Correction of erroneous recognition of income wasn’t accounting method change
Legal Advice Issued by Field Attorneys 20180601F
In Legal Advice Issued by Field Attorneys (LAFA), IRS has concluded that, where a taxpayer purchased 100% of the common stock of a real estate investment trust (REIT) owned by a failed bank pursuant to a standard FDIC purchase and assumption agreement, erroneously treated the assets of the REIT as its own assets, and, as a result, erroneously recognized income, its correction of that recognition was not an accounting method change.
Background—purchases of assets of failed banks. Code Sec. 597 was enacted in ’81 in response to a crisis in the savings and loan industry. It provides the tax treatment of transactions in which a troubled financial institution receives federal financial assistance (FFA) from the Resolution Trust Corporation, the Federal Deposit Insurance Corporation (FDIC), or any similar instrumentality of the U.S. government (Agency). The term “Institutions” includes both the troubled financial institutions and those that acquire the troubled institutions’ assets and liabilities in a transaction facilitated by an Agency.
During the tax years at issue, Reg. § 1.597-3(a) provided that, for all federal income tax purposes, an Institution is treated as the owner of all assets covered by a “loss guarantee”, regardless of whether Agency otherwise would be treated as the owner under general principles of income taxation. A loss guarantee is, generally, an agreement pursuant to which Agency guarantees or agrees to pay an institution a specified amount upon the disposition or charge-off (in whole or in part) of specific assets. (Reg. § 1.597-1(b))
RIA observation: Reg. § 1.597-3(a) was amended effective Oct. 19, 2017, but none of the amendments affect the rule described above for purposes of this LAFA.
For purposes of the rules that apply to transactions in which a troubled financial institution receives FFA from an Agency, with exceptions not relevant here, the purchase price of assets acquired in a taxable transfer is the cost of the assets acquired. (Reg. § 1.597-5(d)(1)) With exceptions not relevant here, the purchase price determined under Reg. § 1.597-5(d)(1) is allocated among the assets transferred in the taxable transfer in the same manner as amounts are allocated among assets under Reg. § 1.338-6(b), Reg. § 1.338-6(c)(1) and Reg. § 1.338-6(c)(2). (Reg. § 1.597-5(d)(2)(i)) The basis of Class I (cash and general deposit accounts, see Reg. § 1.338-6(b)(1)) and Class II (actively traded personal property within the meaning of Code Sec. 1092(d)(1), see Reg. § 1.338-6(b)(2)(ii)) assets equals their fair market value. If the fair market value of the Class I and Class II assets exceeds the purchase price for the acquired assets, the excess is included ratably as ordinary income by the new or acquiring entity over a 6-year period, beginning in the year of the taxable transfer. (Reg. § 1.597-5(d)(2)(iii))
Background—accounting method changes. A change in accounting method is a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan. A “material item” is any item involving the proper time for the inclusion of the item in income or the taking of a deduction. (Reg. § 1.446-1(e)(2)(ii)(a)) In determining whether timing is involved, the pertinent inquiry is whether the accounting practice permanently affects the taxpayer’s lifetime income or merely changes the tax year in which taxable income is reported. (Primo Pants Co., (1982) 78 TC 705) If the practice merely changes the tax year in which the income is reported and does not permanently affect lifetime income, the practice is a change in method of accounting. (Humphrey, Farrington & McClain, TC Memo 2013-23)
Reg. § 1.446-1(e)(2)(ii)(b) sets forth several adjustments that will not be considered a change in accounting method, including “a correction of mathematical or posting errors, or errors in computation of tax liability (such as errors in computation of foreign tax credit, net operating loss, percentage depletion or investment credit)”.
To the extent a taxpayer’s change constitutes a change in method of accounting, rather than an error, a Code Sec. 481(a) adjustment is appropriate. In any year in which taxpayer uses a different tax accounting method from the method used in the preceding year, adjustments must be made under Code Sec. 481(a) to prevent items of income or expense from being duplicated or entirely omitted. The adjustments can be either positive or negative (i.e., increasing or decreasing taxable income). (Reg. § 1.481-1(b); Reg. § 1.481-1(c))
Facts. Acquiring Bank (the Taxpayer) acquired the assets of Failed Bank pursuant to a standard FDIC purchase and assumption agreement. The acquired assets included 100% of the common stock of X REIT. X REIT was not a consolidated subsidiary of the Taxpayer. As such, after the acquisition, X REIT retained basis in its loans.
