Rev. Proc. 85-8

Rev. Proc. 85-8

SECTION 1. PURPOSE

01 The purpose of this revenue procedure is to provide a procedure for accrual basis taxpayers to change their method of accounting for bad debts from the specific charge-off method as provided in section 166(a) of the Internal Revenue Code to the reserve method as provided in section 166(c). This revenue procedure also applies to financial institutions that desire to change their method of accounting for bad debts from the specific charge-off method to the reserve method permitted in sections 585, 586, and 593 of the Code. Taxpayers complying with the provisions of this revenue procedure will be deemed to have obtained the consent of the Commissioner of Internal Revenue to change to the reserve method for deducting bad debts.

02 This revenue procedure clarifies and modifies Rev. Proc. 82-19, 1982-1 C.B. 463, by providing that it is the exclusive procedure available to taxpayers to use to change their method of accounting for bad debts from the specific charge-off method to the reserve method. Rev. Proc. 82-19, as clarified and modified, is superseded by this revenue procedure.

SEC. 2. BACKGROUND

01 Under Rev. Proc. 82-19, a taxpayer could expeditiously change its method of accounting for bad debts from the specific charge-off method to the reserve method by filing a Form 3115, Application for Change in Accounting Method, with its timely filed federal income tax return. Unless a letter was received by the taxpayer from the Service denying permission to change to the reserve method because the Form 3115 was not timely filed, it could be assumed by the taxpayer that the change had been granted. Taxpayers had to comply with all the specific conditions of Rev. Proc. 82-19 for the change to be deemed to have been made with the consent of the Commissioner.

02 Section 446(e) of the Code and section 1.446-1(e) of the Income Tax Regulations provide that in order to change a method of accounting for federal income tax purposes, the taxpayer must obtain the consent of the Commissioner. Section 1.446-1(e)(3)(i) requires that in order to obtain the consent, an application must be filed within 180 days after the beginning of the tax year in which the taxpayer desires to make the change. Section 1.446-1(e)(3)(ii) authorizes the Commissioner to prescribe administrative procedures setting forth the limitations, terms, and conditions deemed necessary to permit a taxpayer to obtain consent to a change in its method of accounting in accordance with section 446(e).

03 Section 481(a) of the Code requires that those adjustments necessary to prevent amounts from being duplicated or omitted be taken into account when the taxpayer's taxable income is computed under a method of accounting different from the method used to compute taxable income for the preceding tax year.

04 Section 1.585-2(d)(2) and (3) of the regulations provide that commercial banks changing their method of accounting for bad debts from the specific charge-off method to the reserve method will compute the initial balance of the reserve at the close of the year of change and deduct the initial balance over a period of 10 years or over a shorter period as may be approved by the Commissioner.

05 Section 1.593-1(a) of the regulations provides that mutual savings banks not having capital stock represented by shares, domestic building and loan associations, and cooperative banks without capital stock organized and operated for mutual purposes and without profit that desire to change their method of treating bad debts must file an application for permission to change at least 30 days prior to the close of the tax year for which the change is to be effective.

SEC. 3. SCOPE

This revenue procedure applies to taxpayers that employ the accrual method as their overall method of accounting and desire to change from the specific charge-off method to the reserve method for deducting bad debts. This revenue procedure also applies to financial institutions that desire to change their method of accounting for bad debts from the specific charge-off method to the reserve method permitted in sections 585, 586, and 593 of the Code.

SEC. 4. CHANGES

01 This revenue procedure is the exclusive procedure available to taxpayers that come within its scope.

02 Subsection 5.03 provides a procedure to determine the appropriate period for taking into account the section 481(a) adjustment. Under Rev. Proc. 82-19, the adjustment period could not exceed 10 tax years. Under this revenue procedure, the adjustment period cannot exceed 6 tax years.

03 Paragraph 5.03 (3) provides that cooperatives may take the section 481(a) adjustment into account in the year of change.

04 Subsection 5.04 provides that any portion of any net operating loss arising in the year of change or in any subsequent year in the adjustment period that is attributable to the negative section 481(a) adjustment may not be carried to those 3 tax years preceding the year of change of which section 172 of the Code otherwise would require it first to be carried.

05 Subsection 6.01 provides in effect that commercial banks are not to compute a section 481(a) adjustment as of the beginning of the year of change but rather are to determine the amount of the reserve for bad debts under section 1.585-2(d) of the regulations. Under Rev. Proc. 82-19 a section 481(a) adjustment was required to be computed as of; the beginning of the year of change with no specific reference to banks subject to section 1.585-2(d) of the regulations.

