IRS Grants Relief to Taxpayer When CPA Firm Inadvertently Failed to Have Taxpayer File Form 3115

Mistakes are made in preparing tax returns and, especially in the heat of tax season, items can be overlooked.  In PLR 201702021 the IRS granted relief in a situation where a CPA firm had accidentally neglected to attach a Form 3115 and have the taxpayer file a copy of the Form 3115 with the IRS for an automatic change of accounting methods.

The taxpayer in this case discussed with its CPA a change in accounting for prepaid insurance costs and decided to go forward with the change.  As the PLR describes the facts:

Taxpayer engaged FirmX to provide compilation services and tax preparation services for Taxpayer in Year2. FirmX provided these services to Taxpayer from Year2 through Year4. Prior to Year4, Taxpayer capitalized its prepaid insurance expenses as a prepaid asset and periodically adjusted the deductions as the asset expired. In Year4, Taxpayer discussed with CPA1 the possibility of changing its method of accounting for the prepaid insurance expenses so that Taxpayer could deduct those expenses in the year that they were paid if they met the 12-month rule under § 1.263(a)-4(f) of the Income Tax Regulations. Such a change would ordinarily qualify as an automatic change of accounting method under section 10.05 of Rev. Proc. 2015-14, 2015-5 I.R.B. 50, and sections 9 and 6.03(1) of Rev. Proc. 2015-13, 2015-5 I.R.B. 419. Taxpayer's management was not sophisticated in tax matters, but they believed that FirmX's experience with complex tax matters would allow FirmX to properly change Taxpayer's accounting method for the prepaid insurance expenses. Taxpayer's management provided all of the necessary information to FirmX and expected FirmX to take all steps necessary to file the proper forms to change the accounting method for the prepaid insurance expenses beginning in Tax Year.

The taxpayer had reason to expect the CPA to be able to handle this matter as she was an experienced CPA working with a reputable firm.  As the memorandum goes on to note:

CPA1 of FirmX was the partner responsible for bringing all the CPA FirmX's service providers together to serve Taxpayer. CPA2 of FirmX, with 35 years of experience in tax planning, review, and preparation was in charge of the tax compliance services for Taxpayer. CPA2 of FirmX utilized various personnel in her office to prepare Taxpayer's Tax Year Form 1120S return in Month1 and Month2 of Year4. CPA2 of FirmX also oversaw the preparation of Taxpayer's Tax Year Form 3115 which was completed on Date4.

So far all seems fine, but the CPA firm was about to under a major change—and the Form 3115’s processing would become an accidental victim of changing their methods for processing returns:

On Date3, FirmX had acquired FirmZ, an accounting firm where Taxpayer was an existing client. The acquisition of FirmZ led to the adoption of a new paperless system for filing and storage of tax forms and records. The new tax return processing procedures resulted in an inadvertent error by FirmX. The result was that Taxpayer's Tax Year Form 3115, although prepared, was not attached to Taxpayer's timely electronically-filed Tax Year Form 1120S. The Form 3115 was prepared and saved in FirmX's electronic file for Taxpayer. However, because a box was not checked on FirmX's internal processing control sheet alerting processing that a Form 3115 was to be attached to the return; it was inadvertently omitted from Taxpayer's Tax Year Form 1120S, and the requisite copy was not filed with the IRS in Ogden, Utah as required by section 6.03(1)(a)(i) of Rev. Proc. 2015-13. Taxpayer's Tax Year Form 1120S, however, was filed consistent with the method change, did reference the Form 3115, and included the requisite section 481(a) adjustment. At the time the return was electronically filed, no one was aware that the Form 3115 was omitted from the Tax Year return and that a copy was not filed with the IRS in Ogden.

The failure to include the Form 3115 was a problem since IRC §446(c) provides:

(e) Requirement respecting change of accounting method

Except as otherwise expressly provided in this chapter, a taxpayer who changes the method of accounting on the basis of which he regularly computes his income in keeping his books shall, before computing his taxable income under the new method, secure the consent of the Secretary.

Not having the IRS’s consent to the change, the taxpayer would not be allowed to accelerate the deduction of prepaid insurance charges, nor would the taxpayer have been allowed what was most likely a negative §481(a) adjustment in the year of change.  But, nevertheless, the returns were prepared on that basis.