The Taxpayer incorrectly believed that, under Reg. § 1.597-3(a), the Taxpayer should be treated as the owner of X REIT’s loans that were covered by FDIC loss guarantees. As a result, The Taxpayer erroneously allocated an amount (phantom basis) to a special account. The Taxpayer also classified those loans as Class II assets under Reg. § 1.597-5(c)(3)(ii). At the same time, the Taxpayer treated X REIT as the owner of the loans for all other Federal income tax purposes, and X REIT continued reporting those loans at their historic cost basis amounts.
By treating X REIT’s loans as Class II assets that the Taxpayer directly acquired from Failed Bank, the Taxpayer erroneously determined that the fair market value of Class I and Class II assets exceeded the purchase price. The Taxpayer thus included an amount in gross income under Reg. § 1.597-5(d)(2)(iii) (Section 597 income) over a 6-year period.
Thereafter, the Taxpayer acknowledged that it should have allocated purchase price only to those loans it actually acquired from Failed Bank and its consolidated subsidiaries. The Taxpayer should not have included the fair market value of X REIT’s loans in the calculation; instead, it should have allocated purchase price to the X REIT stock. If the Taxpayer had done things correctly, the purchase price (the amount of deposit liabilities assumed) would have exceeded the fair market value of the Class I and II assets acquired, and no income inclusion under Reg. § 1.597-5(d)(2)(iii) would have been required.
The Taxpayer requested that IRS agree to a negative Code Sec. 481(a) adjustment so as to correct its errors.
IRS: no accounting method change, so no Code Sec. 481(a) adjustment. IRS concluded that there was no accounting method change here, and so it denied the Taxpayer’s request for a negative Code Sec. 481(a) adjustment.
The Taxpayer maintained that its erroneous inclusion of Section 597 income did not alter its lifetime taxable income, and therefore a Code Sec. 481(a) adjustment—decreasing the Taxpayer’s taxable income for prior Section 597 income inclusions—was appropriate. Specifically, the Taxpayer maintained that this income inclusion would be offset by the phantom basis because such basis would be deductible upon the Taxpayer’s disposition of its banking business. The Taxpayer argued that its fact pattern presents a question of timing difference as opposed to permanent difference.
But IRS said that, contrary to the Taxpayer’s assertions, upon disposition of its banking business, it would not be able to claim a loss in the amount of the erroneously-included Section 597 income. The Taxpayer did not acquire a cost basis in the loans of X REIT because it did not directly acquire those loans. Further, IRS said, there is no authority for the proposition that a taxpayer, by erroneously including income, obtains basis in property that it did not acquire. IRS cited several cases for its conclusion that taxpayers cannot acquire a cost basis in property that they do not own, including Draper, (1950) 15 TC 135, which held that parents could not claim a casualty loss for the jewelry and clothing of their adult daughter.
IRS said that a review of the long-term, lifetime effect on taxable income reveals that the Taxpayer’s erroneous inclusion of Section 597 income resulted in a change to the Taxpayer’s lifetime taxable income. Upon disposition of its banking business, the Taxpayer would not be entitled to a loss stemming from its erroneously included Section 597 income. In fact, X REIT, an entity separate and apart from the Taxpayer, continued to report the loans at their cost basis amounts and account for the loans as the owner. Moreover, the amount of basis that the Taxpayer should have allocated to its basis in X REIT stock was not equal and offsetting to the amount of Section 597 income. The Taxpayer’s reported Section 597 income was an error, not a material item, so that a Code Sec. 481(a) adjustment was inappropriate.
References: For federal financial assistance to domestic savings and loan associations and banks, see FTC 2d/FIN ¶ E-3800; United States Tax Reporter ¶ 5974. For accounting method changes, see FTC 2d/FIN ¶ G-2100 et seq.; United States Tax Reporter ¶ 4464.21.
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