AICPA Comment Letter - Proposed Regulations …



AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

Comments on Proposed Regulations under Section 6655

Relating to Corporate Estimated Tax [REG-107722-00]

Developed by the

Estimated Tax Task Force

Jennifer D. Kennedy, Task Force Chair

Robert Baird

William B. Creps

David P. Culp

J. Knox Teague

Christine Turgeon

George White, AICPA Technical Manager

April 11, 2006

AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

Comments on

Proposed Regulations on Corporate Estimated Tax

under Section 6655 (REG-107722-00)

I. General Comments

On December 7, 2005, the Internal Revenue Service and Treasury Department released proposed regulations under Section 6655 of the Internal Revenue Code relating to corporate estimated tax. In releasing these regulations, the IRS and Treasury have outlined two primary purposes for updating the existing regulations under section 6655. First, the IRS and Treasury wanted to update the current regulations to reflect significant changes to the tax law since 1984, most notably the economic performance rules under section 461(h). Secondly, the IRS and Treasury desire to provide rules that will prevent taxpayers from using certain "techniques" to compute their estimated tax liability, thereby resulting in a more accurate computation of annualized income.

The AICPA applauds the IRS and Treasury for providing comprehensive rules that will assist taxpayers in calculating their estimated tax payments and agrees with the stated purposes for updating the existing proposed regulations. The AICPA also believes that the IRS and Treasury should strive to provide rules that generally allow for a more accurate computation of annualized taxable income. However, as explained in our comments below, we are concerned that the rules are too mechanical, and as a result, distort annualized taxable income and create traps for the unwary. Taxpayers who are not well-versed in these rules could easily run afoul of the regulations and miscalculate taxable income for the annualization period, which could result in unwarranted penalties. Finally, as illustrated in greater detail below, similarly situated taxpayers will be treated differently under these proposed regulations. Accordingly, the AICPA recommends that the IRS and Treasury modify the regulations to eliminate potential pitfalls, provide equitable results for similarly situated taxpayers, and relieve administrative burden.

Our comments below, primarily related to the determination of annualized taxable income, appear in the same general order as the related provisions in the proposed regulations.

II. Background

A. General Overview

Section 6655 of the Code imposes an addition to tax (i.e., a penalty) in the event of an underpayment of estimated tax by a corporation if the corporation’s income tax liability for the year exceeds $500. See sections 6655(a) and (d). The amount of the underpayment is the excess of the required installment of estimated tax over the amount (if any) of the installment paid on or before the due date for the installment. Section 6655(b)(1).

There are four required installments of estimated tax for each taxable year. In the case of a calendar year corporation, the required installments are due on or before April 15th, June 15th, September 15th and December 15th of the taxable year. Section 6655(c). In the case of a fiscal year corporation, the required installments are due on or before the 15th day of the fourth, sixth, ninth and twelfth months of the taxable year. Section 6655(i)(1).

In general, the amount of the required installment of estimated tax is equal to 25 percent of the required annual payment. Section 6655(d)(1)(A). For a “large corporation,” the required annual payment is 100 percent of the tax shown on the return for the taxable year. Sections 6655(d)(1)(B) and 6655(d)(2)(A). A “large corporation” for this purpose is a corporation that had taxable income of at least $1 million for any of the three taxable years immediately preceding the taxable year at issue. Section 6655(g)(2). For a corporation other than a large corporation, the required annual payment is the lesser of (i) 100 percent of the tax shown on the return for the taxable year, or (ii) 100 percent of the tax shown on the return for the preceding taxable year provided that the return covered a period of 12 months and showed a liability for tax. Section 6655(d)(1)(B).

B. Annualized Income Installment

In the case of any required installment of estimated tax by a corporation, the amount of such installment shall be the corporation’s annualized income installment if such amount is less than the installment otherwise determined under the rules described above (i.e., 25 percent of the required annual payment). Section 6655(e)(1).

The amount of any annualized income installment is the excess, if any, of the “applicable percentage” of the tax for the taxable year based on the corporation’s annualized taxable income for the annualization period (or, if applicable, alternative minimum taxable income or modified alternative minimum taxable income), over the aggregate amount of all prior required installments for the taxable year. Section 6655(e)(2)(A). For this purpose, the “applicable percentage” is 25 percent for the first required installment, 50 percent for the second, 75 percent for the third, and 100 percent for the last required installment for the taxable year. Section 6655(e)(2)(B)(ii).

