Section 754 election does not prevent an accounting method change

Plain-English summary

A partnership deferred gains, losses, income, and deductions from securities held through basket transactions until the contracts ended. IRS examiners determined that the partnership beneficially owned the securities and proposed a change to recognize those items earlier, together with a section 481(a) adjustment. The partnership argued that the correction was not an accounting method change because recalculating prior section 734(b) basis adjustments under its section 754 election would create a permanent difference in lifetime taxable income. Chief Counsel rejected that argument because the accounting-method inquiry is made at the partnership level and the elective basis adjustments do not change the partnership's total lifetime income. The sections 446 and 481 correction therefore remained a change in accounting method regardless of the section 754 election or how earlier section 734(b) adjustments would have differed.

Ruling snapshot

• Question: Does a section 754 election prevent a correction from being an accounting method change when earlier section 734(b) basis adjustments would differ under the new method?
• Outcome: Advice given, the correction remains an accounting method change under sections 446 and 481.
• Key authorities: IRC §§ 446, 481, 701, 702, 705, 731, 734, and 754; Treas. Reg. §§ 1.446-1 and 1.481-2

Full text (IRS public release)

Office of Chief Counsel
Internal Revenue Service
Memorandum
Number: 201521012
Release Date: 5/22/2015
CC:PSI:01
POSTF-140487-12

UILC: 734.00-00, 754.00-00,
446.04-00, 481.00-00

date: June 20, 2014

 to:   Associate Area Counsel, Philadelphia (CC:LB&I:HMT:PHI1)
       (Large Business & International )

from: Chief, Branch 1
(Passthroughs & Special Industries)

subject: Change in Accounting Method and IRC § 734(b) Adjustments

This memorandum responds to your request for assistance. This advice may not be
used or cited as precedent.

LEGEND

Taxpayer = ----------------------------------

Bank = ---------------------------

Years = --------------------

ISSUE

Does an adjustment otherwise constituting a change in accounting method under IRC
§§ 446 and 481 still constitute a change in accounting method if Taxpayer had an
election under IRC § 754 in effect for taxable years prior to the year of change and its
basis adjustments under IRC § 734(b) would have been different if the new accounting
method had been used in all taxable years prior to the year of change?

CONCLUSION

An adjustment otherwise constituting a change in accounting method under IRC §§ 446
and 481 constitutes a change in accounting method regardless of whether Taxpayer
POSTF-140487-12 2

made an election under IRC § 754 and its IRC § 734(b) basis adjustments would have
been different if the new accounting method had been used in all taxable years prior to
the year of change.

FACTS

Taxpayer (a limited liability company that is treated as a partnership for federal tax
purposes) purchases and disposes of positions in securities. Taxpayer generally
engages in daily trading of such positions. Taxpayer has conducted much of its
securities trading under various “Barrier Basket Transactions” (Basket Transactions)
with Bank, a broker and investment bank. In a typical Basket Transaction, Taxpayer
makes an upfront payment of 10 percent of the notional amount referenced in the
Basket Transaction. Bank provides the remaining 90 percent, the total amount of which
is used to acquire a “basket” of securities that is actively traded and managed by
Taxpayer’s affiliate on an ongoing basis. The contract between Taxpayer and Bank
describes Taxpayer’s investment as a “premium” that gives Taxpayer the “option” to
receive a cash settlement amount from Bank when the contract expires or is otherwise
terminated. Each contract is for at least a year. The cash settlement amount is
determined by a formula that generally reflects the increase (decrease) in the value of
the securities, including expense and income payments made or received with respect
to the securities held and traded within the Basket Transaction and the interest and fees
payable to Bank for its services and capital. Taxpayer does not recognize gains,
losses, income, or deductions as it trades the securities within the Basket Transaction.
Instead, Taxpayer defers recognition of any tax consequences until the Basket
Transaction expires or otherwise terminates, when Taxpayer recognizes gain equaling
the difference between the cash settlement amount and the upfront payment made.

During the period it engaged in the Basket Transactions, Taxpayer redeemed the
interests of several withdrawing partners. In each case, the distribution exceeded the
withdrawing partner's basis in its interest in Taxpayer, and as a result, the withdrawing
partner recognized gain under IRC § 731. Because Taxpayer had an election under
IRC § 754 in effect, Taxpayer increased its basis in its assets under IRC § 734(b) to
account for the withdrawing partner’s IRC § 731 gain.

