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Tax Court: Defective Change in Accounting Method Can't Be Reversed Years Later without IRS Consent.

(Parker Tax Publishing June 7, 2015)

The Tax Court determined that, although the taxpayer's initial application for automatic consent to change its method of accounting was defective, its consistent use of the new method over seven years constituted a method change. Accordingly, the court rejected the taxpayer's attempt to revert back to its old method without IRS consent. Hawse v. Comm'r, T.C. Memo. 2015-99.


James Hawse was the president and sole shareholder of JHH, Motor Cars, Inc. (JHH), an S corporation that sold new and used vehicles and operated a full service automobile repair and parts department. In 1985, JHH elected to use the last-in, first-out (LIFO) method of accounting for its vehicles inventory. JHH did not make a similar LIFO election for its parts inventory, which it identified using the specific identification method and valued on the basis of lower of cost or market.

In early 2001, Hawse, anticipating that he might sell his dealership, sought to terminate JHH's LIFO election because he viewed the LIFO method as an impediment to the eventual sale of his business. Hawse was concerned that the LIFO method would impede a sale, because either he or the purchaser might have to recapture the accumulated LIFO reserve if he sold the dealership.

JHH attached a Form 3115, signed by Hawse, to its 2001 Form 1120S, requesting the IRS' automatic consent to revoke its LIFO election for the vehicles inventory in favor of the specific identification method pursuant to the automatic consent provisions of Rev. Proc. 99-49. On the Form 3115, JHH stated it would make the necessary Code Sec. 481(a) adjustment by recapturing its stored LIFO reserve of $1,084,437 over a period of four years. JHH further stated that it currently identified its vehicles inventory using the LIFO method, valued at cost, and that going forward, it would identify that inventory using the specific identification method, valued at the lower of cost or market.

JHH did not attach a statement to its Form 3115 explaining how its proposed new methods of identifying and valuing its vehicles inventory were consistent with the requirements of Reg. Sec. 1.472-6 relating to a change from the LIFO method, or how these methods conformed to the LIFO method change requirements of Rev. Proc. 99-49.

On its 2001 through 2007 returns JHH used the specific identification method of accounting for its entire inventory. JHH also made the required Code Sec. 481(a) adjustment, reporting income of $271,109 from the recaptured LIFO Reserve on each of its 2001, 2002, 2003, and 2004 income tax returns. However, contrary to its representation that it would value its entire inventory at the lower of cost or market, JHH used different valuation approaches for its various inventories.

In 2009, Hawse was informed by his accountant that, the IRS had been rejecting Forms 3115 that were filed for automatic terminations of LIFO elections. Hawse claimed his accountant's information was based on a webinar that included an IRS Motor Vehicle Technical Specialist and subsequent discussion with an auto dealership industry professional who advises on LIFO accounting method issues. It appeared that the IRS' position was that dealerships could not use the automatic change provisions to terminate the LIFO method if, after filing their LIFO termination applications, the dealerships did not use the same method of inventory valuation for their entire non-LIFO inventory.

Because JHH had been using different valuation approaches, the accountant advised Hawse that JHH should file amended returns to reinstate the LIFO method for vehicles inventory and to reverse the related Code Sec. 481(a) adjustments. In 2009, JHH filed amended returns for 2002 through 2007 that reflected the valuation of the taxpayer's new inventory under LIFO, consistent with its initial election.

On its amended returns for 2002 and 2003, consistent with its goal of reverting to the LIFO method, JHH reversed the Code Sec. 481(a) adjustment that it had earlier made, computed additional LIFO reserve amounts for years 2001, 2002, and 2003 and claimed deductions for these additional LIFO reserve amounts and refunds as a result of these adjustments on its 2002 and 2003 amended returns.

In 2012, the IRS denied the claimed refunds and rejected the accounting method change on the amended returns.

Consistent Application of Accounting Method was a Change, Despite Defective Application

Under Code Sec. 446(e), once a taxpayer has used an accounting method and filed a first return, the taxpayer must receive approval from the IRS before making any change to that accounting method. Taxpayers may receive automatic consent for an accounting method change by filing a current Form 3115 that follows the requirements laid out under the current automatic consent revenue procedure. Rev. Proc. 99-49 provided the relevant procedures for obtaining automatic consent to change a method of accounting in 2001, the year in which JHH filed its Form 3115.

Under Reg. Sec. 1.466-1(e)(2)(ii)(a), a change in accounting method includes a change in the treatment of any item that involves the proper time for the inclusion of the item in income.