In the case of the first and second required installments, the corporation’s annualized taxable income generally is determined by annualizing the taxable income for the first three months of the taxable year. In the case of the third and fourth required installments, the corporation’s annualized taxable income generally is determined by annualizing the taxable income for the first six and nine months, respectively, of the taxable year. Section 6655(e)(1)(A).

Alternatively, a corporation can elect to use one of two other annualization period options for purposes of determining its four required installments. Section 6655(e)(1)(C).

Under the first alternative, the corporation’s annualized taxable income for the four required installments is determined by annualizing its taxable income for the first two, four, seven and ten months, respectively. Section 6655(e)(1)(C)(i).

Under the second alternative, the corporation’s annualized taxable income for the four required installments is determined by annualizing its taxable income for the first three, five, eight and eleven months, respectively. Section 6655(e)(1)(C)(ii).

III. Simplification of 52/53 week taxable year rules

The IRS and Treasury specifically requested comments on whether the 52-53 week year rules under §1.6655-2(e) should be simplified. It is the view of the AICPA that the current rules that have been restated in the proposed regulations are too complex and thus administratively burdensome. The IRS and Treasury should consider eliminating the detailed rules contained in the proposed regulations and instead rely on the general concept of annualization, which is not defined for non-52/53 week taxpayers. In our experience, 52/53 week taxpayers know how to annualize their applicable annualization period (e.g., 3, 3, 6, 9) without reference to (or knowledge of) these proposed rules.

IV. Revenue Recognition

Prop. Reg. §1.6655-2(f)(1)(i) provides that in determining the applicable gross income for an annualization period, gross income is included in accordance with section 451. However, the proposed regulations do not address how a taxpayer that defers revenue either under Rev. Proc. 2004-34 or Treas. Reg. §1.451-5(c) should account for advance payments in determining their annualized taxable income. That is, under both of these provisions, a taxpayer generally is allowed to defer the recognition of qualifying advance payments to the extent that financial statements defer recognition, but only for a limited time (i.e., one year in the case of Rev. Proc. 2004-34 and two years following the receipt of substantial advance payments under §1.451-5(c)). To the extent income is deferred for financial statement purposes beyond this limited time, it is unclear when the remaining portion of income should be taken into account in determining annualized taxable income for the year the remaining amount must be recognized (i.e., should the remaining amount be recognized in full on the first day of the inclusion year, in full at the end of the inclusion year, ratable throughout the inclusion year, etc.).

The AICPA recommends that the IRS and Treasury include a rule in the final regulations that would allow taxpayers using a deferral method either under Treas. Reg. §1.451-5(c) or Rev. Proc. 2004-34 to recognize advance payments as revenue in the annualization period to the extent the advance payment is recognized in the taxpayer's applicable financial statements in that annualization period. To the extent any portion of the advance payment has not otherwise been recognized in the taxpayer's applicable financial statements, it should be recognized at the end of the next succeeding taxable year in the case of revenue deferred under Rev. Proc. 2004-34. Similarly, substantial advance payments for inventoriable goods that are deferred under Treas. Reg. §1.451-5(c) should be recognized based on financial statement recognition during the annualization periods with any remaining amount recognized in full at the end of the second taxable year.

In the case of revenue that is deferred under Rev. Proc. 2004-34, if the taxpayer does not have an applicable financial statement, or if the taxpayer is unable to determine, as required by the revenue procedure, the extent to which advance payments are recognized in revenues in its applicable financial statements, the IRS and Treasury should consider a rule that would require a taxpayer using the Deferral Method under Rev. Proc. 2004-34 to include the advance payment in gross income to the extent earned as determined under section 5.02(3)(b) in the applicable annualization periods for the taxable year of receipt and the next succeeding taxable year. Any remaining amount should be recognized at the end of the next succeeding taxable year. Such a rule would be consistent with Section 5.02(2) of Rev. Proc. 2004-34, which provides special rules for short taxable years. The AICPA does not believe that multi-year contracts should be treated differently than contracts of one year or less. To require taxpayers to account for multi-year contracts differently than contracts for a period of one year or less would result in a distortion of annualized taxable income.

The examples below illustrate how the rules should be applied in the case of revenue that is deferred under Rev. Proc. 2004-34. The AICPA envisions that similar principles would apply to revenue that is deferred under Treas. Reg. §1.451-5(c).