06 Subsection 8.01 provides that the Service will no longer acknowledge receipt of the copy of the Form 3115 beginning with the publication date of this revenue procedure.

SEC. 5. APPLICATION

01 APPROVAL. In accordance with section 1.446-1(e)(3)(ii) of the regulations, the 180-day rule is waived and under section 1.446-1(e)(2)(i) consent is hereby granted to taxpayers using the accrual method of accounting to change from the specific charge-off method of accounting to the reserve method of accounting for bad debts. This consent is granted for the tax year for which the taxpayer requests a change (year of change) by filing a current Form 3115 in the manner described in section 8 of this revenue procedure and by otherwise complying with the provisions of this revenue procedure. See section 7 of this revenue procedure regarding compliance with the conditions of this revenue procedure.

02 SECTION 481(a) ADJUSTMENT.

(1) An adjustment is required under section 481(a) of the Code to prevent deductions from being omitted when a change in method of accounting is made under the provisions set forth in this revenue procedure. The adjustment, which is negative in this case, referred to as the "section 481(a) adjustment," shall be taken into account in computing taxable income and in computing earnings and profits in the manner provided in section 5.03 below. See Rev. Proc. 79-47, 1979-2 C.B. 528, as to earnings and profits. The approved change shall be considered to be a change in method of accounting initiated by the taxpayer.

(2) A change to the reserve method for both installment and trade account receivables will require that separate section 481(a) adjustments be computed and that separate reserves be maintained.

(3) The amount of the section 481(a) adjustment shall be an amount determined by dividing total net losses on bad debts (bad debt losses less bad debt recoveries) for the 5 tax years preceding the tax year of change (or of the number of years in existence if less than 5 years) by the sum of the amount of outstanding trade receivables at the close of those tax years used above, and then multiplying the amount of outstanding trade receivables at the close of the tax year preceding the year of change by the resulting decimal amount.

03 SECTION 481 ADJUSTMENT PERIOD.

(1) The appropriate period for taking into account the section 481(a) adjustment referred to in section 5.02 is generally determined as follows:

(a) When the entire amount of the section 481(a) adjustment is attributable to the tax year immediately preceding the year of change (first preceding year), the total adjustment is to be taken into account in computing taxable income for the year of change. The amount attributable to the tax year immediately preceding the year of change is the difference in the amount of the adjustment determined under section 481(a) of the Code for the year of change and the amount of the adjustment that would have been required under section 481(a) if the change to the reserve method of accounting for bad debts had been made in the preceding year.

(b) When subparagraph (a) of this paragraph 5.03(l) does not apply and 67 percent or more of the amount of the section 481(a) adjustment is attributable to the 1-tax year period, 2-tax year period, or 3-tax year period immediately preceding the year of change, the highest percent attributable to the 1, 2, or 3-tax year period is to be taken into account ratably over a 3-tax year period beginning with the year of change. Any remaining balance will be taken into account ratably over an additional period equal to the remainder of the number of tax years the taxpayer has used the method of accounting that is being changed. However, the total adjustment period shall not exceed 6 tax years. This subparagraph, 5.03(1)(b), only applies if the taxpayer has used the method being changes for more than 3 years. If the specific change-off method of accounting for bad debts has been used for no more than 4 tax years, 75 percent shall be substituted for 67 percent. An amount attributable to the 1, 2 or 3-tax year period is the difference in the amount of the adjustment determined under section 481(a) of the Code for the year of change and the amount that would have been required under section 481(a) if the change to the reserve method of accounting for bad debts had been made at the beginning of the preceding 1, 2, or 3-tax year period.

(c) In all other situations in which subparagraphs (a) and (b) of this paragraph 5.03(1) do not apply, the total section 481(a) adjustment is to be taken into account ratably over the number of tax years (not to exceed 6) the taxpayer has used the specific charge-off method of accounting.

(2) In applying paragraph 5.03(l), if a taxpayer's books and records do not contain sufficient information to compute the section 481(a) adjustment attributable to the 1, 2, or 3-tax year period immediately preceding the year of change, the taxpayer may reasonably estimate the amounts and attach the computations upon which the estimates are based and attach and sign the following statement to the Form 3115:

Under penalty of perjury, I hereby certify that:

(a) the books and records of (name of the taxpayer) do not contain sufficient information to permit a computation of the section 481(a) adjustment attributable to the 1-tax year period, 2-tax year period, or 3-tax year period immediately preceding the year of change as required by paragraph 5.03(l) of Rev. Proc. 85-8.

