Change In Accounting Method To Deduct Prepaid Expenses Wasn't Allowed Before Final Regs Permitted It

Lattice Semiconductor Corporation and Subsidiaries, TC Memo 2011-100

The Tax Court has held that IRS did not err in denying a corporation's request to change its accounting method to allow it to deduct 12 months of prepaid expenses that spanned two tax years and claim a prepaid expense deduction for 2002 (i.e., a tax year before regs allowing this break became final). The Court rejected the corporation's contention that IRS ignored developing caselaw and abused its discretion.

Background. Under Code Sec. 446(e), once a taxpayer elects a method of accounting, it must continue to use that method until it gets IRS's approval to change to another method. There are two processes, automatic and nonautomatic consent.

In early 2002, IRS issued an advance notice of proposed rulemaking, stating that it expected to propose a rule that would no longer require capitalization of 12-month prepaid expenses under Code Sec. 263. The advance notice instructed taxpayers not to seek to change an accounting method by relying on the rules contained in the notice until they were published as final regs. The advance notice was followed by the issuance of proposed regs. Taxpayers were again advised not to seek an accounting method change in reliance upon the proposed regs until final regs were published. IRS issued final regs in 2004, generally effective for amounts paid or incurred on or after Dec. 31, 2003.

The final regs provided that a taxpayer doesn't have to capitalize amounts paid to create (or facilitate the creation of) any right or benefit that doesn't extend beyond the earlier of (1) 12 months after the first date on which the taxpayer realized the right or benefit, or (2) the end of the tax year following the tax year in which the payment was made (the 12-month rule). (Reg. §1.263(a)-4(f))

Under the final regs, a taxpayer seeking to change to a method of accounting provided in the final regs had to get IRS consent. However, the regs granted consent for the taxpayer's first tax year ending on or after Dec. 31, 2003, if the taxpayer followed the administrative procedures issued under Reg. §1.446-1(e)(3)(ii). (Reg. §1.263(a)-4(p), Reg. §1.263(a)-5(n)) Shortly thereafter, in Rev Proc 2004-23, 2004-1 CB 785, IRS provided procedures for automatic consent to accounting method changes that complied with the final regs' principles. Rev Proc 2004-23 specified that requests for accounting method changes under the final regs for a year earlier than the reg's effective date wouldn't be granted.

Facts. Lattice Semiconductor Corporation and Subsidiaries (Taxpayer), an accrual method taxpayer, designed, developed and marketed high-performance programmable logic devices and related software. It traditionally incurred prepaid expenses for insurance, maintenance and service contracts. These contracts typically did not exceed 12 months, but the contract periods sometimes spanned two tax years. Before 2002, Taxpayer capitalized its prepaid expenses for contracts that extended substantially into the following year.

Nine days after IRS issued its proposed regs, Taxpayer applied for an accounting method change to deduct 12 months of prepaid expenses spanning two tax years under Rev Proc 97-27, 1997-1 CB 680, which provided the general procedures for obtaining IRS's advance (nonautomatic) consent to change an accounting method.

Even though it had not received IRS approval to change its accounting method, Taxpayer claimed a deduction for the prepaid expenses when it filed its consolidated federal income tax return for 2002. Taxpayer calculated a consolidated net operating loss (CNOL) carryback from the 2002 deduction of the prepaid expenses, which it carried back to 2000 and’99. IRS denied Taxpayer's request to change its accounting method in May 2004 and subsequently issued a deficiency notice disallowing the prepaid expense deduction and the corresponding CNOL carrybacks.

Accounting method change not allowed. The Tax Court held that IRS did not abuse its discretion in denying Taxpayer's request to change its accounting method to deduct, rather than capitalize, the prepaid expenses. IRS properly required Taxpayer to obtain its consent under Code Sec. 446(e) before making an accounting method change and to abandon the new method and report taxable income using its old accounting method.

The Tax Court pointed out that the final regs were effective for amounts paid or incurred on or after Dec. 31, 2003, and Taxpayer sought to deduct the prepaid expenses for 2002, a year before the effective date of the final regs. The Court said IRS was justified in enforcing the effective date provisions in the final regs. Taxpayer could only make such a change as was permitted under the provisions of the final regs and Rev Proc 2004-23.

In seeking to deduct the prepaid expenses for 2002, Taxpayer relied on the advance notice of proposed rulemaking and U.S. Freightways Corp. v. Com. (CA 7 2001), 88 AFTR 2d 2001-6703, reversing (1999) 113 TC 329, and Zaninovich v. Com. (9th Cir. 1980), 45 AFTR 2d 80-1442, reversing (1978) 69 TC 605. The Court found this reliance misplaced. The Tax Court dismissed Taxpayer's reliance on the advance notice of proposed rulemaking. It did not purport to change IRS's existing administrative position and did not negate the authorities under the then-existing law.

The Tax Court also rejected the Taxpayer's contention that the Ninth Circuit's decision in Zaninovich—which held that 12-month rental payments by a cash method taxpayer were fully deductible in the year of payment—allowed accrual basis taxpayers, such as Taxpayer, to use the 12-month rule. In Zaninovich, the Ninth Circuit specifically distinguished between an accrual basis taxpayer and a cash basis taxpayer (such as the one in Zaninovich). The Tax Court concluded that Zaninovich only applies to cash basis taxpayers and did not indicate that the Ninth Circuit would follow a 12-month rule for accrual basis taxpayers.

And, while the Seventh Circuit adopted the 12-month rule for accrual method taxpayers in Freightways Corp., the Tax Court found that this holding wasn't binding on IRS, the Tax Court, or taxpayers outside the Seventh Circuit, such as Taxpayer. The Tax Court refused Taxpayer's “invitation to speculate” about whether the Ninth Circuit (to which the Taxpayer's case was appealable) would have followed Freightways, noting that at the time this case was inconsistent with the Tax Court's decisions and those of other Courts of Appeals.

Finding that IRS acted within its discretion in rejecting Taxpayer's accounting method change request under then-existing caselaw, the Tax Court did not address the question of whether the rejection was arbitrary and capricious because IRS had instituted an automatic rejection policy.

References: For accounting method changes, see FTC 2d/FIN ¶G-2100 et seq.; United States Tax Reporter ¶4464.21 et seq.; TaxDesk ¶442,400 et seq.; TG ¶6300 et seq.