At this point the taxpayer faced the possibility of the IRS, upon discovery of this oversight, requiring the taxpayer to return to the older method of accounting for prepaid insurance beginning with the earliest year open for adjustment and for all intervening years, as well as picking up a positive §481(a) adjustment to recapture the difference at the beginning of that open year.

The taxpayer was not aware of the issue until, for unrelated reasons, the taxpayer changed CPA firms.  As the PLR goes on to note:

For reasons unrelated to this omission, Taxpayer hired a new accounting firm around Date5, called FirmY. The omission of Taxpayer's Tax Year Form 3115 was not discovered until Date6, when CPA3 asked Taxpayer for a copy of it. When Taxpayer asked FirmX for a copy of its Form 3115, Firm X discovered that it failed to file Taxpayer's Tax Year Form 3115 with Taxpayer's Tax Year Form 2011S [sic] and failed to file a copy with the IRS in Ogden. As soon as the omission was discovered, FirmX immediately contacted Taxpayer and began preparing this letter requesting relief from the Service.

The new firm’s due diligence review for a new client uncovered the problem simply by asking for a copy of the form—something important to have should the taxpayer later be examined as the burden would be on the taxpayer to show it had permission to adopt the new method.  Now it became clear the taxpayer would not meet that burden because, in fact, the permission had never been properly requested.

But that’s not the end of the story—the original CPA firm at this point asked the IRS to grant the taxpayer the right to make a late election pursuant to the provisions of Regs. §§301.9100-1 and 3 which govern a request for discretionary relief for late regulatory elections to be granted by the IRS.

The IRS, looking at the facts, applied them to the requirements outlined for the IRS to consider in granting discretionary relief:

The information and representations made by Taxpayer establish that Taxpayer acted reasonably and in good faith, and that there are unusual and compelling circumstances meriting a late election under section 7.03(3)(d) of Rev. Proc. 2015-13. The affidavits presented show that Taxpayer reasonably relied on qualified tax professionals for the proper filing of Taxpayer's federal tax return and accompanying Form 3115. The affidavits presented also show that FirmX inadvertently failed to file the Form 3115 with Taxpayer's Form 1120S return and failed to file a copy with the IRS in Ogden, but that the return otherwise reflected the intended change in accounting method, referred to the Form 3115, and included the requisite section 481(a) adjustment. Upon discovery of the error, FirmX filed for relief on behalf of Taxpayer before the government discovered the error.

The information and representations presented establish that Taxpayer is not seeking to alter a return position for which an accuracy-related penalty had been or could be imposed under § 6662 at the time relief was requested. Taxpayer is not using hindsight in requesting relief, and no facts have changed since the time of the original filing deadline.

Finally, granting an extension will not prejudice the interests of the government. It is represented that Taxpayer would not have a lower tax liability in the aggregate for all taxable years affected, if given permission to file the Form 3115 at this time than Taxpayer would have had if had been properly filed by the original due date of the return. Taxpayer has represented that no taxable years are closed by the period of limitations on assessment, and the IRS had not discovered the Form 3115 was missing before Taxpayer filed for relief.

The IRS, based on the above analysis, granted the taxpayer permission to make the late election.

There are a few key lessons to be learned from this ruling.

  • Changing procedures in a practice is a time when advisers need to exercise a heightened level of review to make sure issues like this do not arise.  In this case the change over to the paperless system, without doubt a necessary and useful change in general, along with absorbing the other firm, another likely positive step, meant that those working on this return were not used to the newly required procedures—especially for something that is a bit out of the ordinary, like filing for a change of accounting method.
  • The new CPA firm avoided taking ownership of his error (which might have been discovered many years later) by having due diligence procedures for the new client that uncovered the prior change of accounting methods and then requested the document that should be part of the taxpayer’s permanent record.
  • The old CPA firm took the proper steps by taking steps to obtain a private letter ruling once they uncovered the problem.  An important item to note in the IRS findings is that one condition of relief is that the matter be brought to the IRS’s attention before the IRS discovers the error on its own.  While it might be tempting to “let sleeping dogs lie” and play the odds that an agent wouldn’t ask for proof of permission to change in the future, it’s a choice of action that will likely end badly if any future agent doesn’t behave as some might predict he/she will.