4.10.13  Certain Technical Issues (Cont. 1)

4.10.13.4 
Related Party Transactions (IRC 482)

4.10.13.4.3 
Specific Situations in Which IRC 482 Could Be Applied

4.10.13.4.3.8  (03-16-2015)
Transfer of Tangible Property - Treas. Reg. 1.482-3

  1. The arm's length amount charged in a controlled transfer of tangible property must be determined under one of the six methods listed in Treas. Reg. 1.482-3 (a). Each of the methods must be applied in accordance with all of the provisions of Treas. Reg 1.482-1, including the best method rule of Treas. Reg. 1.482-1(c), the comparability analysis of Treas. Reg. 1.482-1(d), and the arm's length range of Treas. Reg.1.482-1(e). Treas. Reg. 1.482-3(a), the transfer pricing methods are:

    1. The comparable uncontrolled price method, described in Treas. Reg. 1.482-3 (b);

    2. The resale price method, described in Treas. Reg. 1.482-3 (c);

    3. The cost plus method, described in Treas. Reg. 1.482-3 (d);

    4. The comparable profits method, described in Treas. Reg. 1.482-5;

    5. The profit split method, described in Treas. Reg. 1.482-6; and

    6. Unspecified methods, described in Treas. Reg. 1.482-3 (e).

  2. The value of tangible property may be affected by the value of intangible property associated with the tangible property’s transfer. Generally, the transfer of tangible property that has intangible property associated with the transfer will not be considered a transfer of intangible property if the purchaser does not acquire any rights to exploit the intangible property other than the rights relating to the resale of the tangible property under normal commercial practices. Treas. Reg. 1.482-3(f). In such a case, the embedded intangible must be accounted for in evaluating the comparability of the controlled transaction and uncontrolled transaction. If the transfer of tangible property conveys to the recipient a right to exploit an embedded intangible, then it may be necessary to determine the arm’s length consideration for the intangible property separately from the tangible property under the methods in Treas. Reg. 1.482-4.

  3. There are numerous cases involving the sale of goods between a controlled domestic corporation and a controlled foreign corporation. A referral to International Specialists is required in these cases.

  4. In accordance with Rev. Rul. 69-630, 1969-2 C.B. 112, (as modified by Announcement 99-1, 1999-1 C.B. 302) in the cases of a bargain sale between two corporations owned by the same shareholder, the income of the seller will be increased to reflect the arm's-length price, and the basis of the property to the purchaser will be increased by a like amount. Additionally, the amount of the increase will be treated as a distribution by the selling corporation to the shareholder and as a capital contribution by the shareholder to the purchasing corporation, unless the transaction giving rise to the IRC 482 allocation did not have as one of its principal purposes the avoidance of income tax.

  5. The sale of property by a shareholder to his controlled corporation is subject to IRC 482. Anderson v. Commissioner, T.C. Memo 1976-28. The sale of land by a partnership to its controlling corporate partner is also subject to IRC 482. Aladdin Industries v. Commissioner, T.C. Memo 1981-245..

  6. In Dolese v. Commissioner, 82 TC 830 (1984), following a disproportionate distribution of property from their partnership, the partners contributed the land to a charitable organization. IRC 482 was applied to allocate the charitable contributions among the partners consistent with the percentage interests in the partnership.

  7. Similarly, in Northwestern National Bank of Minneapolis, 556 F.2d 889 (8th Cir. 1977), the Service successfully reallocated to a wholly-owned subsidiary a charitable deduction claimed by the parent consisting of assets acquired from the subsidiary by means of an upstream dividend. The subsidiary in this case acquired 10% of the stock of a company for a cost of $100,000. Over time the fair market value of the stock rose to $800,000. After consideration of various alternatives, the subsidiary declared a dividend to its 100% corporate parent of the stock. Within two weeks of receiving its “dividend,” the parent donated the stock to a charitable foundation. The taxpayer argued IRC 482 was inapplicable to a transaction that originated as a dividend distribution. In addressing this, the court stated (at 891-892):

    There is nothing in the language of IRC 482 or its corresponding regulations that is inconsistent with applying IRC 482 to transactions between subsidiary corporations that might not occur in similar form between unrelated taxpayers... The purpose behind the dividend distribution was to obtain a tax advantage not available in an arm's length transaction. This transaction was made possible solely on the basis of appellant's relationship with and control of Bank Building Company, and the end result was a distortion of the respective net income of....

4.10.13.4.3.9  (03-16-2015)
Otherwise Nonrecognized Gains or Losses - Treas. Reg. 1.482-1(f)(1)(iii)

  1. IRC 482 controls when it conflicts with IRC 351 as long as the Commissioner does not abuse his discretion to reallocate income and expenses. Rooney v. United States, 305 F.2d 681 (9th Cir. 1962). In footnote 4, the court in Aladdin Industries, T.C. Memo 1981-245, stated: "It has been routinely held, absent an abuse of discretion by the Commissioner, IRC 482 will override specific non-recognition provisions of the code. National Securities Corp. v. Commissioner, 137 F.2d 600 (3d Cir. 1943), cert. denied 320 US 794 (1943); Central Cuba Sugar Co. v. Commissioner, 198 F.2d 214 (2d Cir. 1952), cert. denied 344 US 874 1952." These cases generally involve the transfer of an asset with built in gain or loss or the splitting of income from deductions to obtain an inappropriate or abusive tax benefit.

4.10.13.4.4  (03-16-2015)
Burden of Proof and Issue Development

  1. There is generally acknowledged a three-tiered approach to the burden of proof in IRC 482 cases:

    1. If the notice of deficiency is clear that the IRS is relying on IRC 482, the burden of proof is on the taxpayer to establish the allocation is unreasonable, arbitrary, or capricious. See, e.g., Eli Lilly & Co. v. Commissioner, 84 T.C. 996, 1131 (1985), aff’d on this issue, rev’d in part, and remanded, 856 F.2d 855, 860 (7th Cir. 1988)..

    2. If IRC 482 is not raised until after the notice of deficiency, but the taxpayer is notified far enough in advance of trial so as not to prejudice him, the burden of proof shifts to the IRS to establish all elements in order to support the allocation under IRC 482

    3. If IRC 482 is raised too late to allow the taxpayer sufficient warning, the IRS cannot rely on IRC 482 at all.

  2. See generally CAL-FARM Insurance Co. v. United States, 647 F. Supp. 1083 (E.D. Cal. 1986); Achiro v. Commissioner, 77 TC 881 (1981). In CAL-FARM, the taxpayer tried to convince the court it had not been given adequate notice of the Service’s reliance on IRC 482 and therefore, the Service should be prohibited from relying on it. The court found in favor of the Service, noting the “first line of the text of the notice [statutory notice of deficiency] refers to an attached examination report prepared by an Internal Revenue Service revenue agent. The revenue agent refers to IRC 482 at page 3 [of the examination report].” Therefore, it is important for examiners to ensure reports clearly reflect the Service's reliance on IRC 482, even if this is an alternative position. In so doing, the burden of proof will remain with the taxpayer to show the Service's proposed adjustment is “unreasonable, arbitrary, and capricious.”

  3. It is important to note IRC 482 applies only at the discretion of the Commissioner. Treas. Reg. 1.482-1(a)(3) states “[e]xcept as provided in this paragraph, IRC 482 grants no right to a controlled taxpayer to apply its provisions at will, nor does it grant any right to compel the district director to apply such provisions.” A taxpayer may report on a timely original tax return the results of its controlled transactions based upon prices different from those actually charged. However, Treas. Reg. 1.482-1(a)(3) does not permit a taxpayer to file an untimely or amended return to decrease taxable income from controlled transactions. See Intersport Fashion West, Inc. v. United States, 103 Fed. Cl. 396 (2012). However, taxpayers may claim a setoff against the Service’s IRC 482 allocation for any other non-arm’s length transaction between the same controlled taxpayers in the same taxable year as the Service’s IRC 482 allocation only if the taxpayer:

    1. Establishes that the transaction that is the basis of the setoff was not arm’s length and the amount of the appropriate arm’s length charge;

    2. Documents all correlative adjustments resulting from the proposed setoff; and

    3. Notifies the Service of the basis of any claimed setoff within 30 days after the earlier of the date of a letter in which the Service transmits an examination report notifying the taxpayer of proposed adjustments or the date of the issuance of the notice of deficiency. Treas. Reg. 1.482-1(g)(4).

  4. For specific guidance on issue development in transfer pricing examinations refer to the Service’s Transfer Pricing Audit Roadmap, which is available at www.irs.gov/pub/irs-utl/FinalTrfPrcRoadMap.pdf

4.10.13.4.5  (03-16-2015)
Examination Reports and Processing

  1. To accomplish tax parity, the Service may allocate items of income or expense among controlled taxpayers IRC 482). The initial transfer pricing adjustment made by the Service, which ordinarily increases the income of the taxpayer, is known as a “primary adjustment.” The corresponding decrease in income of the other related party on the other side of the controlled transaction is known as the “correlative allocation.

  2. When the Service makes an allocation under IRC 482, appropriate correlative allocations will also be made with respect to any member of the group affected by the allocation. Thus, if the Service makes an allocation of income, it will not only increase the income of one member of the group, but correspondingly decrease the income of the other member of the group. Treas. Reg. 1.482-1(g)(2)

4.10.13.4.5.1  (03-16-2015)
Required Elements

  1. A statement will be made in the report to the primary taxpayer to the effect that:

    1. Separate examination reports have been prepared reflecting the IRC 482 correlative allocation with respect to the correlative taxpayer.

    2. The correlative allocation is deemed to have been made in instances where the correlative allocation has no effect on the income tax liability of the correlative taxpayer.

  2. The correlative allocation should not be made until the primary adjustment has been resolved. Pursuant to Treas. Reg. 1.482-1(g)(2)(iii), the primary adjustment may be resolved in one of the following ways:

    1. The assessment of tax following execution of Form 870, Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment.

    2. Acceptance of a Form 870- AD, Offer of Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Assessment of Overassessment.

    3. Payment of the deficiency.

    4. Stipulation in the Tax Court.

    5. Final determination of tax liability by offer-in-compromise, closing agreement, or court action.

  3. To provide uniform treatment of all IRC 482 cases, agreed or unagreed, reports on the primary taxpayer and the correlative taxpayer should be prepared concurrently; kept together (not separate) and transmitted to the next function (i.e., Technical Services, Appeals Office, or campus processing center).

  4. In cases with no tax effect of a correlative allocation (foreign entity, loss entity, etc.), the examiner should make a statement in the preliminary statement to the effect that the correlative allocation is deemed to have been made when and if the adjustments are agreed to and assessment has been made or deficiency has been paid. It is important that this statement included in all reports in order that the taxpayer to which the correlative allocations apply may not escape the effect of these adjustment in the event of a subsequent exam or carryback of losses or credits or other events that have a tax effect.

  5. To ensure that overpayments resulting from the correlative allocations are not scheduled and refunded to the taxpayer, the examiner will note Form 3198 accordingly.

4.10.13.4.5.2  (03-16-2015)
Agreed IRC 482 Issues Involving Primary Adjustments and Correlative Allocations to U.S. Taxpayers

  1. In order to have an agreed IRC 482Allocation of income and deductions among taxpayers issue, all related parties must be in full agreement with the IRC 482 issue.

  2. Obtain a signed agreement (Form 870Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment.) or payment of the deficiency for the taxpayer to which the primary adjustment applies..

  3. Make the correlative allocations and obtain agreements for the overassessment.

  4. The taxpayers will be advised that their cases can be more expeditiously adjusted and closed if the taxpayer scheduled to receive refunds will voluntarily consent in writing to have the refunds applied against the proposed deficiencies.

  5. The taxpayer's written statement can be incorporated in Form 870 The examiner's report in the overassessment cases must include a statement of whether consents as provided for in this paragraph have been furnished and, if not, the reason. The suggested format for the written statement is as follows:

    "The undersigned taxpayer also consents and agrees to the application of so much of the overassessment as represents an overpayment, together with allowable interest thereon, as a credit to the deficiency in tax in the amount of ($amount), together with interest thereon, due from ________________ for the year ________. This is provided that the amount of the overpayment, if any, together with allowable interest, which is in excess of the said deficiency and interest, is otherwise credited or refunded in accordance with IRC 6402 , or the corresponding provisions of prior revenue laws."

