The IRS has updated (Revenue Procedure 2016-29) the list of automatic accounting method changes provided in Revenue Procedure 2015-14 (see Tax Alert 2015-204), effective for a Form 3115 filed on or after May 5, 2016, for a year of change ending on or after September 30, 2015. While many of the automatic method changes remain unchanged from last year's Revenue Procedure, this Alert highlights a few changes that may affect taxpayers in the asset management industry.

A taxpayer making an accounting method change must first determine whether the change is treated as automatic or non-automatic. For an automatic accounting method change request, Form 3115 is attached to the tax return for the year of change and filed by the due date, including extensions, of the tax return. However, a non-automatic change request must be filed on Form 3115 during the tax year for which the change is requested. It is recommended to file as early in that year as possible to provide time for the IRS to respond prior to the due date of the filer's return. For planning purposes, taxpayers should be aware of this difference in timing of the two sets of procedures. Generally speaking, method changes that are not listed in Revenue Procedure 2016-29 must be filed as non-automatic method change requests.

A change in a method of accounting generally requires an adjustment under Section 481(a). The adjustment under Section 481(a) accounts for the cumulative difference between the current and proposed methods, to ensure items of income or expense are not omitted or duplicated. The adjustment is computed by determining the difference in the amount of income or deduction reported as of the beginning of the year of change under its present method of accounting and the amount of income or deduction that would have been reported as of the beginning of the year of change had the taxpayer always been on the proposed method of accounting. The adjustment may increase income (positive adjustment) or decrease income (negative adjustment). Generally, a net positive Section 481(a) adjustment is taken into account over four tax years starting with the year of change. This could potentially cause a taxpayer to benefit from some deferral of income as part of the method change. A net negative 481(a) adjustment is generally taken in the year of change.

Change in overall method from cash to accrual method involving Section 457A deferred compensation

Revenue Procedure 2016-29 modified Section 15.01 with respect to a change in the overall method of accounting from the cash method to accrual method if such a change includes in its Section 481(a) adjustment amounts historically deferred and grandfathered under Section 457A. Taxpayers seeking to change their method of accounting from cash to accrual under this provision are now generally required to seek permission from the IRS to make such change.

Through the release of Revenue Procedure 2016-29, the IRS appears to have addressed an area of uncertainty being discussed within the asset management industry. The impact of asset managers' Section 481(a) adjustments related to deferred compensation where they elect to, or are required to, change their method of accounting from cash to accrual, has been a subject of much debate in the asset management industry. It appears that by requiring taxpayers to request a change in method, the IRS has concerns about the consequences of taxpayers with deferred compensation adjustments affecting such accounting method change. Although investment managers still have the option to make a non-automatic method change request, by requiring taxpayers to seek consent, the IRS is ensuring that it has the ability to review all cash-to-accrual changes with Section 457A adjustments for potentially abusive situations. It also allows the IRS to review taxpayers' determinations of how they spread Section 481(a) adjustments related to Section 457A deferrals, particularly where a taxpayer seeks to spread Section 457A amounts past 2017.

As stated previously, the new Revenue Procedure is effective for Forms 3115 filed after May 5 for tax years ending September 30, 2015. Taxpayers that have previously filed a Form 3115 for an automatic method change for tax years ending on or after September 30, 2015, would not be subject to this Revenue Procedure and the new Section 457A exclusion. It is likely, however, that there is some risk of challenge if the taxpayer intends to spread the deferred compensation income subject to 457A beyond 2017 as we generally expect there to be much scrutiny of all Forms 3115 being filed with Section 457A adjustments.

In circumstances when Revenue Procedure 2016-29 does not apply, for example when the taxpayer is no longer able to use the cash method of accounting due to failure to meet the requirements under Section 448 to use the cash method of accounting, such as admitting a corporate partner into a partnership, a taxpayer may still be able to file an automatic method change under the regulations. However, the changes reflected in Revenue Procedure 2016-29 indicate the position the IRS would likely take upon audit or other review as to whether income subject to 457A can be spread beyond 2017.

Section 475 mark-to-market procedures

The procedures for making a change in accounting to use the mark-to-market method under Section 475(e) or (f) now have a few nuances of which taxpayers should be aware.