Taxpayer’s federal income tax returns for Years are currently under examination by the
Internal Revenue Service. Based upon its review, Field Operations has determined that
the Basket Transactions lack the requirements to be treated as options to purchase
property for tax purposes. Further, Field Operations has determined that Taxpayer had
the burdens and benefits of ownership of the securities underlying the Basket
Transactions, and thus held the beneficial ownership of these securities for tax
purposes. Accordingly, Field Operations has challenged Taxpayer’s deferral of gains,
losses, income, or deductions associated with the Basket Transactions. Field
Operations intends to place Taxpayer on a correct accounting method consistent with
its ownership of the securities. This accounting method will not permit Taxpayer to
defer reporting the relevant gains, losses, income, or deductions until the Taxpayer
POSTF-140487-12 3

identified Basket Transactions expire or terminate but will instead require Taxpayer to
recognize these gains, losses, income, or deductions at a much earlier time, consistent
with Field Operations’ conclusion that Taxpayer, and not Bank, was the owner of each
asset held within the basket. Pursuant to this accounting method change, Field
Operations intends to impose an adjustment under IRC § 481(a) in the first taxable year
under examination.

Previously, advice was provided to Field Operations that a change to no longer treating
certain securities transactions as options and thus, stopping the deferral of the gains,
losses, income, or deductions associated with those transactions, is a service imposed
change in accounting method under IRC § 446. Further, the Advice noted that the
computation and recognition of an appropriate adjustment under IRC § 481(a) was
needed to eliminate any distortions (duplications or omissions of income or deductions)
caused by the accounting method change.

If Taxpayer had correctly accounted for the securities under the new accounting method
imposed by Field Operations, it would have recognized income attributable to the
securities much earlier, and Taxpayer’s resulting income would have been allocated to
all partners, including those who were redeemed, increasing their basis in their interests
in Taxpayer under IRC § 705. These basis increases would have resulted in the
redeemed partners recognizing less § 731 gain upon redemption, and thus Taxpayer’s
IRC § 734(b) adjustments would have been smaller.

Taxpayer agrees that its IRC § 734(b) adjustments would have been smaller had it used
the new accounting method in all prior taxable years. However, Taxpayer asserts that
the proposed accounting method change would create a permanent difference in its
lifetime taxable income because its IRC § 734(b) adjustments will be reduced, and that,
therefore, Field Operation’s proposed treatment of the Basket Transactions does not
involve a change in accounting method. Field Operations has requested advice
concerning whether its proposed treatment of the Basket Transactions is a change in
accounting method notwithstanding Taxpayer’s IRC § 734(b) adjustments.

LAW AND ANALYSIS

IRC § 446(b) provides that if no accounting method has been regularly used by the
taxpayer, or if the method used does not clearly reflect income, the computation of
taxable income shall be made under such method as, in the opinion of the Secretary,
does clearly reflect income. See also Treas. Reg. § 1.446-1(b)(1).

The Commissioner has broad discretion in determining whether a taxpayer’s accounting
method clearly reflects income, and the Commissioner’s determination must be upheld
unless it is clearly unlawful. See Thor Power Tool Co. v. Commissioner, 439 U.S. 522,
532-3 (1979), RCA Corp. v. United States, 664 F.2d 881, 886 (2nd Cir. 1981).
POSTF-140487-12 4

Treas. Reg. § 1.446-1(e)(2)(ii)(a) provides that a change in accounting method 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''
includes ''any item that 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)(a). In determining whether
timing is involved, generally the pertinent inquiry is whether the accounting practice
permanently affects the taxpayer's lifetime taxable income or merely changes the
taxable year in which taxable income is reported. See Rev. Proc. 2002-18, 2002-1 C.B.
678, section 2.01, Rev. Proc. 91-31, 1991-1 C.B. 566, Primo Pants Co. v.
Commissioner, 78 T.C. 705, 723-724 (1982), Knight Ridder Newspapers, Inc. v. United
States, 743 F.2d 781, 798 (11th Cir. 1984), Huffman v. Commissioner, 126 T.C. 322,
343 (2006), Peoples Bank & Trust Co. v. Commissioner, 415 F.2d 1341, 1344 (7th Cir.
1969). If the accounting practice does not permanently affect the taxpayer’s lifetime
taxable income, but does or could change the taxable year in which taxable income is
reported, it involves timing and is therefore an accounting method.