  6. The examiner should refer to Rev. Proc. 99-32, in situations where the taxpayer requests permission to receive payment without further Federal income tax consequences from the taxpayer to which the correlative allocation applies.

  7. The examiner will note Form 3198Special Handling Notice for Examination Case Processing appropriately.

4.10.13.4.5.3  (03-16-2015)
Unagreed IRC 482 Issues Involving Primary Adjustments and Correlative Allocations to U.S. Taxpayers

  1. In unagreed IRC 482 cases where the correlative allocation is the only adjustment on the related entity, do not write a complete report for the correlative allocation. Submit the files on related entities with tax computation sheets in each case file. Prior to closing, the examiner will draft a letter inviting the related entities to file a claim.

  2. In unagreed IRC 482 cases when there are other adjustments on the related entities do not make the correlative IRC 482 allocations, but explain fully the reason for not making the correlative allocation including any inconsistent positions. This explanation should be made in the taxpayer's portion of the Revenue Agent's Report (RAR).

  3. In all unagreed IRC 482 issue cases, the taxpayer to which the correlative allocation applies should be advised of the period of limitations under IRC 6511 for filing a claim. If the period for filing a claim for refund expires in less than 180 days, the examiner should solicit a Form 843, Claim Refund and Request for Abatement, from the taxpayer. Such claims should be picked up and submitted with the case, if possible.

  4. To ensure that overpayments resulting from the correlative allocations are not scheduled and refunded to the taxpayer, the examiner will appropriately note Form 3198.

4.10.13.4.5.4  (03-16-2015)
Related Cases Not Managed In the Same Compliance Area Involving Primary Adjustments and Correlative Allocations to U.S. Taxpayers

  1. When a return is examined in one office and an issue is the transfer of income or deduction to a related taxpayer under examination in another area office, the office making the initial examination will (except in cases arising out of partnership and/or fiduciary return or S corporations) immediately, upon identification of a potential IRC 482 adjustment, advise the examiner of the issue(s) and amount involved.

  2. Immediately upon conclusion of the examination, a notice should be issued to the outside office that will contain sufficient information to enable the receiving office to make the correlative allocation(s) to the related return(s). The initiating office examiner's case files will contain copies of the notification.

  3. Upon receipt of notification, the receiving office will take prompt action to make adjustments for the transfer of income or deduction resulting from the initial examination. In the event the return has been examined and closed, reopening procedures will be considered.

  4. If the corresponding return is not under examination, the examiner should secure the return and prepare the report.

4.10.13.5  (03-16-2015)
Adjustments Between Correlative U.S. Taxpayers to Achieve Consistent Tax Treatment (a/k/a Whipsaw Issues)

  1. Transactions that affect the income, deductions, or credits of two or more taxpayer's returns should be treated consistently between the taxpayers. If the examiner determines the transaction is not treated consistently on the returns of the taxpayers involved in the transaction, corresponding adjustments must be made to ensure proper treatment. The taxpayers that are affected by this transaction are considered "correlative taxpayers" . Also see IRM 4.10.7.4.9 on Whipsaw Issues.

  2. Adjustments made between correlative taxpayers will usually increase the tax liability of one taxpayer and reduce the tax liability of the other.

  3. Service policy (Policy Statement P-4-34) requires that the case of the taxpayer whose tax liability has been reduced will not be closed until the taxpayer whose tax liability was increased agrees to the corresponding adjustment(s) and signs a consent agreeing to the increase in tax or a court establishes the correctness of the adjustment(s). See IRM 1.2.13(2) Servicewide Policies and Authorities, Policy Statements for the Examining Process. Adjustments of this type occur most frequently in the following returns:

    1. Husband and wife filing separate returns;

    2. Taxpayers claiming duplicate dependency exemptions;

    3. Grantor, trust, and beneficiaries;

    4. Parent and child;

    5. Decedent and decedent's estate;

    6. Taxpayers in which the Commissioner has invoked the provisions of IRC section 482 as described above;

    7. Parent and subsidiary corporations; and

    8. Taxpayers involved in whipsaw issues.

  4. If at all possible, correlative taxpayer's cases should be associated and remain together until the taxpayer whose report reflects a deficiency has been assessed, or until the correlative taxpayer's case is placed in suspense. If this is not possible, the procedures in IRM 4.10.13.5.4, Related Cases Not Managed In the Same Compliance Area Involving Primary Adjustments and Correlative Allocations to U.S. Taxpayers should be followed.

  5. Procedures for disposition of related cases for flow-through entities will be closed using the procedures in IRM 4.32, Pass-Through Entity Handbook.

4.10.13.5.1  (03-16-2015)
Definition of Terms

  1. Primary Adjustment - The adjustment, which generally increases the tax liability of the initial taxpayer, and generally creates a corresponding decrease in the tax liability of one or more taxpayers involved in the transaction.

  2. Primary Taxpayer - The taxpayer whose tax liability is affected by the primary adjustment.

  3. Correlative Allocation - The adjustment that generally creates a corresponding decrease in the tax liability of the taxpayer(s) involved in the transaction with the primary taxpayer. Appropriate collateral Allocations may include correlative allocations, conforming adjustments, and setoffs, as described in Treas. Reg. 1.482-1(g).

  4. Correlative Taxpayer - The taxpayer who is involved in the transaction with the primary taxpayer whose tax liability is affected by a correlative Allocation.

4.10.13.5.2  (03-16-2015)
Correlative U.S. Taxpayers Controlled in One Area

  1. The examiner for the primary taxpayer will request the return(s) of all correlative taxpayer(s) in the Area if a manageable number of correlative taxpayers are involved. The cases will remain associated until the primary and correlative Allocations have been proposed and assessments have been made, or until the correlative taxpayers' cases are placed in suspense pending the resolution of the primary taxpayer's case.

  2. If a large number of correlative returns are involved or if the correlative taxpayers reside in other Posts of Duty (PODs) within the Area, PSP's assistance will be requested in ordering and controlling the related taxpayers.

  3. If the correlative taxpayer resides in another Area, both cases may be controlled by an examiner by requesting a CC ESTABD to obtain the return not on AIMS or through the transfer of the related return(s) if:

    1. the adjustment is of major importance

    2. it is for convenience of the government or

    3. it would promote the effective and efficient conduct of the examination

  4. If the above are not applicable, the procedures outlined in the subsection Related Taxpayers Controlled in More Than One Area below should be followed.

  5. If a return must be transferred from one Area to another, the provisions of the subsection Transfers of Returns Prior to the Initial Appointment in IRM 4.10.2.8.3 will be followed. If this is not possible, contact the Area PSP in which the correlative taxpayer is controlled.

  6. The correlative taxpayer(s) will be given notice of the examination (using the procedures outlined in IRM 4.10.2, Pre-Contact Responsibilities) as soon as it is known that adjustments proposed for the primary taxpayer will affect the tax liability of the correlative taxpayer.

  7. A protective claim, Form 1040X or Form 1120X, will be solicited from taxpayers with correlative Allocation(s) that reduces the tax liability and the period for filing a claim for refund when the statute expires in less than 180 days. This will hold the taxpayer's statute open to receive any refund or credit that is due up to the amount of the claim. Letter 897 will be sent to the taxpayer each year requiring protection. Once a protective claim is received, Form 895, Notice of Statute Expiration, will be attached and the statute will be updated according to IRM 25.6 , Statute of Limitations.

4.10.13.5.2.1  (03-16-2015)
Primary and Correlative U.S. Taxpayer's Reports

  1. Prepare the correlative taxpayer's report concurrently with the primary taxpayer's report. Solicit the agreement from the primary taxpayer, whose tax liability has been increased, prior to the agreement for the correlative taxpayer, whose tax liability has been reduced.

  2. The primary taxpayer's report will include a statement that "a separate examination report reflects correlative Allocations to the taxable income of the correlative taxpayer(s)."

    Caution:

    Rules regarding the disclosure of information apply to correlative Allocations, despite the relationship between primary and correlative taxpayers. The correlative report should not disclose tax return information of the primary taxpayer except to the extent explaining the correlative Allocation is necessary.

  3. If agreements are secured from the primary and correlative taxpayers, note Form 3198 so that overassessments resulting from the correlative Allocations are not refunded to the taxpayer prematurely.

4.10.13.5.2.2  (03-16-2015)
Reports Applying Overassessments Against Deficiencies Involving Correlative U.S. Taxpayer

  1. The correlative taxpayer(s) should be given the option of applying any overassessment against the deficiencies of the primary taxpayer as follows:

    1. If the correlative taxpayers are agreeable to the adjustments, the examiner will tell the primary and correlative taxpayers that their cases may be closed more expeditiously if the taxpayer's report reflecting an overassessment would agree to apply the overassessment and any interest to the deficiency of the taxpayer(s) reflecting deficiencies.

    2. The agreement form of the taxpayer having the overassessment will be modified to add a consent to apply the overpayment to the related deficiency. This will be accomplished by adding a paragraph, as follows, to the agreement form:

      "The undersigned taxpayer also consents and agrees to the application of the part of the overassessment that represents an overpayment, and interest allowable thereon, as a credit to the deficiency in tax, in the amount of $_________, and interest thereon, due from (related taxpayer) for the Year(s) ___________; provided the amount of any overpayment and interest allowable thereon that is in excess of the deficiency and interest, is otherwise credited or refunded in accordance with IRC 6402 of the Internal Revenue Code, or corresponding provisions of prior laws."

    3. If the taxpayer(s) agree to apply the overassessment to the deficiency, annotate Form 3198, Special Handling Notice, for the taxpayer(s) with the overassessment: "Apply the overassessment and any interest thereon to (name of taxpayer with deficiency, the taxpayer identification number (TIN), and tax period)." An appropriate notation will also be made in the workpapers.

4.10.13.5.2.3  (03-16-2015)
Protested Primary Adjustments Involving Only U.S. Taxpayers for Primary Adjustment and Correlative Allocation

  1. If the primary taxpayer whose report reflects a deficiency does not agree to the primary adjustment(s) and submits a protest to the 30-day letter, the correlative taxpayer(s) whose report(s) reflect an overassessment will remain associated.

  2. Correlative allocation(s) that reduce the correlative taxpayer's tax liability will be advised of the nature of the adjustment(s), the reason the overpayment cannot be refunded at this time and the possible need to protect the statute of limitations from expiring.

  3. Primary and correlative taxpayers will be forwarded together to Appeals for consideration.

  4. Prior to sending the protested case to Appeals the following action must be taken:

    1. If adjustments other than the correlative allocation(s) exist that result in a deficiency (instead of an overassessment), a partial agreement will be solicited for all non-correlative adjustment. A partially agreed report will be prepared using Form 870, Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment. It must specifically state that the correlative allocation is not reflected in the computation of the deficiency or overassessment. The case will be sent to Case Processing for a partial assessment if the deficiency is agreed. Form 3198 will be noted "Make partial assessment and return to (group) to be associated with related case(s)."

    2. The correlative taxpayer(s) will be invited to file a claim for refund (protective claim) if the period for filing a claim for refund expires in less than 180 days. Letter 897 (DO) will be sent to solicit a claim for each taxable year needing protection. Once a protective claim is received, Form 895, Notice of Statute Expiration, will be attached and the statute will be updated according to IRM 25.6.22, Statute of Limitations, Extension of Assessment Statute of Limitations by Consent.

    3. Form 3198 will be noted to ensure that overpayments resulting from the correlative allocation(s) are not refunded to the taxpayer prematurely.

    4. The statute of limitations will be protected by the office having custody of the case if a deficiency may result from a determination adverse to the Government in the related case.

4.10.13.5.2.4  (03-16-2015)
Statutory Notice of Deficiency Issued for Correlative Allocations Involving Only U.S. Taxpayers

  1. If a statutory notice of deficiency is issued to the taxpayer whose tax liability is increased, due to the primary adjustments, and a timely petition is filed with the Tax Court, the Area will transfer the correlative taxpayer(s) cases (whose tax liability has been reduced) to Appeals to be associated with the case in which the petition has been filed with the Tax Court, if the procedures in item (4) of subsection IRM 4.10.13.5.2, above, have been followed.

