CCA 200004004: Aircraft reclassification followed a change in business facts

Plain-English summary

A company had leased aircraft, then adopted a plan to end leasing and sell aircraft instead. It reclassified planes from depreciable assets to inventory and asked whether this required advance consent for an accounting method change. Chief Counsel advised that, on the facts presented, the new business activity changed the underlying facts, so the related reclassification was not a change in accounting method. The memo called this a close case and said its view might change if the company merely sold off assets while exiting leasing rather than entering an aircraft sales business.

Ruling snapshot

• Question: Did reclassifying the planes from depreciable assets to inventory require consent for an accounting method change?
• Outcome: Advice given: no consent required on the stated facts; factual characterization remained important.
• Key authorities: IRC § 446; Treas. Reg. § 1.446-1(e)(2)(ii).

Full text (IRS public release)

INTERNAL REVENUE SERVICE

Number: 200004004
Release Date: 1/28/2000

August 4, 1999
CC:DOM:FS:IT&A
TL-N-2316-99

UILC: 446.04-03

     INTERNAL REVENUE SERVICE NATIONAL OFFICE FIELD SERVICE ADVICE


MEMORANDUM FOR


FROM:                      Deborah A. Butler
                           Assistant Chief Counsel CC:DOM:FS

SUBJECT:


This Field Service Advice responds to your memorandum dated April 30, 1999. Field Service
Advice is not binding on Examination or Appeals and is not a final case determination. This
document is not to be cited as precedent.


LEGEND:

A                  =                               .
B                  =
Date 1            =
Date 2            =
Date 3            =
Date 4            =
Date 5            =
Tax year 1        =
Tax year 2        =

ISSUE:

       When A, under the facts described, changed the classification of its aircraft from
depreciable assets to inventory, was this a change in method of accounting requiring the
Commissioner’s advance consent.
CONCLUSION:

        Based on the facts presented in the incoming request for advice, we conclude that A’s
change from leasing to selling aircraft is a change in underlying facts, and the concomitant
reclassification of its assets, therefore, is not a change in method of accounting.

FACTS:

        The following facts are based on your incoming request for advice as well as a conference
call between the National Office and the field held on June 21, 1999.

        For approximately eight years, B, a subsidiary of A, was in the business of leasing aircraft
to major airlines. Subsequently, several of B’s major clients went out of business, and on Date 1,
A adopted a formal plan to permanently discontinue the aircraft leasing business product line of B.
B’s new line of business was selling aircraft. From the time of the decision on Date 1 to
discontinue the leasing business, B began selling its leased aircraft until all of them had been sold
by Date 3. Most of them were sold on Date 3. A reported the decision to permanently change
the business of B from that of leasing to selling aircraft in the Date 5 annual report, and it also
publicly announced the change to its shareholders and the investment community on Date 4.
        During the period of time that B was primarily engaged in leasing aircraft (from Date 2
until Date 3) it never included purchase options in its lease agreements, and when leases
terminated, B actively sought new lessees. When aircraft were no longer profitable to lease, the
planes were sold (apparently not merely for parts, based on the sale prices).

        To reflect this new business of selling aircraft, aircraft were now reported as inventory
rather than as depreciable capital assets. This conversion resulted in a substantial loss on A’s
Date 4 consolidated return. Tax years 1 and 2 are under audit, and the Date 3 corporate return
was B’s final return.

LAW:

        Treas. Reg. §1.446-1(e)(2)(ii)(a) provides that a change in the method of accounting
includes 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 which
involves the proper time for the inclusion of the item in income or the taking of a deduction.

        Treas. Reg. §1.446-1(e)(2)(ii)(b) provides that a change in the method of accounting does
not include a change in treatment resulting from a change in underlying facts. See e.g, Example 3,
Treas. Reg. §1.446-1(e)(2)(iii):

       A taxpayer in the wholesale dry goods business computes its income and
       expenses on the accrual method of accounting and files its federal income


       tax returns on such basis. Vacation pay has been deducted in the year in
       which paid because the taxpayer did not have a completely vested vacation
       pay plan, and, therefore, the liability for payment did not accrue until that
       year. Subsequently, the taxpayer adopts a completely vested vacation
       pay plan that changes its year for accruing the deduction from the year
       in which payment is made to the year in which the liability to make
       payment now arises. The change for the year of deduction of the vacation
       pay plan is not a change in method of accounting but results, instead,
       because the underlying facts (that is, the type of vacation pay plan)
       have changed.

