Category: Accounting Periods & Methods
Subject: Publisher's Election to Defer Prepaid Subscription Revenue under Section 455
Title: Effects of Failure to Make Affirmative Election
IRC Sections: 455
Filename: 1286.html
Date Produced: 11/95

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Background
Taxpayer, TP, is in the magazine publishing business. TP has a 9/30 fiscal year. There is a special election under Section 455 which allows accrual basis taxpayers to defer prepaid subscription revenue. TP defers such prepaid revenue for tax purposes; however, it has just come to the attention of TP's tax advisors that no election under Section 455 was ever made. TP's first use of the deferral method for prepaid subscriptions was a number of years ago but after 1958.

Issue
What must be done?

Discussion
It is very clear under Section 455(c)(1) and Regulation Section 1.455-6 that an affirmative election is required and that Section 455 treatment is forbidden absent such an affirmative election.

These rules have existed in essentially their current form since the enactment of Section 455 in 1958 and the adoption of the underlying regulations in 1962.

In the first year in which a taxpayer has prepaid subscription revenue, deferral treatment can be elected without consent of the Commissioner. Thereafter, consent must be obtained prior to use of the deferral method. Sections 455(c)(3)(A) and 455(c)(3)(B). The election applies only on a prospective basis. Section 455(c)(4). Accordingly, when a taxpayer changes from an accrual method of accounting to deferral under Section 455, no Section 481(a) adjustment is required.

Revenue Procedure 84-76, 1984-2 CB 751, provides a streamlined method of obtaining consent to use the deferral method of Section 455 which waives the various time requirements set forth in the regulations under Section 455 and allows the consent request to be made with a timely filed tax return. It is not clear under Revenue Procedure 84-76 whether Form 3115 must be filed. The Rev. Proc. makes no mention of it; however, Form 3115 does provide an area for this type of election.

Under normal circumstances, TP could elect prospectively under Section 455 for the tax year ended September 30, 1995. Any prepaid subscription revenue received in the fiscal year then ended could be deferred under the rules of Section 455. It is very tempting to simply file the 9/30/95 return with the appropriate election under Rev. Proc. 84-76 and ignore the past. It seems to me, however, that this is a very risky proposition for the following reasons.

1. Rev. Proc. 84-76 requires the taxpayer to state under penalty of perjury the method of accounting currently in use. If TP simply states that the accrual method of accounting is used and fails to disclose that prepaid subscription revenues are being improperly deferred, it seems to me that TP and all the professionals involved could be in big trouble. If the facts are completely and honestly disclosed, I think the Service could very well launch a vigorous attack.

2. If the Service really does require Form 3115, then we have to disclose that TP is using a Category A method. I think it is fairly likely that the Service really does require Form 3115. If so, there is very little chance of having the problem with the past go unnoticed.

I advocate filing for a change in accounting method using Form 3115 and under the general rules of Rev. Proc. 92-20 for the tax year ending 9/30/96. TP would disclose the existence of a Category A method. Note that a user fee is required without which Form 3115 is invalid. Currently, the user fee is $900; however, this should be confirmed at the time of filing.

Notwithstanding the fact that a normal election of Section 455 does not give rise to an adjustment under Section 481(a), I believe that such an adjustment will arise in this case equal to the amount of revenue improperly deferred as of the beginning of the tax year 9/30/96. The critical issue is the disposition of that balance. Rev. Proc. 92-20 provides that a positive Sec. 481(a) adjustment, (i.e., an increase in income) is generally taken into over three tax years starting with the year of change. There is an exception if 90% or more of the Sec. 481(a) adjustment arose in the year preceding the year of change in which case the whole adjustment is taken in the year of change. I suggest looking at this issue very carefully.

With respect to the tax year 9/30/95, TP must continue with the erroneous accounting method. TP has established a method of accounting for prepaid subscription revenue (even though the method is illegal without an affirmative election). It is very well settled that a taxpayer cannot change accounting methods, even and erroneous accounting method, without the Commissioner's consent. I advocate disclosure in the return accompanied by a statement that permission has been applied for with respect to the 9/30/96 tax year.

Once Form 3115 is filed, prior years are protected. I suggest filing prior to submission of the return for the 9/30/95 tax year.

The client needs to be made aware of the following risk. In Section 10.01 of Rev. Proc. 92-20, the Service reserves the right to refuse processing of Form 3115. They also reserve the right to force the taxpayer to take the Section 481(a) adjustment into account in whatever manner they deem appropriate in the interest of sound tax administration. Accordingly, the Service might refuse to process Form 3115 in favor of attacking prior years. In the alternative, the Service might force TP to take the Section 481(a) adjustment into income immediately notwithstanding the general three year spread.

In order to intelligently file Form 3115 and comply with the numerous detailed requirements set forth in Rev. Proc. 92-20, it is indispensable that you the preparer study the full text of the Rev. Proc. If you need a copy, I will be happy to provide it.