  2. If a statutory notice of deficiency is to be issued to the taxpayer(s) with correlative allocation(s) that reduce the tax liability for other adjustments, do not include the correlative allocations in deficiency computation. The statutory notice of deficiency must contain an explanation of the correlative allocations so the taxpayer clearly understands the nature of the correlative allocation(s). If the correlative allocations completely offset the tax liability, you cannot issue a statutory notice because you have no deficiency.

4.10.13.5.3  (03-16-2015)
Correlative U.S. Taxpayers Controlled in More than One Area

  1. If the examiner has not secured the correlative return in another Area according to the procedures described in IRM 4.10.13.5.2 above before the examination of the primary taxpayer has been concluded (agreed, protest received, or forwarded for statutory notice of deficiency) and the correlative allocation(s) affect the tax liability of a taxpayer in another Area (except cases arising from flow-through entity returns), the correlative taxpayer's Area must be notified of the correlative allocation(s) and the status of the primary taxpayer.

  2. The primary Area will secure the name, address, and TIN of the correlative taxpayer and notify the correlative Area by:

    1. Completing Form 5346, Examination Information Report;

    2. Attaching an INOLES transcript of the correlative taxpayer to Form 5346; and

    3. Attaching copies of the primary taxpayer's workpapers and to aid the correlative Area in proposing the correlative allocations.

  3. A copy of Form 5346 will remain in the primary taxpayer's case file. The original Form 5346 and attachments will be mailed to the correlative taxpayer's Area, addressed to the Area Director, Attention: Chief, PSP.

  4. Upon receipt of Form 5346 in the correlative taxpayer's Area, PSP will determine if the correlative taxpayer is currently under examination.

    1. If the correlative is not under examination, the return will be ordered, and assigned for examination of the correlative adjustments

    2. If the return is under examination, Form 5346 will be routed to the examiner conducting the examination for consideration and inclusion of the correlative adjustments with any other adjustments in the examination report

    3. If the return has been examined and closed, it will be ordered and reopened to make the correlative adjustment(s)

4.10.13.5.3.1  (03-16-2015)
Primary U.S. Taxpayer Must Close Before the Correlative U.S. Taxpayer

  1. The correlative allocation(s) that reduce the correlative taxpayer's tax liability will be held open until the additional tax for the primary taxpayer has been agreed.

  2. The case(s) of the correlative taxpayer(s) whose adjustment(s) reduce tax liability will be held and placed in IRC 1254 suspense until the examination of the primary taxpayer whose tax liability was increased has been conducted. It will be held in suspense pending notice from the primary taxpayer's Area that the primary taxpayer's examination, whose tax liability was increased, has been concluded.

4.10.13.5.3.2  (03-16-2015)
Suspense of the Correlative U.S. Taxpayer's Returns

  1. The following procedures must be completed before the correlative taxpayer's case can be placed in suspense, maintained and controlled in the Area Office:

    1. The correlative taxpayer will be invited to file a claim for refund (protective claim) if the period for filing a claim for refund expires in less than 180 days. Letter 897 (DO) will be sent to solicit a claim for each taxable year needing protection. Once a protective claim is received, Form 895, Notice of Statute Expiration, will be attached and the statute will be updated according to IRM 25.6.22, Statute of Limitations, Extension of Assessment Statute of Limitations by Consent.

    2. Form 3198 will be noted to ensure that overpayments resulting from the correlative allocation(s) are not refunded to the taxpayer prematurely.

    3. All issues except for the correlative adjustments will be completed prior to forwarding the case for suspense. If possible, partial agreements will be secured for all non-suspense issues using Form 870. It must specifically state that the correlative allocation is not reflected in the computation of the deficiency or overassessment. If a partial agreement was obtained, a partial assessment must be made by Case Processing prior to routing the case for suspense. The examiner will prepare an RAR (Form 4549-A , Form 4605-A, etc.) as far as the corrected taxable income line for any unagreed non-suspense issue, and Form 886, Explanation of Items, on all cases submitted for suspense. Form 3198, Special Handling Notice, will be noted "Partial Assessment - After partial assessment is made, forward to Technical Services for suspense."

    4. Inform the taxpayer that the case has been placed into a suspense status by sending Letter 1014, Letter to taxpayer Advising Him or Her of the Reasons for Suspended Action on his or her Tax Return Examination.

4.10.13.5.3.3  (03-16-2015)
Area Notification of U.S. Taxpayer Correlative Allocations That Affect Income Tax Liability

  1. After the correlative taxpayer's Area has received notice from the primary Area on Form 5436,Examination Information Report and has contacted the taxpayer concerning the correlative allocations which result in a deficiency (instead of an overassessment), the correlative Area will notify the primary Area by letter of the correlative taxpayer's:

    1. agreement;

    2. default after issuance of a statutory notice of deficiency; or

    3. filing of a petition with the Tax Court.

  2. If the correlative Area also has control of the return of another correlative taxpayer whose correlative allocations produce an overassessment, the case will be associated with the related case containing a deficiency and the procedures in item (4) of subsection IRM 4.10.13.5.2.3 above will be followed.

  3. When the primary Area receives notification that all correlative cases are agreed or have defaulted after issuance of the statutory notice of deficiency, then they will advise all correlative Areas to the process and close all related taxpayer cases consistent with the information that was previously sent to them.

  4. If the primary Area receives notification that a related taxpayer has filed a petition with the Tax Court, the primary Area will advise all related Areas and will themselves suspense all correlative cases pending the final outcome of the taxpayer that filed a petition with the Tax Court. The instructions in subsection IRM 4.10.13.5.2.3 above will be followed in placing the case into suspense.

  5. Once the case of the taxpayer that filed a petition with the Tax Court has been concluded, the Area will notify the primary Area of the resolution, which will in turn notify the correlative Areas.

  6. If the deficiency of the correlative taxpayer becomes an overassessment:

    1. the correlative Area will notify the primary Area if the correlative taxpayer agrees to the overassessment.

    2. if the agreement is not secured, the primary Area will be notified of the forwarding of the case for processing the overassessment and the basis for closing the case. When the primary Area receives notice, they will close the overassessment case.

    3. The primary Area will then notify all correlative Areas and similar action on overassessment cases will be taken.

4.10.13.6  (03-16-2015)
Activities Not Engaged in For Profit - Hobby Loss (IRC 183)

  1. IRC 183 (a) provides that no deductions shall be allowed in the case of an activity not engaged in for profit, other than those otherwise allowable under the Code, and supplies some criteria to be used in making the determination as to profit motive. Under IRC 183(d) gives the taxpayer a rebuttable presumption that an activity is a business and not a hobby, if profit results from the activity in three out of five (two out of seven in the case of horse racing, breeding or showing) consecutive years.

  2. Since a full presumption period is not available when the taxpayer first begins the activity , IRC 183(e) allows him to make an election which will defer the determination until he has had the opportunity to achieve the presumption during the initial years of the activity.

  3. Examiners should be aware that failure to make a profit does not in and of itself indicate a lack of a profit motive. This is true regardless of whether the taxpayer has made an election under IRC 183(e) or not. The question of profit motive is a factual one, and all facts must be considered in making any determination.

4.10.13.6.1  (03-16-2015)
Development of IRC 183(a) Issues

  1. In order for an amount to be deductible under I.R.C. 162, the taxpayer must be engaged in a trade or business activity for profit. In order for an amount to be deductible under I.R.C. 212, the taxpayer must be engaged in an activity for the production of income. Normally, business expenses must meet the requirements of either "carrying on a trade or business" (IRC 162) or "for the production of income" (IRC 212). the taxpayer fails to meet the requirements of section 162 and section 212,, the activity is then considered under IRC 183. In other words, examiner should first determine if the activity has a profit motive. The examination should not begin with consideration of IRC 183.

4.10.13.6.1.1  (03-16-2015)
Factual Development

  1. Examiners should determine whether or not the activity is engaged in for profit from all available facts and circumstances without regard to the presumption under IRC 183(d) or the possible election under IRC 183(e). This determination should take into consideration the "relevant factors" listed in Treas. Reg. 1.183-2(b) as well as all other pertinent facts. Exhibit 4.10.13-4. and IRC 183 Activity Not Engaged in for Profit Audit Technique Guide for more guidance.

  2. The IRC 162 position (i.e., substantiation, personal use, etc.) must be developed before the case can be forwarded to Appeals or placed in suspense. Appeals has indicated concern about cases coming in with inadequate factual development of the issue. Discussion of IRC 183(d) and IRC 183(e) with the taxpayer should be postponed until, and if, the activity has been determined to be an activity not engaged in for profit.

4.10.13.6.1.2  (03-16-2015)
Passive Activity Loss Rules

  1. The passive activity loss rules of IRC 469 should be also be considered. Since IRC 469 adjustments are timing adjustments while IRC 183 adjustments are permanent adjustments, the IRC 183 issue should generally be treated as the primary position and the IRC 469 issue should be treated as an alternative position when both issues are present.

4.10.13.6.1.3  (03-16-2015)
Determine If Prior Years Are Being Held In Suspense

  1. If a potential IRC 183(a) issue exists, check with the Technical Services IRC 183 suspense coordinator. If the earlier years are not in suspense, and the activity is determined to be engaged in for profit, allow the deductions to the extent they are otherwise allowable by the Code (i.e., IRC 162). If the activity is not engaged in for profit and IRC 183 (e) is elected, the case must be placed in suspense.

4.10.13.6.1.4  (03-16-2015)
Deductions Under IRC Section 183 Which the Taxpayer May Claim

  1. IRC 183(b) provides for two types of deductions allowed with regard to activities not engaged in for profit. They are the IRC 183 (b)(1) and IRC 183 (b) (2) deductions.

  2. Deductions under IRC 183 are allowable only on Schedule A as itemized deductions. Deductions under section IRC 183 (b) (1) would appear in the proper places on Schedule A (e.g., as mortgage interest or taxes) and any deduction under IRC 183 (b) (2) would be a miscellaneous Itemized Deduction subject to the 2% floor or limited to 2% of adjusted gross income (AGI). The hobby income limitation is applied before the 2% rule.

4.10.13.6.2  (03-16-2015)
Placing Cases in Suspense

  1. Check with the taxpayer and/or the IRC 183 Suspense Coordinator in Examination Technical Services to determine if there is a prior election on file. See IRM 4.8.2., IRC 183 (e) Hobby Loss Suspense.

4.10.13.6.2.1  (03-16-2015)
Election on File

  1. Requisition the returns for all open years not in the suspense file. Examine each of the years that have significant audit potential. If the returns for any years subsequent to the year of the initial IRC 183(a) election do not show significant audit potential, they may be forwarded, unaudited, to suspense along with the year(s) of the initial IRC 183 (a) election.

  2. Secure Audit Information Management System (AMDISA), IMFOLT/R on all open years.

  3. Prepare a report showing the audit results including the IRC 183 (a) issue. The cases examined must be completely worked prior to going into suspense.

  4. Form 3198 should indicate that the case is an IRC 183 (a) case and is related to a previously suspended case and should be routed directly to suspense.

  5. Process the case in the normal manner.

  6. All non-hobby loss issues must be resolved prior to putting the case in suspense. If that issue is unagreed refer to IRM 4.10.13.6.3(2). If needed, secure a statute extension for any non-hobby loss issue(s)..

4.10.13.6.2.2  (03-16-2015)
Election Not on File

  1. Determine if the taxpayer wants, and is eligible, to elect IRC 183(e). The election must be made before the statute of limitations of the return reporting the first year of the activity expires. If an election has not been made prior to the expiration of the statute on the initial year, an election cannot be accepted.

  2. Inform the taxpayer of all the legal and procedural implications of the IRC183(e) election. If the taxpayer does not wish to make the election, the case and the issue should be processed based on the merits that have already been determined. When possible, a written statement should be obtained from the taxpayer or his representative stating that he does not elect the provisions of IRC 183 with respect to the tax year(s) containing the IRC 183 (a) issue. (If the taxpayer declines to provide such a statement, the examiner should make appropriate comments in the workpapers.) Attach the statement to the return(s).

  3. If the taxpayer wishes to make an IRC 183 (e) election:

    1. Secure fully completed and properly signed Form 5213, Election To Postpone Determination as To Whether the Presumption Applies That an Activity Is Engaged in for Profit.