(b) Based on the information that is contained in such records, to the best of my knowledge and belief, the entire amount of the section 481(a) adjustment for the year of change (indicate either "is" or "is not", as the case may be) attributable to the tax year immediately preceding the year of change, and 67 percent (or "75 percent," in applicable cases) or more of the section 481(a) adjustment or the year of change (indicate "is" or "is not", as the case may be) attributable to the 1-tax year period, 2-tax year period, or 3-tax year period immediately preceding the year of change.

(3) A cooperative, within the meaning of section 1381(a) of the Code, shall generally take the total amount of the adjustment into account in computing taxable income for the year of change. See Rev. Rul. 79-45, 1979-1 C.B. 284. The Service in its discretion may, however, require the adjustment to be taken into account ratably over a period of tax years when it determines that this action is appropriate.

04 NET OPERATING LOSS.

Any portion of any net operating loss arising in the year of change or in any subsequent year in the adjustment period that is attributable to the negative section 481(a) adjustment may not be carried to those 3 tax years preceding the year of change to which section 172 of the Code otherwise would require it first to be carried.

05 CEASING TO ENGAGE IN THE TRADE OR BUSINESS.

(1) WITH RESPECT TO A CORPORATION:

If the taxpayer ceases to engage in the trade or business to which the section 481(a) adjustment (subsections 5.02 and 5.03) relates at any time prior to the expiration of the adjustment period referred to in subsection 5.03, the taxpayer shall take into account in that year the balance of the adjustment not previously taken into account in computing taxable income. See Rev. Rul. 80-39, 1980-1 C.B. 112, which holds that if a division of a corporation for which a change in method of accounting had been granted ceases to operate the trade or business for which the change in method was granted, the remaining section 481(a) adjustment applicable to the business conducted by that division of the corporation must be taken into income if the corporation ceases to engage in that trade or business. For purposes of this condition, the taxpayer is not considered to have ceased the trade or business if the cessation is the result of a transaction to which section 381 of the Code applies, but in that case the acquiring corporation shall continue to be subject to this revenue procedure as though it were the acquired corporation.

(2) WITH RESPECT TO A PARTNERSHIP:

In the event a partnership terminates or ceases to engage in the trade or business (within the meaning of section 708 of the Code) to which the section 481(a) adjustment (subsections 5.02 and 5.03) relates at any time prior to the expiration of the adjustment period referred to in subsection 5.03, the balance of the adjustment not previously taken into account in computing ordinary income shall be taken into account in that year. A partnership ceasing to engage in the trade or business includes the incorporation of such trade or business in a transaction to which section 351 applies. See Rev. Rul. 77-264, 1977-2 C.B. 187.

(3) WITH RESPECT TO A SOLE PROPRIETOR:

If the individual (sole proprietor) ceases to engage in the trade or business to which the section 481(a) adjustment (subsections 5.02 and 5.03) relates at any time prior to the expiration of the adjustment period referred to in subsection 5.03, the balance of the adjustment not previously taken into account in computing taxable income shall be taken into account in the year of cessation. A sole proprietor ceasing to engage in the trade or business includes the incorporation of such trade or business in a transaction to which section 351 of the Code applies (see Rev. Rul. 77-264). A sole proprietorship does not cease to engage in that trade or business when the individual taxpayer sells a partial interest in the proprietorship and continues to be actively engaged in the management of the business that is subsequently operated as a partnership. The section 481(a) adjustment remaining at the time the partnership is formed is taken into account by the sole proprietor as though there had been no change in ownership. See Rev. Rul. 66-206, 1966-2 C.B. 205.

06 BAD DEBT DEDUCTION

(1) The amount of the bad debt deduction for the year of change and tax years thereafter will consist of the reasonable addition to the reserve for bad debts for each year as provided by section 166(c) of the Code, plus any amount of the section 481(a) adjustment determined in accordance with subsection 5.02 above required to be taken into account during the adjustment period.

(2) A taxpayer that changes from the specific charge-off method to the reserve method for bad debts under this revenue procedure must keep its books and records for the year of change and for later years on the reserve method.

(3) A taxpayer must take the full amount of the section 481(a) adjustment into account in determining its additions to the reserve for future years, even though it may not yet have taken all of the section 481(a) adjustment into account as a deduction in the computation of its taxable income. Also, it must file the statement required by section 1.166-4(c) of the regulations with its return for the year of change and for subsequent tax years.

(4) In computing the reserve for bad debts, a taxpayer will not include notes receivable sold without recourse or to be sold in the immediate future without recourse. Worthless debts arising from unpaid wages, salaries, fees, rents and similar items of taxable income shall not be allowed as a deduction under section 166 of the Code unless the income that these items represent has been included in the return of income for the year in which the deduction as a bad debt is claimed or included in a prior tax year.

