The American Institute of CPAs (AICPA) recommended in a June 8 letter to the Internal Revenue Service (IRS) that taxpayers making an accounting method change for mischaracterized research and experimental expenditures (R&E expenditures) under Internal Revenue Code section 174 should compute a section 481(a) adjustment.
The AICPA explained that the current administrative framework provided to a taxpayer – who either has mischaracterized an expenditure as an R&E expenditure or has mischaracterized an R&E expenditure as a capital expenditure or an inventoriable expenditure and wishes to correct such mischaracterization – is inconsistent and confusing. Prior to the issuance of Rev. Proc. 2015-14 a taxpayer who had mischaracterized R&E expenditures as either a capital expenditure or an inventoriable cost, or vice versa, could effectuate such correction either by:
- Filing an amended tax return for the taxable year in which the mischaracterization occurred (assuming such taxable year is not barred by the statute of limitations); or
- Filing an automatic accounting method change under Appendix section 7.01 of Rev. Proc. 2011-14 to correct such mischaracterization prospectively using cut-off transition procedures.
Subsequent to the issuance of Rev. Proc. 2015-14, it is unclear:
- Whether Appendix section 7.01 applies to method changes for amounts characterized as R&E expenditures which, instead, should have been capitalized or inventoried; and
- How the IRS expects taxpayers to effectuate such mischaracterizations.
To reduce future controversy in this area, the AICPA offered three recommendations:
- Add to the Treasury and IRS Priority Guidance Plan for 2015-2016 the project regarding procedures for changing methods of accounting for R&E expenditures;
- Modify Rev. Proc. 2015-14 to add a new Appendix section 7.02 to clarify that the automatic procedures apply to corrections of expenditures mischaracterized as R&E expenditures, which, instead, should have been capitalized or inventoried, in addition to corrections for expenditures, capitalized or inventoried that should have been characterized as R&E expenditures. Method changes to correct such mischaracterizations should be implemented with a section 481(a) adjustment and receive audit protection; and
- Provide in the new Appendix section 7.02 for accounting method changes to comply with the 2014 final pilot model regulations under section 174 (Treas. Reg. § 1.174-2). These changes likewise should enable taxpayers to make the method changes with a section 481(a) adjustment and receive audit protection.
Furthermore, the AICPA recommended that to the extent taxpayers may make accounting method changes for mischaracterized R&E expenditures with a section 481(a) adjustment they should receive audit protection for prior years. This suggestion, the AICPA wrote, is in the IRS’s interest because taxpayers changing from a method where R&E expenditures have been improperly capitalized or included in inventory would have an economic incentive to voluntarily fix their prior erroneous method.
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