    2. Requisition all returns beginning with the initial year.

    3. Obtain AMDISA, IMFOLT/R for all tax returns.

    4. Perform audit functions as warranted, paying particular attention to the full development of the IRC 183 issue.

    5. The open years that are examined must be completed prior to going into suspense.

    6. Prepare a report on each of the open years disallowing the IRC 183 loss to the extent required by Treas. Reg. 1.183-1(b).

    7. Attach Form 3198 , Special Handling Notice for Examination Case Processing, to the outside of the case file and indicate "Suspense Case IRC 183(e) - Forward to Technical Services" . The group should forward the case direct to Technical Services with Form 3210Document Transmittal.

    8. Make appropriate comments in the workpapers to document the election and advise the taxpayer to retain all pertinent books and records for each of the presumptive period years.

    9. Attach the election to the back of the first year's return with the form number showing above the tax return.

    10. All partial assessments or unagreed issues should be resolved prior to suspending.

4.10.13.6.3  (03-16-2015)
Reports

  1. If there are other issues which are agreed and generate a deficiency, two reports will be required. One report will contain the agreed issues and the other report only the IRC 183 (a) issues as unagreed. Include in the agreed report a statement regarding the IRC 183 (a) suspense issue as unagreed. On the unagreed report, the IRC 183 (a) issues should be written up as if the case will go directly to Appeals. Form 3198 Special Handling Notice for Examination Case Processing, should indicate "Partial Agreement - after assessment forward to Technical Services for IRC 183 (e) suspense."

  2. If there are other unagreed issues besides the IRC 183 (a) issue, the unagreed report will contain both the unagreed issue(s) and the "IRC 183 (a) issue(s)" before the case is forwarded to Appeals. Note the Form 3198 , Special Handling Notice for Examination Case Processing, for the case to be forwarded to Technical Services for suspense after resolution of unrelated issues.

4.10.13.6.4  (03-16-2015)
Election to Postpone Determination

  1. Form 5213,Election To Postpone Determination as To Whether the Presumption Applies That an Activity Is Engaged in for Profit, extends the statute of limitations for assessment of tax for all years in the presumption period until two years after the due date (determined without regard to extensions) for filing the return for the last year in the presumptive period.

  2. The IRC 183(e) election extends the period for assessment of the additional tax attributable to the IRC 183 activity and automatic adjustments resulting from the change in adjusted gross income. Therefore, it is necessary that a separate Form 5213 be obtained for each separate activity which is in question. Unrelated IRC 183 issues should be resolved before placing the case in suspense.

  3. Changes in filing status should be considered. When individuals marry, remarry, or divorce in any of the years, a separate statute extension should be secured for that year.

  4. All non hobby loss issues must be resolved prior to suspension of the hobby loss issue. If the non hobby loss issue is unagreed see IRM 4.10.13.6.3(2) If needed a statute extension must be obtained for that unagreed issue.

  5. Upon the filing of all or a sufficient number of returns of the presumptive period, the cases will be returned to the examiner for a determination. The examiner should make sure that any profits have not been a result of income manipulation.

4.10.13.7  (03-16-2015)
Change in Accounting Method

  1. An accounting method is used to determine when and how a taxpayer reports income and expenses.

  2. During an examination, it may become necessary to determine whether a taxpayer is using a correct method of accounting and to propose changes to improper or incorrect methods.

  3. A change in 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. This subsection covers the following basic rules:

    1. For identifying if such a change is required, and

    2. For calculating the required audit adjustments

  4. Due to the rapidly changing rules for changes in accounting methods, examiners should also consult the Technical Advisor Methods of Accounting & Timing Issue Practice Group

4.10.13.7.1  (03-16-2015)
General Rule of Methods of Accounting

  1. IRC 446 (a) requires taxable income to be computed under the method of accounting that the taxpayer uses to compute book income. A taxpayer may be allowed to maintain books under one method and use a different method to report taxable income as long as the taxpayer clearly reflect income and maintains worksheets to ensure that all book to tax entries have been made. However, if no method of accounting is used regularly or if the method does not clearly reflect income, then the computation of taxable income may be changed to a method that most clearly reflects income. IRC 446 (b).

4.10.13.7.2  (03-16-2015)
Cash Method of Accounting

  1. The cash method of accounting is the most common method used by small businesses. The IRS has issued guidance to provide small business taxpayers with exemptions that allow these taxpayers to use the cash method and to eliminate the need for the taxpayers to account for inventories under an accrual method. Through the years, the guidance and exemptions has evolved. . Rev. Proc. 2000-22 IRB 1008 exempts taxpayers with average gross receipts of $1 million or less from accrual method/requirement to account for inventories, as long as the taxpayer met the “conformity requirement.”

  2. IRC 446(c)(1) specifically identifies the cash method as a permissible method of accounting. The cash method generally requires an item to be included in income when actually or constructively received and permits a deduction for an expense when paid (Treas. Reg. 1.446-1(c)(1)(i)). The cash method will generally be allowed unless there is a specific provision of the Code or Treasury Regulations that requires the use of a different method.

  3. There are special rules under Treas. Reg. 1.446 and Treas. Reg. 1.471 in cases in which it is necessary to use an inventory. Treas. Reg. 1.446-1(c)(2)(i) generally requires taxpayers who maintain inventories to use the accrual method of accounting for purchases and sale of merchandise. Therefore, as a general rule, taxpayers who maintain inventories are not allowed to use the cash method of accounting. See IRM 4.10.13.7.4.

  4. Requirements:

    1. taxpayers must not regularly use accrual method for books, records, reports and financial statements.

    2. Qualifying taxpayers must change from inventory method to treat merchandise inventory in the same manner as a material and supply that is not incidental under Treas. Reg. Section 1.162-3. Thus, merchandise inventory is deductible when consumed and used in the year the taxpayer sells the merchandise or finished goods.

    Service will not challenge taxpayer’s use of cash method (and taxpayer’s failure to account for inventories under IRC 471) in earlier year if consistently used cash method, satisfies gross receipts test and meets the conformity requirement.

  5. Rev. Proc. 2001-10, 2001-2 IRB 272 (Dec. 2000) affirmed and expanded exemption provided to small taxpayers. It superseded Rev. Proc. 2000-22 (above).

    1. Continues exemption for taxpayers with average gross receipts of $1 million or less from accrual method/requirement to account for inventories (effective for years on or after December 17, 1999).

    2. Conformity requirement removed. Thus, qualifying taxpayers can keep books and financial statements on accrual method and use cash method for tax purposes.

    3. Clarifies proper time to deduct inventory treated as not incidental material and supplies under Treas. Reg. 1.162-3: deductible later of when (1) sells merchandise or finished goods or (2) year paid.

    4. Clarifies that exemption does not apply to tax shelters [IRC 448 (a)(3)]

    5. Service will not challenge taxpayer’s use of cash method (and taxpayer’s failure to account for inventories under IRC 471) in earlier years if gross receipts test met.

  6. Notice 2001-76, 2001-52 IRB 613 (Dec., 2001) Expanded exemption for small taxpayer using the cash method to $10 million or less average gross receipts and business meets any one of following four safe harbors:

    1. Principal business activity is not retailing, farming, wholesaling, manufacturing, mining, publishing or sound recording.

    2. Principal business is provision of services even if taxpayer is providing property incident to those services.

    3. Principal business activity is custom manufacturing.

    4. Regardless of taxpayer’s primary business activity, taxpayer may use cash method for any separate trade or business that satisfies a-c above.

    5. inventoriable items may be treated as not incidental material and supplies under Treas Reg 1.162-3: deductible later of when (1) merchandise or finished goods used or consumed or (2) year paid.

    Exemption does not apply to entities covered by IRC 448 or IRC 447 (corporations engaged in farming). The Service will not challenge the use of the cash method for earlier years if revenue procedure applies. Notice effective immediately – Clarified by Notice 2002-14 , 2002-8 IRB 1.

  7. Rev. Proc. 2002-28, 2002-18 IRB 1 finalized Notice 2001-76. It adopts a new two-prong principal business test -a taxpayer may determine its principal business activity using either:

    1. The gross receipts for its prior year OR

    2. The average annual gross receipts for its three most recent years

  8. Rev. Proc. 2002-28 provides 26 examples and a flow chart which clarify rules such as the following:

    1. Rev. Proc. 2002-28 effective date: Taxable years ending on or after December 31, 2001

    2. Service will not challenge earlier years use of the cash method if taxpayer meets requirements of Rev. Proc. 2002-28.

    3. Specific taxpayers will be exempt for cash method if average gross receipts $10 million or less and the taxpayer is not prohibited from using the cash method by IRC 448 or required to use the accrual method by IRC 447.

    4. The specific taxpayer should be one of the following 3 categories: (1) Have a good NAICS Code, or even if the code is bad, be either a (2) Service provider or (3) Custom manufacturer (There is also a separate trade/business category).

  9. Under IRC 448(a), the following entities are generally prohibited from using the cash receipts and disbursements method of accounting::

    1. All Tax Shelters defined in IRC 448.b)

    2. C-Corporations with gross receipts over $5 million IRC 448

    3. an 1120-S Corporation can go up to $10 million

    4. Be a corporation engaged in farming [IRC 447 447].

    5. Partnerships with corporation partners and gross receipts over $5 million

  10. No conformity requirement: The taxpayer has 4 options:

    1. Cash with Treas. Reg. 1.162-3 (requirement to treat all inventoriable items as not incidental materials and supplies under Treas. Reg. 1.162-3)

    2. Cash with inventory.

    3. Cash with inventory - Accrual with Treas. Reg. 1.162-3

    4. Accrual with inventory.

    .

  11. Additional rules:

    1. If the entity was not in existence for the entire three-year period, the average receipts rule will be calculated based on the period for which the company was in existence

    2. All taxpayers treated as a single employer under IRC 52 or IRC 414are treated as a single taxpayer to apply the gross receipts test

    3. Short years should be annualized

    4. Gross receipts should be reduced by returns and allowances

    5. A S Corporation may use the cash method of accounting unless the entity is a tax shelter, within the meaning of IRC 461(c)(3), or is otherwise required to use an accrual method (e.g., taxpayer maintains an inventory)

4.10.13.7.2.1  (03-16-2015)
Exceptions That May Allow the Use of the Cash Method

  1. If the taxpayer has gross receipts less than $1 million, the exceptions from mandatory use of the accrual method under Rev. Proc. 2001-10 2001-10 (modified by Rev. Proc. 2011-14 and successor) may be applicable. Under this revenue procedure, taxpayers with average annual gross receipts of $1 million or less are not required to use the accrual method of accounting under IRC 446 and to account for inventories under IRC 471. A taxpayer has average annual gross receipts of $1 million or less if, for each prior tax year ending on or after December 17, 1998 the taxpayer's average annual gross receipts for the 3 tax years ending with the applicable prior tax year does not exceed $1 million. Aggregation rules for gross receipts may apply. See Treas. Reg. 1.448-1(f)(2) However, this exception is not available for tax shelters.

  2. Procedures are provided whereby the taxpayer may obtain automatic consent to change to the cash method of accounting and account for inventoriable items under Treas. Reg. 1.162-3. This regulation requires taxpayers with materials and supplies (other than incidental materials and supplies) to deduct the cost of these items in the year that they are actually consumed or used in operations.

  3. The Service has also issued Rev. Proc. 2002-28 (modified by Rev. Proc. 2011-14 and successor) that allows eligible small businesses with average annual gross receipts of $10 million or less to use the cash receipts and disbursements method of accounting. A taxpayer that satisfies the gross receipts criteria must determine whether its principal business activity code is an eligible code under the North American Industry Classification System (NAICS) at www.census.gov. The following NAICS codes are ineligible for the Qualifying Small Business Exception:

    1. mining activities within the meaning of NAICS codes 211 and 212;

    2. manufacturing within the meaning of NAICS codes 31–33;

    3. wholesale trade within the meaning of NAICS code 42;

    4. retail trade within the meaning of NAICS codes 44 and 45; and,

    5. information industries within the meaning of NAICS codes 5111 and 5122.

  4. This revenue procedure describes how qualifying small businesses may obtain automatic consent to change to the cash method of accounting, if they are not prohibited from doing so under other provisions, such as IRC 448 or IRC 460.