SEC. 6. FINANCIAL INSTITUTIONS

01 Commercial banks and other financial institutions to which section 585 of the Code applies shall effect the change as provided in section 5 of this revenue procedure, but the amount of the initial balance of the reserve for bad debts shall be determined at the end of the year of change in accordance with the provisions of section 1.585-2(d) of the regulations in lieu of the manner indicated in paragraph 5.02(3) above.

02 Small business investment companies and business development corporations described in section 586 of the Code shall effect the change as provided in section 5 of this revenue procedure, but the amount of the section 481(a) adjustment shall be determined as of the beginning of the year of change in accordance with the provisions of section 586 of the Code in lieu of the manner indicated in paragraph 5.02(3) above.

03 Mutual savings banks not having capital stock represented by shares, domestic building and loan associations, and cooperative banks without capital stock organized and operated for mutual purposes and without profit shall effect the change as provided in section 5 of this revenue procedure, but the amount of the section 481(a) adjustment shall be determined as of the beginning of the years of change in accordance with the provisions of section 593 of the Code in lieu of the manner indicated in paragraph 5.02(3) above.

SEC. 7. COMPLIANCE WITH CONDITIONS

Taxpayers making a change from the specific charge-off method to the reserve method of accounting for bad debts without complying with all the conditions of this revenue procedure will be deemed to have initiated the change without obtaining the consent of the Commissioner.

SEC. 8. MANNER OF EFFECTING THE CHANGE

01 Taxpayers to which this revenue procedure applies must effect the change in their methods of accounting for bad debts pursuant to the provisions set forth in this revenue procedure by filing a current Form 3115 in duplicate. The original shall be attached to the taxpayer's timely filed federal income tax return for the year of change. A copy of the current Form 3115 shall be filed with the National Office addressed to the Commissioner of Internal Revenue, Attention: CC:C:C:1, 1111 Constitution Avenue, N.W., Washington, D.C., 20224, no later than 270 days after the beginning of the tax year of change. However, (1) mutual savings banks not having capital stock represented by shares, domestic building and loan associations, and cooperative banks without capital stock organized and operated for mutual purposes and without profit must, to comply with section 1.593-1(a) of the regulations, file their copy of a current Form 3115 with the National Office no later than 60 days after the end of the tax year in which the initial balance of the reserve for bad debts is determined. In addition to providing all of the information required on the current Form 3115, the taxpayer must state: (1) that it proposes to take the section 481(a) adjustment into account over the appropriate period required by subsection 5.03 and (2) the period over which the section 481(a) adjustment will be taken into account and the reasons for such conclusion. The Service will no longer acknowledge receipt of the copy of the Form 3115 filed as indicated in section 8.01 of Rev. Proc. 82-19 beginning with February 11, 1985. The Service will sample the Forms 3115 to determine whether the requirements of this revenue procedure have been followed. The National Office or the district director may advise the taxpayer of required adjustments to the change in method of accounting for bad debts filed under this revenue procedure. Also, if it is found that the taxpayer does not qualify for the automatic change in method of accounting under this revenue procedure, the National Office or the district director will advise the taxpayer.

02 In order to assist in the processing of these changes in method of accounting and to insure proper handling, reference to this revenue procedure, shall be made a part of the Form 3115 by either typing or legibly printing the following statement at the top of page 1 of Form 3115: "FILED UNDER REV. PROC. 85-8."

03 The signature of the person requesting the change in method of accounting must appear in the space provided for it on the Form 3115. If an agent is authorized to represent the taxpayer before the Service, to receive the original or a copy of correspondence concerning the request, or to perform any other act(s) regarding the application on behalf of the taxpayer, the power of attorney must reflect such authorization(s) and be attached to the original and copy of the Form 3115. If the taxpayer is a member of an affiliated group that has elected to file a consolidated federal income tax return, a Form 3115 submitted on behalf of the taxpayer must be signed by a duly authorized officer of the common parent. (See section 1.1502-77 of the regulations.)

04 Each member of an affiliated group desiring to make a change in method of accounting under this revenue procedure must file a separate Form 3115 in the manner described above.

SEC. 9. INQUIRIES

Inquiries regarding this revenue procedure may be addressed to the Commissioner of Internal Revenue, Attention: CC:C:C:1, 1111 Constitution Avenue, N.W., Washington, D.C. 20224.

SEC. 10. EFFECT ON OTHER DOCUMENTS

Rev. Proc. 82-19 is clarified and modified and as clarified and modified is superseded.

SEC. 11. EFFECTIVE DATE

This revenue procedure shall be effective for applications, Forms 3115, filed for tax years beginning on or after February 11, 1985, the date of its publication in the Internal Revenue Bulletin.