Rev. Proc. 2016-55: Automatic Accounting Method Changes

An accounting method dictates how a taxpayer reports income and expenses for federal tax purposes. When a taxpayer needs to change their method of accounting, they must secure consent from the Internal Revenue Service (IRS). To simplify this requirement, the IRS provides a streamlined, automatic consent process for a specific list of common adjustments.

For the changes identified in this guidance, a taxpayer does not need to wait for an approval letter from the IRS before implementing the new method. Consent is considered granted automatically, provided the taxpayer follows the specific procedural requirements.

Scope of Automatic Changes

The IRS provides an extensive list of accounting method changes that qualify for the automatic consent procedure. These changes are each assigned a specific designated automatic accounting method change number (DCN) for identification purposes on the required application form. The available automatic changes cover a wide range of common adjustments.

Common categories for automatic changes include:

• Depreciation and amortization: Taxpayers using an incorrect method to depreciate or amortize an asset can use the automatic procedures to switch to a permissible one, such as the Modified Accelerated Cost Recovery System (MACRS).
• Capitalization versus deduction: This includes adopting the de minimis safe harbor under Treasury Regulation §1.263(a), which allows taxpayers to deduct small-dollar expenditures. Taxpayers can also make an automatic change to alter their treatment of repair and maintenance costs, moving from capitalizing these costs to deducting them.
• Inventory accounting: Businesses subject to the Uniform Capitalization (UNICAP) rules under Internal Revenue Code (IRC) Section 263A can use the automatic process to change their methods for allocating costs to inventory. Other changes include switching the method used to value inventory, such as moving from an improper method to a permissible one.
• Revenue recognition: A change in this category involves how a business treats advance payments from customers. Taxpayers can use the automatic procedures to adopt the deferral method for certain advance payments under Treasury Regulation §1.451-8, which allows income recognition to be deferred to the tax year following the year of receipt.

The Section 481(a) Adjustment

When a taxpayer changes an accounting method, an adjustment under Internal Revenue Code Section 481(a) is required. This calculation is designed to prevent the duplication or omission of amounts of income or expense due to the change. It represents the cumulative difference between the taxpayer’s income as calculated under the old method and what it would have been under the new method, computed as of the beginning of the year of the change.

The Section 481(a) adjustment can be either positive or negative. A positive adjustment occurs when the change results in an increase to taxable income, which happens when the new method accelerates income recognition or defers deductions. A negative adjustment results in a decrease to taxable income, which occurs when the new method defers income or accelerates deductions.

The timing for recognizing this adjustment in taxable income depends on whether it is positive or negative. A net positive Section 481(a) adjustment is recognized ratably over a period of four tax years, beginning with the year of the change. A net negative Section 481(a) adjustment is taken into account entirely in the year of the change, providing an immediate tax benefit.

To illustrate, consider a business that improperly capitalized $40,000 of repair costs over several years instead of deducting them. The business files for an automatic change to correctly deduct these expenses. This results in a negative Section 481(a) adjustment of $40,000, which the business can deduct on its tax return for the year it implements the change.

Information and Calculations for Form 3115

To execute an automatic accounting method change, a taxpayer must complete and file Form 3115, Application for Change in Accounting Method. This form requires detailed information about the taxpayer, the methods being changed, and the legal justification for the new method. The form and its instructions can be found on the IRS website.

The initial part of Form 3115 requires basic taxpayer information, such as name, address, and taxpayer identification number. The DCN, which corresponds to the specific automatic change being made, must be entered on the form. The form also requires a clear and detailed description of both the present method of accounting being changed and the proposed new method.

A portion of the form is dedicated to the Section 481(a) adjustment. The taxpayer must attach a statement showing the detailed computation of this adjustment, including the amounts of income or expense under the old and new methods for all prior years. The net result of this calculation must be reported on Form 3115.

The form also requires the taxpayer to provide the legal basis for the proposed change. This involves citing the specific revenue procedure or Treasury Regulation that authorizes the automatic change. The taxpayer must demonstrate eligibility to use the proposed method and that the change complies with all applicable rules.

Filing Procedures for an Automatic Change

Once Form 3115 is completed, the taxpayer must follow a dual-filing procedure. The original, signed Form 3115 must be attached to the taxpayer’s federal income tax return for the year of the change. This return must be filed by its due date, including any extensions.

In addition to filing the form with the tax return, a separate copy of the signed Form 3115 must be filed with the IRS. This copy must be sent to a specific service center, and it is important to verify the correct address in the most recent Form 3115 instructions. This second filing ensures the IRS has a record of the change.

The deadline for filing this duplicate copy is no earlier than the first day of the year of change and no later than the date the original Form 3115 is filed with the federal tax return.

The taxpayer should retain a copy of the filed Form 3115 and proof of mailing for their records. The IRS may review the application during a subsequent examination of the tax return. If the IRS determines that the change was not made in conformity with the applicable revenue procedure, the automatic consent can be retroactively revoked.