. For automatic changes, since consent is granted upon proper filing, there is no further communication from the IRS unless the return is selected for examination.

The final step is to report the Section 481(a) adjustment on the tax return. A negative adjustment is deducted in its entirety in the year of the change. A positive adjustment is spread over a period of four tax years, beginning with the year of the change, to lessen the immediate tax impact.