ANALYSIS:

        A change in underlying facts, rather than a change in method of accounting, occurs when a
taxpayer continues to apply its existing method of accounting to a change in business practices, a
change in economic or legal relationships, or an otherwise altered fact situation. In Example 3,
supra, the taxpayer has applied its existing method of reporting to a changed fact situation. The
different tax consequences arose from a different legal obligation and economic condition, not
from a change in method of reporting. See generally, Stephen F. Gertzman, Federal Tax
Accounting ¶9.07 (2d ed. 1993). In this case, a change in facts occurred (now selling rather than
leasing aircraft) which necessitated an accounting change. Thus, of course, the accounting change
was a direct result of the change in facts of B’s business operations and comes under the change
in underlying facts exception to a change in method of accounting.

        It is important to note, though, that the change in underlying facts exception to a change
in method of accounting does not preclude the existence of a timing change. Rather, the
regulations allow an exception for a change in underlying facts, notwithstanding a change in
timing caused by the change in facts. See Treas. Reg. §1.446-1(e)(2)(ii)(b) and Decision, Inc. v.
Commissioner, 47 T.C. 58 (1966), acq. 1967-2 C.B. 2, infra.

         Decision is a frequently cited case for what constitutes a change in underlying facts. In
that case, taxpayer changed a business policy; it changed its advertising contract terms and billing
procedures. These changes resulted in a deferral of income when compared to its previous
contractual terms with its customers. The court stated that the change in customer contracts and
billing terms, which affected income recognition, was not a change in method of accounting.
"Although the change had consequences in the annual determination of income, such
consequences were not produced by the accounting system. In essence this kind of business
policy change was no different from a decision to lower prices or halt production for a year." 47
T.C. at 64.

        Similarly, in Angelus Funeral Home v. Commissioner, 47 T.C. 391 (1967), acq., 1969-2
C.B. 20, aff’d, 407 F.2d 210 (9th Cir. 1969), cert. denied, 396 U.S. 824 (1969), taxpayer sold
funeral plans under a contract providing that the amounts would be deposited and maintained in


trust for the benefit of the purchaser, and used only for specified purposes consistent with the
trust relationship. Subsequently, the taxpayer changed its contract to one requiring it to pay
interest to the purchaser and permitted it to use the funds as it wished. The court held that there
was not a change in method of accounting, but rather a change in facts had occurred. That is,
amounts received under the earlier contract did not have to be included in income until used for
the intended purposes, but amounts received under the later contract were includible at the time
of payment. See also Charles Schniers v. Commissioner, 69 T.C. 511 (1977) (cash basis taxpayer
entered into agreements with purchaser that payment was not due until the following year and that
taxpayer would have no rights, claim or action against purchaser for payment prior to the
succeeding year; court held that due to the agreement, there was no change in accounting
method).

        In Morris-Poston Coal Co. v. Commissioner, 42 F.2d 620 (6th Cir. 1930), taxpayer
discontinued its business of mining and selling coal and started the business of leasing its property.
The Sixth Circuit held that taxpayer was not bound by the accounting methods formerly used with
respect to its revenue from coal mining. "[T]he outstanding controlling fact is that petitioner’s
going business, with its established customs of sale and methods of bookkeeping, ended....It then
engaged in a new businessBwith the same capital...but of a different character, with different
prospective income...."

       Diebold, Inc. v. United States, 891 F.2d 1579 (Fed. Cir. 1989), aff’g, 16 Ct. Cl. 193
(1989), is different from the instant case. In Diebold, taxpayer had consistently accounted for its
replacement modules (used to repair ATM machines) as inventory, and then sought, by way of
amended returns, to treat them as depreciable assets without requesting the Commissioner’s
advance consent. The court held that taxpayer’s claim for refunds was based on an impermissible
change in method of accounting from the accounting method regularly used by the taxpayer in
computing income. Diebold had established the inventory method of accounting for the
replacement modules and sought to change to a different method by treating the modules
as depreciable assets rather than as inventory. Unlike the instant case, there was no factual
change to its business.

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS:

        While we have concluded, based on the facts as presented to us, that there was a change in
underlying facts and not an unauthorized change in method of accounting, this is a very close call
on this issue, and this analysis might change if the facts are other than as presented to us.




                                                                    . Second, we might be able to
argue that A never entered the business of selling planes; it simply exited the business of leasing


planes by selling the assets used in its leasing business. In that event, the cases related to a change
in business, such as Morris-Poston Coal, are inapplicable.




                                                       DEBORAH A. BUTLER



                                                 By:
                                                       GERALD M. HORAN
                                                       Senior Technician Reviewer
                                                       Income Tax & Accounting Branch
                                                       Field Service Division