Prior to the release of Revenue Procedure 2015-14, a taxpayer could make an automatic change to elect into Section 475 mark-to-market treatment in the entity's final year of its trade or business. However, in Revenue Procedures 2015-14 and 2016-29, if the election year is the final year of a trade or business, a taxpayer may no longer make an automatic change. Interestingly, regarding a change from the mark-to-market method of accounting to a realization method as described in Section 23.02 of Revenue Procedure 2016-29, the same eligibility rule described above would not apply. In other words, a taxpayer may not change its method from realization to mark-to-market in its final year of business, but it may make the reverse change, from mark-to-market to realization, in its final year, provided other eligibility requirements listed in Section 5.01 of Revenue Procedure 2015-13 and Section 23.02 of Revenue Procedure 2016-29 are met. Depending on a taxpayer's mix of income types and characterization of gains and losses in its final year of business, this could warrant further consideration.

Starting for tax years ending on or after May 31, 2014, taxpayers may revoke previously made Section 475(f) mark-to-market elections through an automatic method change. Revenue Procedure 2016-29 sets out the manner in which to make the election to use the mark-to market method of accounting under Section 475 or to revoke such an election. The electing taxpayer makes a valid election or revocation by filing a notification statement with the original federal income tax return for the tax year immediately preceding the election/revocation year (without regard to extensions). If the taxpayer, after filing the statement, subsequently fails to file a Form 3115 to change its method of accounting, the method change will not be considered valid, and the taxpayer will be deemed to have an impermissible method.

The potential pitfalls when making or revoking Section 475(f) elections can be detrimental. In Poppe v. Commissioner (T.C. Memo. 2015-205), the Tax Court held that the taxpayer did not fulfill the necessary filing requirements to make a valid Section 475(f)(1) mark-to-market election because the taxpayer failed to sign and mail a Form 3115 for the requested year of change. In such a situation, under Section 2.06 of Revenue Procedure 2002-18, the Commissioner has the ability to require a taxpayer to change back to its former method, even if the change was from an impermissible method to a permissible method. This could give the IRS full discretion in deciding which method should apply in those instances, mark-to-market or realization.

New automatic accounting method change for start-up expenditures

Revenue Procedure 2016-29 adds Section 10.01 on changes for start-up expenditures under Section 195 to the list of automatic accounting method changes. Automatic consent procedures are now available to a taxpayer who wants to change its method of accounting under Section 195 to change either the characterization of an item as a start-up expenditure or the determination of the tax year in which the related active trade or business begins.

The term "start-up expenditure" means any amount paid or incurred in connection with investigating the creation or acquisition of an active trade or business, creating an active trade or business, or any activity engaged in for profit and for the production of income before the day on which the active trade or business begins and which would be allowable as a trade or business deduction for the tax year in which paid or incurred. The term "start-up expenditure" does not include any amount with respect to which a deduction is allowable under Sections 163(a), 164, or 174.

There can be uncertainty as to the date on which an active trade or business begins. For a management company for which an analysis of start-up expenditures has not been thoroughly performed, this could provide an opportunity to revisit expenses incurred and reevaluate whether they have been properly categorized. The timing of the deduction would potentially vary depending on how the expense is categorized.

For both types of changes - characterization of an item and determination of tax year in which active trade or business began - the automatic consent granted by the Commissioner does not create any presumption that the proposed characterization or tax year is permissible under Section 195. The director will ascertain whether the taxpayer's proposed characterization and/or tax year is permissible. In other words, granting of the automatic consent does not necessarily mean the method request will be sustained; the requested items must still meet the requirements as prescribed in Section 195.

Implications

The release of Revenue Procedure 2016-29 serves to maintain a consolidated and updated list of automatic method changes, even as new method changes are added to the list with frequency. The various additions, modifications and removals are performed each for different reasons, sometimes at the encouragement of taxpayers. The topics mentioned above, namely deferred compensation, 475(f) mark to market elections and start up expenditures, are just some of the changes within Revenue Procedure 2016-29 that taxpayers within the asset management industry should be aware of when reviewing their methods of accounting.

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