4.10.13.7.3  (03-16-2015)
Accounting for Long Term Manufacturing Contracts

  1. IRC 460 defines a long-term contract as any contract for the manufacture, building, installation or construction of property if such contract is not completed within the taxable year it was entered into. Treas. Reg. 1.460-1(b) defines a contract for the manufacture of personal property as a manufacturing contract. In contrast, a contract for the building, installation, or construction of real property is a construction contract.

  2. The rules for manufacturing contracts are described in Treas. Reg. 1.460-2. Specifically, a contract for the manufacture of property shall not be treated as a long-term contract unless the contract involves the manufacture of:

    1. Any unique item of a type which is not normally included in the finished goods inventory of the taxpayer (IRC 460 (f)(2)(A)), or

    2. Any item which normally requires more than 12 calendar months to complete (without regard to the period of the contract) (IRC 460 (f)(2)(B))

  3. Per Treas. Reg. 1.460-2(b), an item is not considered unique if it meets one or more of the following safe harbors:

    1. The item has a short production period. An item is not unique if it normally requires 90 days or less to complete.

    2. An item is not unique if the total allocable contract costs attributable to customizing activities (that are incident to or necessary for the manufacture of the item) do not exceed 10 percent (10%) of the estimated total allocable contract costs allocable to the item.

    3. A unique item ceases to be unique when the taxpayer includes similar items in the finished goods inventory.

  4. In determining if the time to manufacture the item exceeds 12 months in general, all activities of the manufacturer and the related parties must be taken into account. This would generally include the time to produce components and other assemblies by the manufacturer and any related party, which could be an entity with more than 50% ownership (80% for a C corporation).

  5. The production period for an item begins in general when the manufacturer incurs at least 5% of the total estimated costs, including the planning and design stages, and ends when the item is ready to be held for sale and all reasonably expected production activities are complete (Treas. Reg. 1.460-2(c)). Reference the final regulations for manufacturers with long-term contracts.

4.10.13.7.3.1  (03-16-2015)
Audit Techniques

  1. To identify a long term contract issue:

    1. Ask the taxpayer for a list of all contracts open at year-end

    2. Select contracts to review

  2. To determine if the taxpayer is a service provider or a manufacturer:

    1. Review the bid file and statement of work

    2. Request contract files to identify the effective date, contract price, type of contract (fixed price, cost plus, cost share, time and material)

  3. To determine if the length of the contract exceeds 12 months:

    1. Identify the delivery schedule for the items produced under the contract

    2. Request a list of subcontractors because this may add to the total length of the contract

  4. To determine if the item is unique:

    1. Request a copy of the proposal

    2. Review the proposal for customizing costs

4.10.13.7.4  (03-16-2015)
General Rules for Inventories

  1. Under Treas. Reg. 1.471-1, a taxpayer must account for inventories if the production, purchase, or sale of merchandise is an income-producing factor in the taxpayer's business. A taxpayer that is required to maintain inventories must use the accrual method of accounting with regard to purchases and sales. Inventory includes all raw materials and supplies that have been acquired for sale, or that will be physically incorporated into the merchandise intended for sale, plus work in process, and finished goods even though it may use the cash method for all other items of income and expense Accounting for inventories may be required even if the inventory balance is zero at the end of the taxable year. J. P. Sheahan Associates, Inc. v. Commissioner, T.C. Memo 1992-239.

  2. Since the sale of merchandise is an income-producing factor for manufacturers, they must use the accrual method to account for sales and purchases. Determining whether merchandise is an income-producing factor requires computing a ratio of the total annual merchandise cost to gross receipts. If the percentage is less than 15, the Service tends not to litigate the inventory issue as it views the merchandise as not income producing. See for example Wilkinson-Beane, Inc. v. Commissioner, T.C. Memo 1969-79 for a discussion of merchandise being income producing in a service business context.

4.10.13.7.5  (03-16-2015)
Accrual Method Timing Issues

  1. The underlying principle of accrual method accounting is the matching of income and expenses in the proper year. If a taxpayer with inventory were to use the cash method of accounting, then purchases could possibly be deducted in a different period from the recognition of income from the sale of those items. Under the accrual method, items are included in income when the following tests are met:

    1. All the events fixing the taxpayer's right to receive the income have occurred (Treas. Reg. 1.451-1(a)). This right could be fixed when the goods are shipped, delivered, accepted, or when title passes to the purchaser. (Treas. Reg. 1.446-1(c)(1)(ii)(C))

    2. The amount of income can be determined with reasonable accuracy. Treas. Reg. 1.451-1(a) and Treas. Reg. 1.446-1(c)(1)(ii)(A)

  2. For expenses, Treas. Reg. 1.461-1(a)(2)(i) provides, under an accrual method of accounting, a liability is incurred and generally taken into account for federal income tax purposes, in the taxable year in which::

    1. All events necessary to establish the fact of liability or deduction have occurred

    2. The amount of the liability can be determined with reasonable accuracy, and

    3. Economic performance has occurred

      The first two requirements, above, are commonly referred to as “the all events test.” The application of the economic performance rule depends on the nature of the costs. If costs arise out of the provision of services or property, or the use of property, economic performance generally occurs when the property or services are provided, or the property is used. Specific costs, identified in the regulations as payment liabilities, are taken into account when paid. Note that there are other timing rules (e.g., the 3 1/2 month rule for prepaid services or the recurring item exception) in the Code that may take precedence over these generalized economic performance rules.

  3. If the liability has met the all-events test under IRC 461 as of year-end, a deduction for accrued vacation pay and bonuses to unrelated taxpayers is allowed only if paid within 2 1/2 months of year-end (Temp. Reg. 1.404(b)-1T, Method or arrangement of contributions, etc., deferring the receipt of compensation or providing for deferred benefits..

    1. An employee must actually receive payment in cash for the taxpayer to get the deduction for the prior year (IRC 404(a)(11).

    2. A corporation using the accrual method is allowed to deduct accrued compensation (including vacation pay and bonuses) payable to cash-basis controlling shareholders as of the day such compensation is received (actually or constructively) by the shareholder IRC 267(a)(2).

  4. Losses on sales or exchanges between related parties are disallowed IRC 267(a)(1).

4.10.13.7.6  (03-16-2015)
Changing Accounting Methods

  1. Once a method of accounting is adopted, the taxpayer must request permission to change methods. If the taxpayer files two consecutive tax returns using an impermissible method, the taxpayer must then request permission to change to a permissible (i.e., correct) method. A permissible method is considered adopted after one return is filed.

  2. A change in method of accounting is a change in:

    1. The overall method of accounting, such as cash to accrual, or

    2. The treatment of any material item. A material item is any item that involves the proper time for the inclusion in income or the taking of an item as a deduction in any given period

  3. Some of the more common accounting method changes for taxpayers include changes in inventory valuations, depreciation methods, and recording income from long-term contracts. A change in accounting method is handled differently from the correction of an error, which is remedied by filing an amended income tax return. Examples of errors include:

    1. Posting errors

    2. Misclassification of items where such misclassification does not affect the timing of income or expense

    3. Errors in the computation of Foreign Tax Credit

4.10.13.7.7  (03-16-2015)
Voluntary Changes in Accounting Method

  1. Voluntary changes are initiated by the taxpayer by filing a Form 3115, Application for Accounting Method Change, using one of two Revenue Procedures:

    1. Automatic: Rev. Proc. 2011-14 and successors. Form 3115 must be attached to the taxpayer's timely filed, with extensions, tax return for the year of change, or

    2. Approval Required: Rev. Proc. 97-27 and successors for all other changes. Form 3115 must be filed during the year of change

  2. User fees are generally not required when applying for one of the automatic changes in accounting methods. There is no acknowledgment under the automatic change procedures of Rev. Proc. 2011-14 and successors.

  3. Form 3115, Application for Accounting Method Change, filed under Rev. Proc. 97-27 and successors should be filed as early as possible to allow for processing time prior to the due date of the return for the year of change. Normally, an acknowledgment will be mailed within 30 days of the filing date for Rev. Proc. 97-27 and successor requests.

  4. Advantages for making a voluntary change include a four-year spread of a taxpayer unfavorable (positive) adjustment under IRC 481(a), possible audit protection for prior years, and no assessment of penalties and interest.

  5. Taxpayers under examination – The general rule (scope limitation) is that a taxpayer may not request a voluntary method change while under examination for any year. However, the following exceptions may apply:

    1. 90-day Window: The 90-day window is available during the first 90 days of a taxable year if
      (1) the taxpayer has been under examination generally for at least 12 months as of the first day of the taxable year, and
      (2) the method which the taxpayer seeks to change is not an issue under consideration or an issue that has been placed in suspense

    2. 120-day Window: The taxpayer may file a Form 3115 within the 120-day period following the date an examination ends generally, provided that the change requested is not an issue under consideration or an issue that has been placed in suspense at the time the form is filed.

    3. Consent of Director: If the taxpayer is under examination and not in one of the two windows described above, it may request the examiner's permission to submit a Form 3115. The team/group manager, as delegated by the Area Director/Director of Field Operations, will normally consent to the filing of the application unless the method of accounting to be changed would ordinarily be included as an item of adjustment in the year(s) for which the taxpayer is under examination.

  6. In additional to these circumstances, a taxpayer under examination may file a Form 3115without the benefit of audit protection for prior years (including the years under examination) if the method of accounting to be changed is:

    1. Described in the appendix to Rev. Proc. 2011-14 and successors, and that description provides that the change is not subject to the audit protection provisions of section 7 of that procedures, or

    2. Is an "issue pending" for any taxable year under examination. For this purpose, an issue is pending for any taxable year under examination if the Service has given the taxpayer written notification indicating an adjustment is being made or will be proposed with respect to the taxpayer's method of accounting.

    Note:

    For years ending on or after December 31, 2001, the IRC 481(a) adjustment period is four taxable years for a net positive adjustment for an accounting method change, and one taxable year for a net negative adjustment for an accounting method change. See Rev. Proc. 2002-19. Rev. Proc. 97-27, modified by Rev. Proc. 2002-19, and Rev. Proc. 2011-14 both provide a one-year adjustment period for a negative adjustment under IRC 481.

4.10.13.7.8  (03-16-2015)
Involuntary Changes in Accounting Method

  1. Involuntary changes are covered by Rev. Proc. 2002-18, which provides guidance to examiners initiating accounting method changes. Section 2.03 of the procedure states that the "taxpayer does not have a right to a retroactive change, regardless of whether the change is from a permissible or impermissible method." Accordingly, the examiner is not obligated to consent to a retroactive change in accounting method requested by the taxpayer either by a formal or informal claim. However, if the examiner initiates a change in accounting method issue that, upon development, results in a taxpayer favorable result, the examiner should follow through using the Service initiated change procedures.

  2. The examiner has the authority to change a taxpayer's method of accounting when no method has been used regularly, or the method used does not clearly reflect income. The examiner also has the authority to select a proper method, and the selection may only be challenged by showing there was an abuse of discretion. Wilkinson-Beane, Inc. v. Commissioner, T.C. Memo 1969-79. Examiners will be faced with potential accounting method change issues in three situations:

    1. The examiner determines that the accounting method used by the taxpayer is impermissible and does not clearly reflect income - IRC 446(b) issue.

    2. The taxpayer changed its method of accounting without obtaining the consent of the Commissioner - IRC 446(e) issue.

    3. The taxpayer filed an amended return or claim (formal or informal) which constitutes a "retroactive" change in accounting method. -IRC 446(e) issue. See Rev. Rul. 90-38.

  3. Examples of method change issues that may be raised during an examination include:

    1. Changing from cash to accrual method as required by IRC 448

    2. Change from improper depreciation methods under IRC 167 and IRC 168

    3. Expensing items required to be capitalized under IRC 263 or IRC 263A

    4. Changing the timing of accrual under IRC 451 or IRC 461

  4. When the examiner initiates an accounting method changes:

    1. The entire IRC 481(a) adjustment ordinarily is taken into account in the earliest year of examination

    2. There is no four-year spread

    3. Interest and penalties may be assessed

4.10.13.7.9  (03-16-2015)
IRC 481(a) Adjustment

  1. IRC 481(a) adjustment prevents the duplication or omission of income and expenses. It is computed as of the beginning of the year of change (the earliest year under examination). Simply stated the adjustment represents the cumulative difference (without regard to the statute of limitations) between the taxpayer’s present and proposed methods.