A. Example 1. On November 1, 2007, A, in the business of giving dancing lessons, receives an advance payment for a 1-year contract commencing on that date and providing for up to 48 individual, 1-hour lessons. A provides eight lessons in 2007 and another 35 lessons in 2008. In its applicable financial statement, A recognizes 1/6 of the payment in revenues for 2007, and 5/6 of the payment in revenues for 2008. A uses the Deferral Method under Rev. Proc. 2004-34. For federal income tax purposes, A must include 1/6 of the payment in gross income for 2007, and the remaining 5/6 of the payment in gross income for 2008.

For estimated tax purposes, the taxpayer in Example 1 should be permitted to recognize revenue in 2007 and 2008 in the annualization period in which the advance payment is recognized in its applicable financial statements. To require the taxpayer to recognize the remaining portion of the advance payment in the first annualization period of 2008 would result in a distortion of annualized taxable income, which would be inconsistent with one of the stated purposes for updating the existing regulations.

B. Example 2. Assume the same facts as in Example 1, except that the advance payment is received for a 2-year contract under which up to 96 lessons are provided. A provides eight lessons in 2007, 48 lessons in 2008, and 40 lessons in 2009. In its applicable financial statement, A recognizes 1/12 of the payment in revenues for 2007, 6/12 of the payment in revenues for 2008, and 5/12 of the payment in gross revenues for 2009. For federal income tax purposes, A must include 1/12 of the payment in gross income for 2007, and the remaining 11/12 of the payment in gross income for 2008.

For estimated tax purposes, the taxpayer in Example 2 should be permitted to recognize revenue for 2007 in an annualization period to the extent the advance payment is recognized in its applicable financial statements (i.e., 1/12 will follow the financial statements). In 2008, the taxpayer should recognize revenue in the annualization period to the extent the advance payment is recognized in its applicable financial statements (i.e., 6/12 of the revenues will be recognized in 2008 when the applicable financial statements recognize the revenue). The remaining portion of the advance payment should be recognized on the last day of the taxable year (i.e., 5/12 of the payment will be recognized on the last day of the taxable year).

V. Timing of Expenses

A. Definition of Incurred

The proposed regulations provide rules for determining when an expense is considered incurred in an annualization period for purposes of section 461 and thus may be taken into account in that period. Specifically, Prop. Reg. §1.6665-2(f)(1)(iii) provides that, in the case of an accrual method taxpayer, only items of deduction which have been incurred under Reg. §1.461-1(a)(2) may be taken into account in computing taxable income in the annualization period. Prop. Reg. §1.6655-2(f)(1)(iii) further provides that the provisions of section 170(a)(2) and Reg. §1.170A-11(b), Reg. §1.461-4(d)(6)(ii), Reg. §1.461-5, and any other provision that has a similar effect cannot be used in determining whether the item has been incurred. To avoid uncertainty and controversy as to what other provisions could be interpreted as having a "similar effect," the AICPA recommends that the IRS and Treasury provide an exhaustive list of rules that taxpayers may not take into account when determining whether an expense is incurred in an annualization period.

B. Expenses Incurred at the End of the Year or After Year-end

Prop. Reg. §1.6655-2(f)(2)(i) allows taxpayers to consider certain expenses incurred at the end of a tax year or after year-end as incurred ratably throughout the year. The objective of this rule appears consistent with the principle of matching revenue with related expenses and providing for a more accurate computation of annualized taxable income. However, the expenses qualifying for this exception are restricted to only those expenses incurred between the 15th day of the last month of the taxable year and the last day of the taxable year, or for expenses incurred after year-end. This arbitrary period creates significant administrative burdens, as well as a trap for unwary taxpayers who may incur the expense before this period. Moreover, this mechanical rule will treat similarly situated taxpayers differently depending upon when they incur a recurring expense, even if such expense is incurred only one day later. Accordingly, the AICPA recommends that the IRS and Treasury allow a pro rata portion of a taxpayer's recurring expenses to be taken into account during the annualization period so long as the expense will be incurred during the taxable year (or within 8 1/2 months of year-end). As explained below, such a rule would be more consistent with financial accounting principles, avoid traps for the unwary, and allow similar treatment for similarly situated taxpayers.

