Category: Accounting Periods & Methods
Subject: Section 481(a) Adjustment--Recapture
Title: Transfer of 481(a) Adjustment to Successor Entity
IRC Sections: Section 481(a)
Filename: 1078.html
Date Produced: 7/97

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Background
Taxpayer is an LLC formed by a husband and wife to be the successor entity to a business previously operated as a sole proprietorship run by the husband. The taxpayer is in the business of constructing swimming pools and is concerned about the need to adopt the accrual method of accounting given the unfavorable court decisions in this area (e.g., J.P. Sheahan Associates, Inc., 63 TCM 2842, Dec. 48,174(M), TC Memo. 1992-239).

Rev. Proc. 92-74, 1992-2 CB 442, provides a streamlined procedure designed to help taxpayers required to use the accrual method of accounting due to the presence of inventories make the change in an expeditious manner. The Rev. Proc. controls the treatment of the Section 481(a) adjustment resulting from such change.

In general, taxpayers are permitted to spread the net Section 481(a) adjustment over the number of tax years the cash method has been used, not to exceed three years. There are other restrictions as well. See Rev. Proc. 92-74, Section 5.03. Since the LLC is newly formed, the general rule would apparently force the entire adjustment to be recognized in the year of change. That is a very undesirable situation.

Issue
Does the period during which the taxpayer operated the business as a sole proprietorship count for purposes of determining the maximum period over which the Section 481(a) adjustment can be spread?

Answer
No, the prior period of operation as a sole proprietorship does not count for purposes of determining the number of years the taxpayer has used the prior accounting method.

Discussion
Rev. Proc. 92-74 does not address the predecessor entity issue. For operational rules for determination of the proper spread period, Rev. Proc. 92-74 refers to Rev. Proc. 92-20, 1992-1 CB 685, the general-purpose procedure for accounting method changes.

Previous to Rev. Proc. 92-20, the use of an accounting method by certain predecessor entities counted for purposes of determining the number of tax years a method had been in use. See Rev. Rul. 66-206, 1966-2 CB 206. Rev. Proc. 92-20 changed that position, although in a very cryptic manner.

The crux of the matter under Rev. Procs. 92-74 and 92-20 is how long has the taxpayer used the method in question. When there is a change in form, such as from a proprietorship to a partnership, are we dealing with one taxpayer--i.e., the partnership is a continuation of the proprietorship--or do we have two separate taxpayers, a proprietorship and a partnership? If there is only one taxpayer, the predecessor's use of the method should count for purposes of determining the spread period. If there are two, the prior use should be ignored.

Section 3.01 of Rev. Proc. 92-20 provides that the term taxpayer has the same meaning as the term person under Section 7701(a). Section 3.01 distinguishes this interpretation from that of the definition of the term taxpayer under Section 7701(a)(14). The definition of person under Section 7701(a) is very narrow: a person is defined as an individual, estate, trust, partnership, association, company, or corporation. On the other hand, the definition of taxpayer under Section 7701(a)(14) is very broad: a taxpayer is defined as any person subject to any internal revenue tax.

What does all this mean?

If the term taxpayer is defined narrowly, as under Section 7701(a), then a proprietorship is a different person (i.e., taxpayer) than a successor partnership. On the other hand, if taxpayer is defined broadly, as under Section 7701(a)(14), then a proprietorship (which is subject to any internal revenue tax) is arguably the same taxpayer as a partnership (which is also, broadly speaking, subject to any internal revenue tax).

Rev. Proc. 92-20 chose the more restrictive definition. Accordingly, it seems clear (more or less) that a partnership is a different taxpayer for purposes of the Section 481 adjustment than its predecessor sole proprietorship. Hence, it does not seem possible to use the period during which the proprietorship used the cash method of accounting for purposes of determining the number of years over which the Section 481 adjustment is spread.

Rev. Proc. 92-20 was recently supplanted by the issuance of Rec. Proc. 97-27, 1997-21 IRB, which is now to stand as the general-purpose procedure for changing accounting methods. The conclusions set forth above are unchanged by Rev. Proc. 97-27.