4.10.13.7.9.1  (03-16-2015)
IRC 481(b) Tax Limitation

  1. IRC 481(b)(1) provides a limitation on the tax for the taxable year of change that is attributable to the adjustments required under IRC 481(a) if the entire amount of the IRC 481(a) adjustment is taken into account in the year of change. If such adjustment increases the taxpayer's taxable income for the year of the change by more than $3,000, then the tax for such year this is attributable to the adjustment shall not exceed the lesser of:

    • The tax attributable to taking such adjustment into account in computing taxable income for the taxable year of the change under IRC 481(a) and Treas. Reg. 1.481-1, or

    • The aggregate of the hypothetical increases in tax that would result if the adjustment was included ratably in the taxable year of the change and the two preceding taxable years.

      Note:

      While IRC 481(b) may limit the tax, it does not change the year in which the tax is due. This computation is mandatory.

  2. IRC 481(b)(2) provides a second alternative limitation on the tax for the taxable year of change. If the taxpayer establishes from its books and records what its taxable income would have been under the new method of accounting for one or more consecutive taxable years immediately preceding the taxable year of the change, then the tax attributable to the IRC 481(a) adjustment will not exceed the smallest of the following amounts:

    • The tax attributable to taking the adjustments into account in computing taxable income for the taxable year of the change under IRC 481(a) and Treas. Reg. 1.481-1;

    • The tax attributable to such adjustments computed under the 3-year allocation provided in IRC481(b)(1) , if applicable, or

    • The net increase in the taxes that would result from allocating that portion of the adjustments to the one or more consecutive preceding taxable years under the new method of accounting and from allocating the balance thereof to the taxable year of the change.

  3. The taxpayer has incorrectly used the cash method and the examiner is changing the method to an accrual method. Steps for computing the tax limitation under IRC481(b):

    1. Compute the increase in tax for the year of the change that is attributable to the adjustments required under IRC 481(a). Calculate this increase by taking the difference in tax that would be due in the year of change with the IRC 481 (a) adjustment and the tax computed for such without the IRC 481(a) adjustment.

    2. Compute the tax attributable to the IRC 481 (a) adjustments for the taxable year of the change and the two preceding taxable years as if an amount equal to one-third of the net amount of such adjustment had been received or accrued in each of such taxable years. Calculate this increase by taking the excess of the tax for such year computed with the allocation of one-third of the net adjustment to such taxable year over the tax computed without the allocation of any part of the adjustment to such year.

    3. If the taxpayer satisfies the conditions set forth in IRC 481(b)(2) , compute the tax attributable to the IRC 481 (a) adjustment for the taxable year of change and the consecutive taxable year or years immediately preceding the taxable year of the change for which the taxpayer can establish his taxable income under the new method of accounting. Calculate this increase by taking the excess of the tax for such year computed with the allocation of the net adjustment to such taxable year over the tax computed without the allocation of any part of the adjustment to such year.

  4. For the purpose of computing the increase in taxes, net operating loss under IRC 172 or capital loss carryback or carryover under IRC 1212 should be considered. This would include the net increase or decrease in tax attributable to any taxable year preceding the year of change to which no adjustment is allocated under IRC 481(b)(1) or (2), but which is affected by a net operating loss or by a capital loss carryback or carryover determined with reference to taxable years to which the adjustments under IRC 481(b)(1) or (2) are allocated.

  5. For additional guidance, refer to the MAP IPG website

4.10.13.7.9.2  (03-16-2015)
Partnerships and S Corporations

  1. In the case of a change in method of accounting by a partnership/S Corporation, the adjustments required by IRC 481(a) shall be made on the partnership/S Corporation's return. However, the limitations on tax under IRC 481(b) apply to the individual partners/shareholders. IRC 481(b) applies to a partners/shareholder whose taxable income is increased by more than $3,000 as a result of such adjustments to the flow-through entity's ordinary income. See IRM 4.10.8.3. and Exhibit 4.10.8 for report writing procedures.

4.10.13.7.9.3  (03-16-2015)
Example Of The Required Calculation Under IRC 481(a)

  1. The following illustrates a change in accounting method from the overall cash method to the overall accrual method. Assume that 2010 is the earliest year under exam. This would be the year of change.

    Account 1/1/2010 12/31/2010
         
    Account Receivable $200,000 $250,000
    Raw Materials 25,000 20,000
    Work in Process 10,000 15,000
    Finished Goods 15,000 10,000
    Account Payable (50,000) (45,000)
    Total $200,000 $250,000
  2. The IRC 481(a) adjustment is $200,000. This represents the net difference in the increase in income from the cash to accrual method. The current year adjustment is $50,000. This is the net difference between the balances at the beginning and the end of the year. It reflects an increase in income that would be reported under the accrual method of accounting.

4.10.13.7.9.4  (03-16-2015)
Example Of The Required Calculation Under IRC 481(b)

  1. In the preceding example, the IRC 481 (b) tax limitation is applicable because the IRC 481 (a) adjustment is over $3,000. For the IRC 481(b)(1) computation, the adjustment should be spread evenly between the current year (2010) and the two prior tax years (2009 and 2008).

    Note:

    If the taxable income of two prior years is in the same tax bracket as the year of adjustment, including the total of all adjustment, there would be no benefit from applying the IRC 481(b) limitation. Likewise, benefits could be limited if the taxpayer has a NOL carryback. The two prior year returns are only used for computation purposes. No tax is assessed on these tax years. Any difference in tax from completing this calculation will be shown as a credit in the tax due on the current year's examination.

  2. IRC 481 (b) Computation: The IRC 481(a) adjustment is $200,000 and the current year adjustment is $50,000. The first computation is to calculate the tax for 2010:

        IRC 481(b) computation:
             
        2008 2009 2010
    IRC 481(a) $200,000 $66,667 $66,667 $66,667
    Add'l Tax $78,000 $16,667 $22,667 $22,667
             
    IRC 481(b) Credit ($15,999)      
    Tax Due $62,001   $62,001  
  3. The total tax per IRC 481(b) is $62,001, which is considerable less than the tax calculated on the entire IRC 481(a) adjustment in 2010, the year of change ($78,000). The taxpayer will be allowed a credit of $15,999 against the IRC 481(a) adjustment in 2010.

    Note:

    The taxpayer will still owe tax on the current year adjustment of $50,000. The current year adjustment is not considered in the IRC 481(b) computations. Also, self-employment (SE) tax is not considered in the IRC 481(b) computation.

4.10.13.7.10  (03-16-2015)
Summary

  1. Remember the taxpayer's method of accounting must clearly reflect income. The cash method generally will be allowed unless there is a specific provision of the Code or Treasury Regulations that requires the use of a different method such as IRC 448 or IRC 471. There are special rules under Treas. Reg. 1.446 and Treas. Reg. 1.471 requiring the use of the accrual method by a taxpayer required to have inventories.

  2. For taxpayers who are required to maintain inventories, there are two safe harbor exceptions to the general rule: (1) the Small Taxpayer Exception (Rev. Proc. 2001-10) and (2) the Qualifying Small Business Exception (Rev. Proc. 2002-28).

    1. For all taxpayers with gross receipts of less than $1 million, the exceptions from mandatory use of the accrual method under Rev. Proc. 2001-10 may be applicable.

    2. For eligible taxpayers, Rev. Proc. 2002-28 allows small businesses with average annual gross receipts of $10 million or less to use the cash receipts and disbursements method of accounting

  3. Qualifying small business taxpayers that are permitted to use the cash method for an eligible trade or business and that do not want to account for inventories under IRC 471 must treat all inventoriable items in such trade or business in the same manner as materials and supplies that are not incidental under Treas. Reg. 1.162-3. An inventoriable item is any item either purchased for resale to customers or used as a raw material in producing finished goods.

  4. Voluntary changes are initiated by the taxpayer by filing a Form 3115 under either the automatic or advance consent provisions

  5. Involuntary changes are covered by Rev. Proc. 2002-18. It is important to note that any change in accounting method adjustment must conform to the applicable Code sections, such as IRC 263A , 44 IRC 446, IRC 448, IRC 451, IRC 460, IRC 471, and IRC 481(a).

  6. if the examiner’s IRC 481(a) adjustment increases taxable income for the year of the change by more than $3,000, a tax computation is mandatory under IRC 481(b).

  7. Examiners should review Change in Accounting Method information on the Methods of Accounting & Timing Issue Practice Group website for current developments.

4.10.13.8  (03-16-2015)
Real Estate Developers: Alternative Treatment of Common Improvements Under Rev. Proc. 92-29

  1. Real estate developers are allowed to use an alternative cost method of accounting for common improvements under Rev. Proc. 92-29, 1992-1 C.B. 745. Please refer to statute extension Form 921 , Form 921Form 921-I, and Form 921-P and IRM 25.6.22 for additional guidance and IRM 25.6.22 for additional guidance.

  2. The Rev. Proc. 92-29 Program is currently assigned to Technical Services. Refer to IRM 4.8.8.22 for additional information." When IRM 4.10.13.8 was last updated, IRM 4.8.8.22 did not exist. IRM 4.8.8..22 provides detailed guidance on Rev. Proc. 92-29 and makes it clear that the preparation of Rev. Proc. 92-29 statute extensions is the responsibility of Technical Services.

  3. A developer that fails to substantially comply with the provisions of this revenue procedure will not be permitted to use the alternative cost method, and therefore, may not include the common improvement costs that have not been incurred under IRC 461(h) in the basis of properties for purposes of determining gain or loss from such properties.

  4. A developer may allocate estimated costs of common improvements to the basis of lots sold despite the limitations imposed by IRC 461 (h). Developers who wish to use the "10-year window " under Rev. Proc. 92-29 may receive an automatic consent by filing a timely and correct request with the Service: Office of the Director, Technical Services Internal Revenue Service Attn: SE:S:E:TS Mail Stop 5000 24000 Avila Road, Laguna Niguel, CA 92677. If the 10-year window will not be used, the developer must request a Private Letter Ruling to obtain permission.

  5. Rev. Proc. 92-29, section 6.01, requires the developer to file a request for consent with the District Director. However, in the 2001 due to the reorganization of the Internal Revenue Service , the office of District Director was abolished. Developers must file a request with the Area Director for the internal revenue area where the legal residence or principal place of business of the person required to make the return (if the developer is an individual, estate, or trust is located), or the area where the principal place of business or the principal office or agency (if the developer is a corporation or partnership is located). The contact information for Area Directors can be found in Rev. Proc. 2014-1

  6. When the Area Director’s office receives Rev. Proc. 92-29 documents (i.e. initial requests, statute extensions, annual statements, or supplemental requests), they should be forwarded to the local Rev. Proc. 92-29 Coordinator in Technical Services. The contact information for the Rev. Proc. 92-29 Coordinator by state may be found on the My SBSE Website under Examining Taxes, Issues and Procedures, Construction, Contacts at http://mysbse.web.irs.gov/exam/tip/construction/contacts/23074.aspx.

  7. Developers who wish to use the alternative method of accounting for their estimated common improvement costs without regard to the ten-taxable year horizon discussed in Rev. Proc. 92-29 6.02 must request a Private Letter Ruling to obtain permission to use the alternative cost method of accounting for their common improvement costs.

  8. Common improvements vary depending on the type of development. Examples of common improvements include streets, sidewalks, sewer lines, playgrounds, clubhouses, tennis court, and swimming pools. Common improvements must meet the following requirements:

    1. Be real property or real property improvements that benefit two or more properties separately held for sale.

    2. The developer must be contractually obligated or required by law to provide the improvement(s). For example, an agreement to provide improvements in exchange for a building permit is a common improvement (Herzog Bldg. Corp. v. Comr., 44 T.C. 694 (1965)), a statement in a buyer's Housing and Urban Development report that the developer will provide improvements does not qualify as a contractual obligation (Rev. Rul. 76-247, 1976-1 C.B. 217), and an oral promise to a buyer to provide improvements is not sufficient (Bryce's Mountain Resort, Inc. v. Comr., 50 T.C.M. 164 (1985)).

