Existence of §754 Election Does Not Impact Whether Change in Treatment of an Item is an Accounting Method Change

In Chief Counsel Advice 201521012 the IRS concluded that an adjustment of the treatment of an item will not cease to be required to be treated as a change in a method of accounting merely because the taxpayer was a partnership with an election under §754 in place that would have caused a change in the §743(b) adjustment had the new method of accounting been used in the past.

In this case exam was proposing a change in accounting methods that would cause an acceleration of income recognition by a partnership.  Exam had concluded that the taxpayer was using an improper method of accounting to defer recognition of income on various securities.  Had such income been recognized under the method of accounting proposed by the agent the income would have been recognized earlier and the basis of assets held by the partnership would have been increased.

However during periods when the “improper” method had been used various partners had withdrawn from the partnership.  Pursuant to the partnership’s election under §754, a basis adjustment was calculated under §743(b).  That adjustment was larger as computed under the taxpayer’s method than it would have been had it been calculated under the proposed method.

The taxpayer therefore argued:

However, Taxpayer asserts that the proposed accounting method change would create a permanent difference in its lifetime taxable income because its IRC § 734(b) adjustments will be reduced, and that, therefore, Field Operation’s proposed treatment of the Basket Transactions does not involve a change in accounting method.

Accounting methods affect the timing, but not the amount, of income and deduction for a taxpayer.  If something affects the ultimate amounts recognized then it would not qualify as an accounting method—and this is what the partnership is arguing.

Why is this important?  The major reason is because if the treatment involves a change in accounting method, IRC §481(a) will allow the IRS to “reach back” and require the partnership to recognize the cumulative understatement of income.  If it is not an accounting method, this would most likely constitute merely an “error” for which the IRS would only be able to assess tax on differences in income for the years remaining open to assessment (most likely the prior three years).

So exam posed the question to the National Office asking if, in fact, the existence of the §754 adjustment would cause this to no longer be an accounting method change.

The National Office dismisses this view and holds that the change remains an accounting method change regardless of the existence of a §754 election and a prior §743(b) adjustment that would be affected by the method.

The memo notes:

The determination of whether a partnership has a change in accounting method does not depend on whether the partnership made an election under IRC § 754, whose only purpose and effect is to eliminate distortions caused by partnership distributions and sales of partnership interests. The partners of a partnership using a given accounting method ultimately recognize the same amount of cumulative taxable income over the life of the partnership whether or not the partnership makes an election under IRC § 754.

The memo outlines the specifics of applying the adjustment to this set of facts by noting:

When there is a change in accounting method to which IRC § 481(a) is applied, income for taxable years preceding the year of change must be determined under the accounting method that was then used, and income for the year of change and the following taxable years must be determined under the new accounting method as if the new method had always been used. Accordingly, Taxpayer’s IRC § 734(b) adjustments for years preceding the year of change must be computed using the accounting method that was then used. Taxpayer’s IRC § 734(b) adjustments for the year of change and subsequent years must be redetermined consistent with the new accounting method.

In computing the net § 481(a) adjustment, a taxpayer must take into account all relevant accounts. See Rev. Proc. 2002-18, section 2.04(1), Rev. Proc. 97-27, 1997-1 C.B. 680, section 2.05(1). Here, the IRC § 481(a) adjustment represents the difference in gain or loss for all of the underlying securities that would have been recognized under the new method, less the gain or loss that was recognized under the prior method as of the beginning of the year of change. Taxpayer’s IRC § 734(b) adjustments for taxable years prior to the year of change, as calculated under the prior method, are fully taken into account in calculating the basis in the securities. In addition, beginning in the year of change, Taxpayer’s basis in its securities will be modified to reflect the gain or loss recognized in connection with the change in accounting method.