The American Institute of CPAs has recommended to the IRS that taxpayers making an accounting method change for mischaracterized research and experimental expenditures under Code Section 174 should compute a Section 481 (a) adjustment.

In its June 8 letter to the IRS, 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.

The AICPA said that 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:
1. 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;

2. 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, 

3. 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. section 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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