    3. The improvement(s) must not be depreciable by the developer.

  9. For any taxable year, the estimated cost of common improvements is equal to the amount of common improvement costs incurred under IRC 461(h) plus the amount of common improvement costs the developer reasonably anticipates it will incur during the ten succeeding taxable years.

  10. A developer may include in the basis of properties sold, their allocable share of the estimated cost of common improvements without regard to whether the costs are incurred under IRC 461 (h). There is an important limitation, however. As of the end of any taxable year, the total amount of common improvement costs included in the basis of the properties sold may not exceed the amount of common improvement costs that have been incurred under IRC 461(h).

  11. Taxpayers must comply with certain requirements on a project by project basis in order to use the Alternative Cost Method. If this limitation precludes a developer from including the entire allocable share of the estimated cost of common improvements in the basis of the properties sold, the costs not included may be taken into account in a subsequent taxable year to the extent additional common improvement costs have been incurred under IRC 461 (h).

    1. File an original initial request for each real estate project with the Service as explained in IRM 4.10.13.8. The developer must also attach a copy of each request to its timely filed (determined with regard to extensions of time) original federal income tax return for the taxable year. Each request must include all information set forth in Rev. Proc. 92-29, section 6.04. The request must include a copy to the return, a schedule of common improvements, costs, and estimated completion date.

    2. Sign a restricted consent extending the statute of limitations on assessment with respect to the use of the alternative cost method for each year the alternative cost method is used.

      Note:

      Consult with Area Counsel if the entity is a TEFRA (Tax Equity and Fiscal Responsibility Act of 1982) partnership.

    3. File an annual statement for each project with the Service as explained in IRM 4.10.13 .The developer must also attach a copy of each annual statement to its timely filed (determined with regard to extensions of time) original federal income tax return for the taxable year. The annual statement must include all information set forth in Rev. Proc. 92-29, section 8.02 describing the project and updating the estimated costs of common improvements, how the costs were allocated, the number of lots sold, the costs incurred under IRC 461(h), and the costs included in the basis of lots sold

    4. File a supplemental request on or before the expiration of the period previously approved and continue to use the alternative cost method with respect to common improvements not completed at that time. The supplemental request must be filed in the same manner as for the initial request described in IRM 4.10.13 The supplemental request must include all information set forth in Rev. Proc. 92-29 Section 9.02. including describing the project and updating the estimated costs of common improvements, how the costs were allocated, the number of lots sold, the costs incurred under IRC 461(h), and the costs included in the basis of lots sold. The taxpayer must also submit an updated statute extension.

  12. Examiners examining developers who elect the alternative cost method should:

    1. Review Rev. Proc. 92-29,

    2. Secure information regarding any required filings by the taxpayer from the Rev. Proc. 92-29 Coordinator in Technical Services,

    3. Ensure the taxpayer has made the proper computations, and

    4. Verify that the taxpayer did not include in the basis of lots sold the costs of improvements that were never built or that do not meet the requirements.

4.10.13.9  (03-16-2015)
Self-Rented Property and Renewable Options

  1. Self-rental income is rental income of a taxpayer from property leased to a trade or business activity in which the taxpayer materially participates. See Treas. Reg. 1.469-2(f)(6). Self-rentals are a common business practice, primarily used to limit the taxpayer's non-tax liability with respect to the rental property.

  2. While rental income is generally passive income, which can offset unrelated passive losses, certain types of rental income are recharacterized as nonpassive income, the most common being self-rental income. If a taxpayer leases property to a business in which he materially participates within the meaning of temp Treas. Reg. 1.469-5T, net rental income is treated as nonpassive income under this rule. Self-rental income is reportable on Schedule E. It should not be entered on the individual taxpayer's Form 8582, Passive Loss Limitations, where it could otherwise be used to offset passive losses from other activities. However, a net loss from a self-rental activity remains passive and should be reported on the Form 8582.

  3. There is an exception to the recharacterization of self-rental income. Treas. Reg. 1.469-11(c)(ii) permits self-rental income to be treated as passive income if there is a written binding lease entered into before February 19, 1988. As a practical matter, the Service seldom sees leases signed prior to 1988 that bind current years. Thus, self- rental income is generally recharacterized as nonpassive income and cannot be entered on Form 8582.

  4. The question often arises whether a new lease, signed after 1988 under a renewable option provision in a pre-1988 contract qualifies for the written biding lease exception described in paragraph (3), above. A new lease as a result of an option to renew provision does not meet the exception in Treas. Reg. 1.469-11(c)(ii). The clear language of Treas. Reg.1.469-2(f)(6) and 1.469-11(c)(ii) provides that the grandfather exception, which permits self-rental income to be treated as passive income, applies only to rental obligations in existence before February 19, 1988. State law generally draws a distinction between options and the underlying enforceable obligation. While an option may exist, generally there is no underlying enforceable legal obligation until the option is exercised, which clearly is post-1988 for most renewable options in current years. Thus, rental income based on a renewable option is nonpassive income. This income should not be entered on Form 8582 as passive income, which would allow unrelated passive losses to become deductible.

    Note:

    See Krukowski, 114 T.C. 25 (05/22/2000) for an example of a case in which the Court held that the renewable option did not constitute a pre-1988 binding contract.

4.10.13.10  (03-16-2015)
Personal Holding Company Deficiency Dividends

  1. A personal holding company (PHC) is a closely-held company whose income is derived from passive income and/or from payments received for personal services performed by a shareholder.

  2. The PHC penalty tax is self-assessed and calculated on Part 1 of the Schedule PH, Form 1120U.S. Personal Holding Company (PHC) Tax.

  3. The PHC is purely computational; there is no intent provision, unlike the Accumulated Earnings Tax, IRC 531.IRM 4.10.13.2.

  4. IRC 542 (a) provides two objective tests for determining PHC status on a year by year basis:

    1. adjusted ordinary gross income test

    2. a stock ownership test

  5. Under the provisions of IRC 541, a tax of 20 percent is imposed on a PHC’s undistributed personal holding company income.

  6. The personal holding company provisions were enacted to combat the use of "incorporated pocketbooks" by wealthy taxpayers as a means of sheltering investment income from taxation at the higher individual rates and enjoying the benefits of the graduated rate structure at both levels. The original intent of these provisions was to discourage companies from holding excessive accumulations of earnings by forcing distributions to be paid.

    Note:

    Personal holding companies are not subject to the accumulated earnings tax of IRC 531.

4.10.13.10.1  (03-16-2015)
Procedures for Personal Holding Company Cases

  1. The examiner should prepare an initial report recommending the assertion of the PHC tax, where appropriate. The report should reflect separate computations of PHC income, PHC tax liability, and income tax liability. The examiner should follow the procedures for "Excepted Agreed" cases, including preparation of Form 4549-A, Form 4665, and Form 886-A. If the case is unagreed, this report becomes the final report and normal procedures for unagreed cases apply.

  2. See IRM 4.10.8.9, Deficiency Dividends for detailed report writing instructions and sample forms in IRM 4.10.8 Exhibits 4.10.8.3-7.

4.10.13.10.1.1  (03-16-2015)
Deficiency Dividend Procedures

  1. If neither jeopardy assessment nor fraud is involved, and the taxpayer agrees to all adjustments including the liability for PHC tax in the amount proposed, the taxpayer may be relieved of the liability for the PHC tax by payment of "deficiency dividends" . If the corporation makes the payment of this deficiency dividend within 90 days following formal notification, the corporation is relieved of having to pay the PHC tax.

  2. The examiner must notify the taxpayer regarding the deficiency dividend procedures of IRC 547. The proper sequence is:

    • Securing a signed agreement from the taxpayer, where the taxpayer agrees to the amount of the tax liability, signing Form 870 to allow a proper assessment,

    • Payment of the deficiency dividend, and

    • The filing of a claim by the taxpayer claiming credit for a deficiency dividend deduction.

  3. A determination of the taxpayer's liability for PHC tax must be made in the manner prescribed by IRC 571(c). Three means of making a qualifying determination are:

    1. Form 2198, Determination of Liability for Personal Holding Company Tax, an informal agreement as provided in the regulations.

    2. An other determination method – the date of determination by a decision of the Tax Court of the United States is the date upon which decision becomes final, as prescribed in section 7481. See section Treas Reg. 1.547-2(b)(ii). And under -2(b)(iii), the date upon which a judgment of a court becomes final.

    3. Form 866, Agreement as to Final Determination of Tax Liability, a final determination under IRC 7121.

4.10.13.10.2  (03-16-2015)
Form 870

  1. The taxpayer's agreement to the additional tax shown on the initial report is indicated by signing Form 870, Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment. The Form 870 must include the following statements as outlined in IRM 4.10.8.9Examination of Returns - Report Writing:

    • The waiver of restrictions on assessment and collection contained herein is subject to the approval of Form 2198, Determination of Liability For Personal Holding Company Tax, relating the taxpayer's liability for Income and Personal Holding Company Tax.

    • This waiver will not take effect until after the expiration of the 120-day period beginning with the effective date of Form 2198.

    • If the taxpayer complies with IRC 547, Deduction for deficiency dividends, relating to the payment of deficiency dividends, by paying the deficiency dividends within 90 days after the effective date of Form 2198 and filing a proper claim on Form 976 subsequent to the payment of the deficiency dividends and within 120 days after the effective date of Form 2198, then the amount of the deficiency stated on this waiver shall be reduced by the amount necessary to give effect to the timely paid deficiency dividends and the remainder, if any, will be assessed.

    • If, at the expiration of the 120-day period beginning with the effective date of the Form 2198, a Form 976 has not been filed or timely deficiency dividend payments have not been made, the entire amount of the deficiency shown in this waiver will be assessed.

      Note:

      The four conditions noted above should be placed on an attachment to Form 870 with a heading that reads: "This statement is attached to and made a part of Form 870 in the case of (Taxpayer's Name)."

4.10.13.10.3  (03-16-2015)
Form 2198

  1. After the Form 870 is signed, the examiner should prepare Form 2198Determination of Liability For Personal Holding Company Tax, relating the taxpayer's liability for Income and Personal Holding Company Tax, secure the taxpayer's signature on the original and one copy. The original should be initialed by the examiner and group manager to indicate their acceptance of the form. The case should then be submitted to Technical Services (TS). See IRM 4.8.8.4.2, Reviewer Responsibilities.

  2. The reviewer will sign the Form 2198 provided sufficient time remains on the statute in addition to the 120-day period for filing a Form 866.

  3. The original of the approved Form 2198 is attached to the return for the last taxable year covered by the agreement. The duplicate Form 2198, Letter 1152 (DO), and three Form 866 are mailed to the taxpayer by registered or certified mail, as appropriate.

    Note:

    Treas. Reg. 1.547-2(b)(1)(v) provides that the date of determination is the date the Form is mailed to the taxpayer, with one exception. If the dividends are paid after the agreement is approved but before it is mailed, the effective date is the date the agreement was signed by the Service.

4.10.13.10.4  (03-16-2015)
Final Closing Agreement Procedures

  1. Form 866Agreement as to Final Determination of Tax Liability is not routinely used in lieu of Form 2198Determination of Liability for Personal Holding Company Tax unless advised by Counsel for a unique situation. If Form 866 is utilized as the agreement document, the examiner should prepare the agreement and secure the taxpayer's signature. The Form 866 is then forwarded to Technical Services for processing as provided in the Closing Agreement manual section, Form 866Closing Agreements - Processing Closing Agreements in Appeals.

  2. After the closing agreement is approved, a copy is forwarded to the taxpayer along with three Form 976Claim for Deficiency Dividends Deductions by a Personal Holding Company, Regulated Investment Company, or Real Estate Investment Trust by the designated review. Form 3198, Special Handling Notice, is attached to the case file identifying it as a closing agreement case.

4.10.13.10.5  (03-16-2015)
Post-Determination Procedures

  1. The case is suspended by Technical Services until the earlier of:

    1. Receipt of Form 976 from the taxpayer, or

    2. 120 days from the "date of determination"

4.10.13.10.5.1  (03-16-2015)
Form 976 Procedures

  1. The Code allows the real estate community, specifically personal holding, REIT and RIC, to reduce their taxable income by declaring a dividend and distributing it to their shareholders. The dividend would be substantially all the income earned for the year. If for some reason it was found out that not all the appropriate amount of income is declared the taxpayer may declare a deficiency dividend using a issue the dividend.