For purposes of section 446, lifetime taxable income is analyzed with respect to the
item(s) at issue solely at the partnership level. See, e.g., Treas. Reg. § 1.481-2(c)(5)(i).
Accordingly, it is appropriate to disaggregate the elective basis adjustments relating to a
departing partner’s recognition of partnership built-in-gain, and the change in a partner’s
basis resulting from the change in timing of the item’s recognition, which are irrelevant
to the determination of whether the change in the timing of recognition of gains, losses,
income, or deductions resulting from trades of the securities within the Basket
Transaction constitutes a method of accounting for purposes of sections 446 and 481.

Partnerships are flow-through entities that do not pay an entity-level income tax under
IRC § 701. Instead, under IRC § 702, each partner must take into account in
determining their income tax their distributive share of the partnership’s income. IRC
§ 705 provides in part that each partner's basis in their partnership interest is increased
by their distributive share of income from the partnership.

IRC § 731(a)(1) provides in part that in the case of a distribution by a partnership to a
partner, gain shall be recognized by the partner to the extent that any money distributed
exceeds the adjusted basis of the partner's interest in the partnership immediately
before the distribution. Unless the partnership increases the basis of its assets to reflect
the IRC § 731(a)(1) gain recognized by the withdrawing partner, there may be a
temporary distortion in the income recognized by the remaining partners, who may be
taxed on the built-in gain economically attributable to the redeemed partner.

To eliminate these timing distortions, IRC § 734(b)(1) provides in part that, if the
partnership has an election under IRC § 754 in effect, the partnership shall increase the
adjusted basis of partnership property by the amount of any gain recognized to the
distributee partner under IRC § 731(a)(1). The partnership takes any IRC § 734(b)
adjustments into account when calculating its gain or loss upon sale or disposition of
property subject to an IRC § 734(b) adjustment. The purpose and effect of an election
POSTF-140487-12 5

under IRC § 754 and basis adjustments under IRC § 734(b) are to eliminate distortions
in the timing of income and loss. An election under IRC § 754 does not affect the total
income recognized by all the partners over the life of the partnership.

When there is a change in accounting method to which IRC § 481(a) is applied, income
for taxable years preceding the year of change must be determined under the
accounting method that was then used, and income for the year of change and the
following taxable years must be determined under the new accounting method as if the
new method had always been used. Accordingly, Taxpayer’s IRC § 734(b) adjustments
for years preceding the year of change must be computed using the accounting method
that was then used. Taxpayer’s IRC § 734(b) adjustments for the year of change and
subsequent years must be redetermined consistent with the new accounting method.

In computing the net § 481(a) adjustment, a taxpayer must take into account all relevant
accounts. See Rev. Proc. 2002-18, section 2.04(1), Rev. Proc. 97-27, 1997-1 C.B. 680,
section 2.05(1). Here, the IRC § 481(a) adjustment represents the difference in gain or
loss for all of the underlying securities that would have been recognized under the new
method, less the gain or loss that was recognized under the prior method as of the
beginning of the year of change. Taxpayer’s IRC § 734(b) adjustments for taxable
years prior to the year of change, as calculated under the prior method, are fully taken
into account in calculating the basis in the securities. In addition, beginning in the year
of change, Taxpayer’s basis in its securities will be modified to reflect the gain or loss
recognized in connection with the change in accounting method.

The determination of whether a partnership has a change in accounting method does
not depend on whether the partnership made an election under IRC § 754, whose only
purpose and effect is to eliminate distortions caused by partnership distributions and
sales of partnership interests. The partners of a partnership using a given accounting
method ultimately recognize the same amount of cumulative taxable income over the
life of the partnership whether or not the partnership makes an election under IRC §

754. A change in accounting method under IRC § 446 occurs when
     Taxpayer/partnership no longer treats certain securities transactions as options and
     thus, stops deferring the gains, losses, income, or deductions associated with those
     transactions.

CASE DEVELOPMENT, HAZARDS, AND OTHER CONSIDERATIONS

No opinion is expressed or implied on whether Taxpayer’s transactions constitute
options under IRC § 1234.
POSTF-140487-12 6

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine the ability of the Internal Revenue Service to protect the
privileged information. If disclosure is determined to be necessary, please contact this
office for our views.

Please call Benjamin Weaver at (202) 317-6769 if you have any further questions.

                                     Sincerely,



                                     ________________________________
                                     David R. Haglund
                                     Chief, Branch 1
                                     Office of the Associate Chief Counsel
                                     (Passthroughs & Special Industries)