Given the potential for the adjustments to trigger extremely large tax liabilities, accounting method changes made by the IRS on audit can be doomsday scenarios for unwary taxpayers.
In Nebeker v. Commissioner, T.C. Memo. 2016-155, the court addressed a common situation where the IRS makes an adjustment on audit that is an accounting method, but it does not follow the accounting method change rules.
Facts & Procedural History
The taxpayer operated a Schedule C business that provided project management consulting primarily for aerospace and defense companies.
The taxpayer employed a number of independent contractors who provided services to his clients.
The taxpayer paid his independent contractors every two weeks for labor and travel expenses they incurred, regardless of whether the his clients had paid the invoices associated with the subcontractors’ labor and expenses. The taxpayer would then invoice and collect on the invoices at a later time.
Beginning in 2004 and running through 2009, the taxpayer claimed the income tax deduction for outside labor associated with payments made to his contractors for the year in which the he received payment for the contractor expense, regardless of whether he paid the subcontractor in a prior year.
So the taxpayer deducted $1,373,309 and $392,210 for 2006 and 2009, respectively, even though he only paid $1,087,551.72 and $180,665.62.
The IRS audited the tax returns and proposed to disallow the difference between the amount deducted and paid in each year.
About Accounting Method Changes
Accounting method changes are timing issues. It is a question of “when” not “if” a tax deduction, credit or income is to be reported.
Accounting method changes include changes in the overall plan of accounting for gross income or deductions (i.e., changing from cash to accrual or vice versa) or changes in the treatment of any material item used in such overall plan.
Accounting method changes usually require the taxpayer (or the IRS, if the IRS is making the change) to make a catch-up adjustment in the current year to account for the treatment of the item in prior years. This is often referred to as a Section 481 adjustment.
Accounting method changes can result in favorable adjustments that result in a reduction of taxes in the current year. They can also result in unfavorable adjustments that increase the amount of tax in the current year. Whether favorable or unfavorable, these adjustments are usually quite large as they can change the tax treatment for several years or for several decades and report the change all in one year.
For example, a taxpayer who changes their method of accounting for depreciation on a building that has been held for a number of years may be able to make a catch-up adjustment in the current year to account for depreciation that was not taken in the prior years. This can result in the taxpayer being entitled to a large depreciation deduction in the current year. This adjustment can reduce the taxpayer’s tax liability in the current year by allowing the missed depreciation deductions from the prior year to all be taken in the current year.
What if the IRS Audit Misses the Catch-up Adjustment?
Say that the IRS makes an accounting method adjustment for one year, but then closes the audit and fails to make the later year adjustments? What is the taxpayer to do? Can they file an amended return for the other year(s) to make the change themselves? This brings us to the Nebeker case.
In Nebeker, the IRS only disallowed the taxpayer’s 2006 and 2009 deductions. It did not make a catch-up adjustment in 2006 to account for the same items in the 2004 and 2005 tax years.
The court concluded that the IRS’s audit adjustments were in fact an accounting method change. As noted by the court, this requires a catch-up adjustment in 2006. So the taxpayer is to file an amended return.
The court did not provide the facts to say with any certainty, but it would seem like this adjustment would essentially nullify the IRS’s adjustments in 2006 and 2009.