  2. When and where to file:

    1. File Form 976 within 120 days after the determination date

    2. A PHC must file Form 976 with the IRS office where the determination of PHC status was made

    3. A RIC or a REIT must file Form 976 with the Internal Revenue Service Center where the income tax return for the tax year for which the determination applies was filed, unless the situations below apply

    4. If the determination is made by a RIC or REIT under IRC 860 (e)(4), file Form 976 with the Internal Revenue Service, P.O. Box 9941, Mail Stop 4912, Ogden, UT 84409. This is the same address for filing Form 8927, Determination Under IRC 860(e)(4) by a Qualified Investment Entity

    5. If the determination is from an agreement with the delegate (under IRC 547(c)(3) or IRC 860(e)(3)) any claim resulting from the deficiency dividend deduction may be filed with the delegate or corresponding IRS office

  3. The deficiency dividend must be of such a nature as would have permitted its inclusion in the computation of the deduction for dividends paid under IRC 561 for the tax year for which the tax liability exists, if it had been distributed during that year.

  4. If the taxpayer files a timely Form 976, the claim is date stamped and the case is returned to the examiner to verify the accuracy of the information reflected on the claim.

  5. If Form 976 is filed after the 120-day period, the case will be returned to the examiner for disallowance of the claim.

  6. The disallowance of a Form 976 claim is effected by the issuance of a certified notice of disallowance of claim, unless the taxpayer has executed Form 2297 (Waiver of Statutory Notification of Claim Disallowance). A letter of explanation may also accompany the notices. The tax is then assessed per the full amount reflected in the initial report.

  7. If the Form 976 claim is determined to be allowable in full or in part, the examiner should prepare:

    1. A report to allow a credit for the deficiency dividends. This report will be the same as the initial report except that credits on Line 8 of Form 4549-A will shown "PHC Deficiency Dividend Deduction" and the applicable amount, and the "Other Information" section will state whether Form 976 has been allowed in full or in part (See IRM 4.10.8 Exhibit 4.10.8-6),

    2. Form 3189, Deficiency Dividend Case Transmittal, see IRM 4.10.8 Exhibit 4.10.8-7,

  8. Form 3189 should be flagged to identify the case as a PHC case. The restricted interest box should also be checked and "IRC section 547" annotated.

  9. See Notice 2003-19, 2003-1 C.B. 703, under IRC 860 and Treas. Reg.1.860-2 concerning a deficiency dividend deduction for a "qualified investment entity" (RIC or REIT), which reflects the "place of filing" as "Ogden Submission Processing Center".

4.10.13.10.6  (03-16-2015)
Miscellaneous Considerations

  1. Neither Form 2198 nor Form 866 should be entered into unless sufficient time remains to allow assessment after the 120-day period and before expiration of the statutory period. However, a consent extending the period of limitation on assessment may be executed in the normal manner.

  2. IRC 6501 (f) provides a six-year period of assessment instead of the normal three-year period if a corporation failed to file Schedule PH or a schedule setting forth specified information regarding its income and shareholders.

  3. Deficiency dividends are deemed to be paid from earnings and profits of the year under examination rather than those of the current period. However, the dividends are taxable to the shareholders in the year in which paid.

  4. Although the taxpayer is relieved of the liability for PHC tax by the payment of deficiency dividends, the liability for restricted interest and any applicable penalties remains.

  5. The IRC 465 at-risk rules only apply to corporation that meet the PHC stock ownership test (without regard to the income test).

  6. Alternative minimum tax adjustment for circulation expenses applies only to PHCs (IRC 56(b)(2)(C) )Adjustments in computing alternative minimum taxable.

Exhibit 4.10.13-1 
Bardahl Manufacturing Formula - Modified by The Empire Steel Casting Decision

Following is the formula used by the Tax Court to compute working capital needs in the Bardahl Manufacturing Corporation case.

1. Determine the amount of current and accumulated earnings.

2. Require justification of current and accumulated earnings only to the extent represented by the excess of current assets over current liabilities including Federal income taxes due.

3. Determine (a) the operating expenses for the full year, including the cost of goods but excluding depreciation and (b) the adjusted operating cycle in terms of percent of a year. Then, multiply (a) by (b) to get the amount of net liquid assets necessary to meet ordinary operating expenses. The adjusted operating cycle is the time required to convert cash into raw materials, raw materials to Inventory. Inventory into sales and accounts receivable and the period required to collect the outstanding accounts. In the Bardahl case the computation was based on the operating expenses of the succeeding year.

4. Ascertain the amount needed to meet specific and definite plans for expansion, extraordinary expenses, etc.

5. Compare the funds required or computed in (3) plus (4) with the funds available as computed in (2). If funds available exceed funds required the excess is unreasonable accumulation.

6. Check to see whether corporate funds were used for non-liquid investments which have no relationship to the business. Such investments are considered as additional working capital. If this amount when added to the funds available as computed in (2) exceeds the funds required as computed is (3) plus (4) the excess is an unreasonable accumulation.

Exhibit 4.10.13-2 
Bardahl-Apollo Formulas Compared

  Bardahl Apollo
1. Cost of Materials $800,000.00 $800,000.00
2. Average beginning-ending inventory 80,000.00 80,000.00
3. Material turnover per year 10.00% 10 times
4. Months/days per material inventory turnover (12 X 10%) 1.2 months 36.5 days
5. Average daily cost of material ($80,000/36.5) No step 2,191.78
6. Days cost of material tied up in inventory (36.5 x $2,191.78) No step 80,000.00
7. Sales $2,400,000.00 $2,400,000.00
8. One day sales ($2,400,000/365) No step $6,575.34
9. Trade accounts receivable at end of year $600,000.00 $600,000.00
10. Percentage of year sales uncollected 25.00% No step
11. Average number of months sales uncollected 3 months No step
12. Days sales tied up in accounts receivable ($600,000/$6,575.34) No step 91.25 days
13. Cost of Sales $1,000,000.00 $1,000,000.00
14. Expenses (including estimated Federal Income Tax Payments) 500,000.00 500,000.00
Total of 13 and 14 $1,500,000.00 $1,500,000.00
15. Less depreciation 100,000.00 100,000.00
16. Annual operating expense $1,400,000.00 $1,400,000.00
17. Operating cycle percentage (Step 3 plus 10) 35.00% No step
18. Ordinary operating expense (35% x $1,400,000) $490,000.00 No step
19. Daily operating cost ($1,400,000/365) No step $3,835.62
20. Operating cost tied up in accounts receivable (91.25 x $3,835.62) No step $350,000.00
21. Material cost (line 6)   $80,000.00
22. Operating cost during collection period   $350,000.00
23. Working capital needs $490,000.00 $430,000.00

Exhibit 4.10.13-3 
Letter 572 Proposal to Issue a Notice of Deficiency for Excess Accumulated Earnings Under IRC Section 531

  1. IRM 4.10.13.2.8,Notification of Unreasonable Accumulation of Earnings says: "In any proceeding before the Tax Court involving the allegation that a corporation has permitted its earnings and profits to accumulate beyond reasonable business needs, the burden of proof is on the Commissioner unless a notification is sent to the taxpayer under IRC 534 (b). However, if such a notification is sent to the taxpayer and he/she timely submits the statement described in IRC 534 (c), the burden of proof will be on the Commissioner as to the grounds given in the statement"

  2. Letter 572 replaces Pattern Letter P-572. It also streamlines the Notice of Deficiency for the tax that IRC 531 requires to be paid on accumulated earnings. It allows the taxpayer(s) time to respond to the letter by submitting a statement and including facts sufficient to show the basis for the accumulation. We will then determine whether the Notice of Deficiency should be issued. The letter primarily will affect corporation returns Form 1120. It points to the earnings and profits accumulate beyond the reasonable needs of the business.

  3. IRM 4.8.8.2(2) Accumulated Earnings Tax , indicates that only officials and Technical Services’ reviewers delegated to sign notices of deficiency pursuant to Servicewide Delegation Order 4-8 are authorized to sign notifications under IRC 534(b) according to Rev. Proc. 56-11, 1956-1 C.B. 1028. Therefore, the case is forwarded to Technical Services to sign Letter 572. Technical Services will return the case to the group for certified mailing and suspense.

Exhibit 4.10.13-4 
Activities Not Engaged in For Profit Check Sheet

IRC 183 Activities Not Engaged in For Profit Audit Technique Guide (ATG) has been developed to provide guidance to Revenue Agents and Tax Compliance Officers in pursuing the application of IRC 183, Activities Not Engaged in for Profit (sometimes referred to as the “hobby loss rule”).

The purpose of the guide is to:

  1. Assist in distinguishing between a business activity (where deductions may be allowable under IRC 162)

  2. a non-business “for profit” activity (where deductions may be allowable under IRC 212)

  3. an activity not engaged in for profit (where deductions are strictly limited by specific rules contained in IRC 183) and

  4. a personal activity (where deductions are generally disallowed byIRC 262, except to the extent otherwise allowable),

  5. Provide examination techniques,

  6. Supply applicable law, and

  7. Provide written guidance in report writing.

This guide is not designed to be all inclusive. This guide is not legal precedent and should not be relied upon as such. It is not designed to remove the discretion given to managers and examiners in the application of a variety of audit techniques or procedures appropriate to any given examination.

Treas. Reg. 1.183-2(b) lists certain relevant factors normally to be taken into account in making a determination regarding the purpose of an activity, it being intended that such factors are not necessarily all-inclusive and that no one factor shall be determinative:

  1. Manner in which taxpayer carries on activity:

    • Are books and records accurate and complete? If not, why not?

    • Are books comparable to types of books kept by others in same activity?

    • What advertising and promotion activity did the taxpayer perform to gain clients/buyers (describe in detail)?

    • What other relationship did the taxpayer have with his clients/buyers (trace each transaction in gross receipts to the individual who paid the taxpayer the money)? with his suppliers? with his employees?

    • Has taxpayer abandoned the unprofitable methods? What method replaced them?

    • Does taxpayer have a license to operate?

    • Is taxpayer insured for business?

    • Is the activity conducted in an area zoned for business?

    • Does the city, country or state regulate the activity? Has taxpayer been investigated by them? Does he file sales tax reports with the state?

    • Was any element of the activity admittedly personal?

    • Is the activity still being conducted? With what result? What is the plan for future years?

    • How is the taxpayer's telephone number listed in the white/yellow pages?

    • Can taxpayer provide affidavits from witnesses?

  2. Expertise of taxpayer and/or advisors:

    • Pre-activity research by taxpayer.

    • History of all similar activities by taxpayer and related family members.

    • Education background.

    • What did taxpayer tell preparer when first introducing the activity during the preparation of the return?

    • What is preparer's (and other advisor's) background?

    • What related organizations does taxpayer belong to? When did he join?

    • What related publications does taxpayer subscribe to? How long?

  3. Time and effort expended by the taxpayer in carrying on the activity:

    • How many hours per day? What task?

    • What is the routine?

    • Which person does what part of the activity?

  4. Expectation that assets used In activity may appreciate in value:

    • Analyze each asset, whether capital, depreciable, intangible or part of inventory. How much is each asset worth today?

    • Has the taxpayer ever offered to sell any of the assets?

    • Has anyone every offered to buy any of the assets?

    • See Treas. Reg. 1.183-1(d)(1) regarding appreciation of farmland.

  5. Success of the taxpayer in carrying on similar or dissimilar activities:

    • Look at copies of taxpayer's returns (back 10-15 years if possible).

    • Did taxpayer ever have a hobby not shown on tax returns but of similar nature? Get details.

  6. Taxpayer's history of income or losses with respect to the activity:

    • Chart gross receipts since beginning of activity (including any unclaimed amounts). Look for pattern.

    • Chart any expenses. Look for pattern.

    • Chart net profits/losses.

      Note:

      If the current examination year is the first year of activity, wait until the next year is filed before closing the first year (needs group manager approval).

  7. Amount of occasional profits, If any, which are earned

  8. Financial status of the taxpayer:

    • For all years activity claimed, chart amount of profit/loss, other taxable income, other non-taxable income.

    • Chart the tax savings for all years (including credits claimed).

  9. Elements of personal pleasure or recreation:

    • By the taxpayer

    • By the members of the taxpayer's family

    • By the taxpayer's friends


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