The AICPA believes that the proposed regulations will create significant administrative burdens for taxpayers because of the significant divergence from financial accounting principles. Taxpayers typically begin their estimated tax calculations using financial statement (“book”) income for the relevant period and then adjust that amount for book-tax differences, similar to the manner in which a tax return is prepared. Generally, financial accounting principles require recurring expenses to be accrued and recognized ratably during the year so that such expenses are matched against the related revenue. As a result, these regulations as drafted would require taxpayers to ignore their available financial accounting data and recompute their baseline book income using the mechanical rules set forth in the regulations even though there is no annual book-tax difference.

This administrative burden was not an issue with the prior proposed regulations, which also contained an end of the year rule, because there was no economic performance requirement in those regulations. The requirement that a taxpayer satisfy economic performance with respect to a particular item of expense within the annualization period in order to be able to take it into account in determining annualized taxable income is generally the cause of the significant divergence from financial statement income. At the very least, the IRS and Treasury should allow taxpayers to take into account recurring expenses that are fixed and determinable in the annualization period, so long as economic performance will be satisfied by the end of the taxable year or within 8 1/2 months of year-end. Such a rule would still accomplish the objective of the IRS and Treasury to eliminate certain "techniques" that taxpayers have been using to reduce or eliminate their quarterly estimated tax payments because the rule would only allow for a pro rata portion of the expense to be taken into account in the annualization period (rather than the full amount of the expense annualized) and would retain the annual limitations on compensation deductions.

Either of the rules proposed by the AICPA would result in a more accurate computation of annualized taxable income, yet still yield different results than a taxpayer would achieve by computing its estimated tax liability based on 25% if its actual tax liability for the year. Specifically, to the extent that an item of income is earned or expense is incurred (i.e., all three prongs under section 461 are satisfied) within the annualization period, the specific item of income or expense would be annualized, which would clearly vary from the amount of the deduction the taxpayer would actually claim in its tax return. The AICPA believes that the purpose of the annualization exception should be to provide protection against underpayment penalties for income earned late in the taxable year. Thus, the rules should strive to provide the most accurate picture of annualized taxable income based on the facts known as of the end of the annualization period. Clearly, recurring expenses are known with certainty and thus a pro rata portion should be taken into account in each annualization period.

The examples below illustrate how the proposed regulations, as drafted, create traps for the unwary and treat similarly situated taxpayers differently.

Example 1. Assume a calendar year taxpayer has a history of paying real property taxes on December 31. The lien date is January 1. In determining its annualized taxable income, the taxpayer may take into account a pro-rata portion of its real property tax expense in each annualization period under Prop. Reg. §1.6655-2(f)(2)(i) because the liability is fixed and determinable with reasonable accuracy, and the taxpayer has a history of incurring the specific item of expense between the 15th day of the last month of the taxable year and the last day of the last month of the taxable year.

Contrast this situation with a calendar year taxpayer that has a history of paying real property taxes on December 1. Under the rule in Prop. Reg. §1.6655-2(f)(2)(i), this taxpayer would be unable to take into account any portion of the real property tax expense in determining its annualized taxable income for any annualization period.

This example highlights the unfairness of the rule as drafted. The AICPA does not believe that the IRS and Treasury should promulgate rules that treat similarly situated taxpayers differently based on such an arbitrary distinction. Moreover, this rule creates a significant trap for less informed taxpayers who could lose the ability to include a deduction for a recurring expense in the computation of its annualized taxable income simply because it was paid on the 14th day of the last month of the taxable year instead of the 15th. Finally, this example also demonstrates the significant administrative burden with the recurring rule as drafted because a taxpayer would be required to redetermine its book income for an annualization period, which will include a pro rata portion of the property taxes, for estimated tax purposes even though there will be no book-tax difference in actual taxable income.

Example 2. Assume a calendar year taxpayer that uses an accrual method of accounting has a history of deducting real estate taxes on the lien date, subject to the recurring item exception of Treasury Regulations §1.461-5. Further assume that the lien is assessed on March 15, with 100 percent of the tax due on January 15 of the following year. Under the general rule for deductions, the real estate tax liability is not taken into account for purposes of determining the first annualized income installment, which is based on the income and deductions from the first three months of the tax year, because economic performance with respect to the real estate tax liability did not occur by the end of the first annualization period. However, because the taxpayer has a history of incurring the real property tax expense after year end, the taxpayer may take into account a pro rata portion of the expense beginning with the computation of its first annualized income installment.