The Tax Court noted that JHH's initial application for automatic consent failed to comply with all the terms and conditions of Rev. Proc. 99-49: JHH did not cite on Form 3115 the applicable section of the revenue procedure's appendix, nor did it attach to Form 3115 a separate statement describing how its new methods of identifying and valuing its inventory conformed to the requirements. The court stated that while the two defects might appear trivial, the revenue procedure itself demanded strict compliance with all requirements and the defects precluded JHH receiving automatic consent to change its method of accounting from LIFO to specific identification.

Having concluded that JHH did not receive automatic consent for a method change, the Tax Court stated it would need to decide whether, notwithstanding this failure, JHH's filing of its 2001 through 2007 tax returns in accordance with a new method of accounting was itself a method change.

The court questioned Hawse' assumption that, because the IRS did not automatically consent to JHH's requested accounting method change, that no change in fact occurred and JHH was still on the LIFO method. The court found Hawse misconstrued Code Sec. 446(e), noting that section creates a legal duty to seek advance consent to a change in accounting method, but it does not bar a change from occurring without consent. The court pointed out that Code Sec. 446(e) affords the IRS the power to grant retroactive changes in accounting methods as well as prospective ones. It concluded that when the IRS examined JHH's 2002 and 2003 returns and determined that JHH had revoked its LIFO election in 2001, the IRS had plainly accepted the change.

The court observed that in Huffman v. Comm'r, 126 T.C. 322 (2006), the Tax Court emphasized that the consistent treatment of an item involving a question of timing will establish such treatment as a method of accounting. Because use of the specific identification method rather than the LIFO method accelerated JHH's recognition of vehicle sales income, the court determined it involved a question of timing under Reg. Sec. 1.466-1(e)(2)(ii)(a). The court observed that in Johnson v. Comm'r, 108 T.C. 448 (1997), it had found that a two-year deviation could establish a new method of accounting, and determined that JHH's seven-year consistent use of the specific identification method established that treatment as a method of accounting under Huffman.

Thus, notwithstanding its failure to secure the IRS' automatic consent, the court determined JHH changed its method of accounting from LIFO by accounting for its vehicles inventory on the specific identification method on its 2001 through 2007 tax returns.

Amended Return and Attempted Reversion to LIFO

Because JHH had changed its method of accounting by consistently applying the proposed method change over seven years, the Tax Court determined JHH's attempt to revert to the LIFO method with its amended returns was a second attempt to change its accounting method.

First, the court noted it had previously held that a taxpayer changes its method of accounting when it changes its treatment of an item in order to adhere to a method adopted pursuant to a prior accounting election (Capital One Fin. Corp. v. Comm'r, 130 T.C. 147 (2008)). On its amended returns JHH changed its treatment of its vehicles inventory to adhere to its previously elected LIFO method, and the court found that was an accounting method change.

Second, the court noted under Reg. Sec. 1.446-1(e)(2)(ii)(c), a change from specific identification to LIFO is a change in an overall plan or system of identifying items in inventory and thus qualifies as an accounting method change.

Third, the court found the two changes that JHH proposed to make with its amended returns involved material items: the first change reversed the Code Sec. 481(a) recapture of LIFO reserve and the second change computed LIFO reserve amounts for tax years 2001, 2002, and 2003 and deducted them. The court determined JHH's reversal of the Code Sec. 481(a) adjustment and deduction of additional LIFO reserve amounts retroactively postponed its recognition of LIFO reserve; hence, both changes related to the proper timing of income and thus amounted to changes in the treatment of material items under Reg. Secs. 1.446-1(e)(2)(ii)(a) and (c).

Accordingly, the court held the changes that JHH made on its amended returns constituted a retroactive change in method of accounting for which the IRS's consent was required, and the IRS was well within its discretion to refuse such consent and to refuse to accept JHH's amended returns.


The Tax Court found JHH did not receive automatic consent under Rev. Proc. 99-49 to change its method of accounting for its LIFO inventory to specific identification, but, notwithstanding this failure, by consistently accounting for that inventory on its 2001 through 2007 returns using the specific identification method, JHH nevertheless changed its method of accounting. Further, the court determined JHH's amended returns, on which it attempted to revert to the LIFO method, reflected a second change in method of accounting to which JHH also did not obtain the IRS's consent. Accordingly, the Tax Court held the IRS was entitled to reject JHH's amended returns and Hawse was not entitled to his claimed refunds.

For a discussion of accounting method changes, see Parker Tax ¶ 241,590. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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