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Tax Court Rules for IRS on Impermissible Accounting Method Change
By Ann W. Seelmeyer, CPA, and Kevin F. Powers, CPA Taxpayers often want to change their methods of accounting, whether related to an overall method of accounting or to a specific item like depreciation on fixed assets. Authors Ann Seelmeyer and Kevin Powers discuss a recent U.S. Tax Court ruling that reinforces why taxpayers must follow all of the applicable procedures to ensure that the Internal Revenue Service (IRS) will approve the change. Section 446(a) of the Internal Revenue Code (IRC) provides that “taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.” 1 The related regulation provides that “a change in the method of accounting includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan.” 2 Taxpayers may apply to the IRS, via Form 3115, “Application for Change in Accounting Method,” to change a method of accounting. The IRS has broad discretion to approve or disapprove a change. Permission is not granted unless the taxpayer and the IRS agree to certain conditions. The IRS also may force the taxpayer to change its method of accounting when that method does not clearly reflect taxable income. The Capital One Case The Taxpayer Relief Act of 1997 added Section 1272(a)(6)(C)(iii) to the IRC. The section requires taxpayers to treat credit card receivables as creating or increasing original issue discount (OID) on the pool of credit card loans to which the receivables relate. The IRS subsequently issued Revenue Procedure 98-60, which explained how taxpayers could secure automatic consent to change their method of accounting for pools of credit card receivables. From 1995 through 1999, Capital One recognized late-fee income at the time the fee was charged to the cardholder for both financial accounting purposes and federal income tax purposes (in other words, the current-inclusion method). On its 1998 tax return, Capital One filed a Form 3115 to change its method of accounting for interest and OID to apply the new provisions for the treatment of credit card receivables. On its Form 3115, Capital One requested permission, under Section 12.02 of Revenue Procedure 98-60, to change its method of accounting for interest and OID that are subject to the provisions of Section 1004 of the Taxpayer Relief Act of 1997. Capital One continued to treat late-fee income under the current-inclusion method on its 1998 and 1999 tax returns. On its 2000 tax return, however, the financial institution began treating the late-fee income as increasing OID. After filing its 2000 tax return, Capital One filed a petition to treat the late-fee income as increasing OID on its pool of credit card loans, thus reducing taxable income for 1998 and 1999. The IRS argued that Sec. 446(e) prohibited a retroactive change in the treatment of the 1998 and 1999 late-fee income from the current-inclusion method to a method conforming to the provisions of Sec. 1272(a)(6)(C)(iii). The Tax Court Ruling The Form 3115 gave no indication that the late-fee income would be treated as OID. In fact, the Tax Court found the language used in the Form 3115 “ambiguous and vague.” 3 By failing to mention late-fee income on the Form 3115, and failing to account for late-fee income as OID on the 1998 and 1999 tax returns, Capital One did not obtain proper consent for the change. Capital One argued that it was nonetheless entitled to change its treatment of late-fee income because it was not changing the treatment of a material item. It contended that late-fee income was a component of interest, including OID, and was not a separate “item.” Consequently, Capital One could make changes to these components of interest without first receiving IRS consent. The Tax Court disagreed, stating that late-fee income is a separate and distinct item of income. The court noted that Capital One earned more in late-fee income than any other type of fee, and late fees are earned for reasons independent of the reasons other types of income are earned, such as finance charges, over-limit fees, interchange fee, and cash advance fees. Make Strict Compliance the Rule Ann Seelmeyer is a senior manager with Crowe Horwath LLP in the Louisville, Ky., office. She can be reached at 502.420.4443 or ann.seelmeyer@crowehorwath.com. Kevin Powers is an executive with Crowe Horwath LLP in the Oak Brook, Ill., office. He can be reached at 630.586.5140 or kevin.powers@crowehorwath.com. "Tax Court Rules for IRS on Impermissible Accounting Method Change" 1 “General rule for methods of accounting,” Internal Revenue Code, Section 446(a), www.law.cornell.edu/uscode/html/uscode26/usc_sec_26_00000446----000-.html. 2 Revenue Rule 90-38, Internal Revenue Service Revenue Ruling, April 10, 1990, www.taxlinks.com/rulings/1990/revrul90-38.htm. 3 “Capital One Financial Corp. v. Commissioner,” TaxCore Court Documents, www.ustaxcourt.gov/InOpHistoric/CapitalOne.TC.WPD.pdf. Download PDF Under U.S. Treasury rules issued in 2005, we must inform you that any advice in this communication to you was not intended or written to be used, and cannot be used, to avoid any government penalties that may be imposed on a taxpayer. 
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