Contrast that situation with a taxpayer who has a history of paying the expense on June 30. As in the example above, the all-events test and economic performance are not met at the end of the first annualization period. Therefore, under the general rule, the taxpayer may not take the expense into account in determining its annualized income in the first quarter. Further, because the taxpayer does not have a history of incurring the expense at the end of the taxable year or after year end, it is not eligible to take into account a pro rata portion of the real property tax expense, as was the case in the example above. Rather, the taxpayer in this case would only be able to take the expense into account in determining its third annualized installment (assuming the taxpayer uses a 3-3-6-9 methodology) because economic performance occurred on June 30, and at that point, the expense would be considered incurred for purposes of section 461.

Example 3. Assume a calendar year taxpayer that uses an accrual method of accounting has a history of deducting real estate taxes on the lien date, subject to the recurring item exception of Treasury Regulations §1.461-5. Further assume that the lien is assessed on March 15, with 100 percent of the tax due on January 15 of the following year. The taxpayer pays its real estate tax in two installments, one in November and one in January 2007. In this case, the taxpayer would be able to take into account a pro rata portion of the real property tax expense it paid in January in each of its required annual installments. However, with respect to the portion of the tax that was paid in November, the taxpayer would not be able to take any portion of that expense into account in determining its estimated tax liability.

The IRS and Treasury requested comments as to whether the final regulations should provide an additional exception, similar to the exception provided in Prop. Reg. §1.6655-2(f)(2)(i), that would permit a taxpayer to take into account for an annualization period a proportionate amount of a specific item of expense that is attributable to income earned throughout the year but incurred after the applicable annualization period. The IRS and Treasury also asked that, to the extent such an exception would be appropriate, comments be provided as to what specific types of expenses would meet the requirements of the rule, as well as whether the exception should provide for any additional limitations.

Based on the concerns expressed above, the AICPA recommends that the IRS and Treasury adopt such a rule, as it provides for a more reasonable matching of income and expenses. That is, the final regulations should allow taxpayers that have a history of incurring a specific item of expense to elect to take into account a pro-rata portion of the estimated annual expense in determining annualized taxable income for the installment period, if the item would be incurred during the taxable year or within 8 1/2 months of year-end. Such a rule would be more like the computation of financial statement income and thus result in less administrative burden for taxpayers and less traps for the unwary.

C. Developing a "History"

Prop. Reg. §1.6655-2(f)(2)(i)(B) provides that for purposes of paragraph (f)(2)(i), a taxpayer has a history of incurring or paying a specific item of expense at the end of the taxable year, or after the end of the taxable year that is deemed incurred or paid during the taxable year, if, in each of the two prior taxable years immediately preceding the current taxable year (or the immediately preceding taxable year if the taxpayer was not in existence for the two preceding taxable years), the taxpayer incurred or paid the specific item of expense at the end of each taxable year, or after the end of each taxable year in which the item was deemed incurred or paid during such taxable year.

The AICPA believes that the IRS and Treasury should eliminate the rules requiring proof of a "history" of incurring a specific item of expense in order to be able to take into account a portion of that expense in determining annualized taxable income for the installment period. As illustrated below, the general scheme of requiring a two-year history of incurring a specific item of expense (one year for new taxpayers), creates administrative burdens and traps for the unwary and treats similarly situated taxpayers that have the same recurring expenses differently.

In the case of new expenses that will be recurring, a taxpayer, under the proposed regulations, must develop a history of incurring the specific item of expense at the end of the taxable year, or within 8 1/2 months of year end, in order to be able to take a portion of the expense into account in determining annualized taxable income for the installment period. This mechanical requirement results in similarly situated taxpayers with the same recurring expense being treated differently, a trap for the unwary, and an administrative burden.

For example, assume a taxpayer purchases real property and now will incur real property taxes each year. Clearly the expense will be recurring, but the fact that the taxpayer does not have a proven history means that the taxpayer cannot take the expense into account in determining its annualized taxable income. The result of this rule is that similarly situated taxpayers will be treated differently, as other taxpayers that are incurring real property taxes during the year may take the expense into account in determining their annualized taxable income, while a taxpayer who incurs the same expense for the first time is precluded from taking the same deduction into account.

In addition, this rule creates an administrative burden for taxpayers because of the divergence from the computation of income for financial accounting purposes. As discussed above, in determining taxable income for purposes of computing the estimated tax liability, taxpayers generally begin with financial statement income for the appropriate period. In this example, the taxpayer's financial statements would include a portion of the real property tax expense in the computation of book income. For estimated tax payment purposes, however, the proposed regulations would require that the taxpayer eliminate that deduction from the computation of annualized taxable income simply because the taxpayer had not developed a "history" of incurring the expense, even though such amount would clearly be deductible in the taxpayer's federal income tax return.

Moreover, this rule also creates a trap for the unwary because many taxpayers will not realize that the new recurring expense such as real property taxes should be treated differently for purposes of computing their annualized taxable income for estimated tax purposes than the taxpayer otherwise would treat the expense in computing taxable income. That is, the taxpayer will be able to use recurring item exception under section 461 to take the real property tax deduction into account in determining its taxable income but will not be able to take the deduction into account in determining annualized taxable income for estimated tax purposes because the taxpayer has not developed the requisite proof. Because of these concerns, the AICPA recommends that the history proof requirement be eliminated from the final regulations.

In addition to creating issues for taxpayers who are incurring an item of expense for the first time, the rule in Prop. Reg. §1.6655-2(f)(2)(i)(B) also creates a problem for taxpayers who are requesting permission to change their accounting method. In order to be able to compute their annualized taxable income using the new method of accounting, the taxpayer must first develop the requisite history under Prop. Reg. §1.6655-2(f)(2)(i)(B). In other words, the taxpayer will have to use the new method of accounting for two years before it will be considered to have a history of incurring the expense either at the end of the taxable year or after year-end and therefore be able to take that expense into account in determining its annualized taxable income under the new method of accounting.

For example, assume that a calendar year taxpayer deducts rebates in the year in which the rebates are paid. On June 1, 2006, the taxpayer requests permission to change its method of accounting to use the recurring item exception beginning in 2006. The taxpayer receives consent from the IRS National Office on July 15, 2007. Under Prop. Reg. §1.6655-2(f)(2)(i)(B), the taxpayer arguably would not be able to take into account a ratable portion of the rebates paid at the end of the year or after year-end in determining its annualized taxable income until 2008. This result is seemingly inconsistent with the rule in Prop. Reg. §1.6655-6, which would allow taxpayers to compute their taxable income in accordance with the new method of accounting once consent is received. As illustrated in the example above, even though the taxpayer has received consent to change its method of accounting, the taxpayer will be unable to use the new method of accounting in determining its annualized taxable income for two taxable years (i.e., until the requisite history is developed). If the IRS and Treasury do not eliminate the history requirement from the final regulations, as suggested above, the AICPA recommends that the IRS and Treasury consider adding a rule that would provide that taxpayers who receive consent to change a method of accounting are deemed to have met the requirement of having a “history” of incurring the expense.

The history requirement in Prop. Reg. §1.6655-2(f)(2)(i)(B) also results in a distorted computation of annualized taxable income for new taxpayers. The proposed regulations provide that a new taxpayer can establish a history for a specific item of expense if they incur that same expense in the immediately preceding taxable year either at the end of the year, or after year end. This rule presents a couple of issues. First, in the first taxable year of existence, a new taxpayer cannot take into account any item of expense that it expects to incur either at the end of the taxable year or after year-end, which results in a distorted computation of taxable income. Further, this rule assumes that a taxpayer will incur all recurring expenses in the first taxable year of existence. If a specific item of expense isn't incurred in the taxpayer's first year of existence, the taxpayer must look to develop a history for that specific item of expense under the two-year rule. The history requirement clearly creates an administrative burden for taxpayers who will have to specifically identify when an item of expense is incurred for the first time to determine whether it needs to have incurred the expense only once or whether it needs to develop a two-year history for incurring the specific item of expense before such amount may be taken into account in determining annualized taxable income. In addition, the rule creates a trap for unwary taxpayers who may not be aware that a specific item of expense cannot be taken into account in determining annualized taxable income because the requisite history has not yet been developed. For these reasons, the AICPA recommends that the history requirement be removed from the final regulations. If, however, the rule is retained, the AICPA recommends that the IRS and Treasury modify the rule for new taxpayers to allow new taxpayers who anticipate regularly incurring a specific item of expense at the end of the taxable year or after year-end to take a pro-rata portion of the estimated annual expense in determining annualized taxable income for the installment period.

D. Prepaid Expenses

The proposed regulations do not specifically address how a taxpayer using the 12-month rule in Reg. §1.263(a)-4(f)(1) should take prepaid expenses into account in determining annualized taxable income. The AICPA recommends that the final regulations clarify that a taxpayer accelerating a deduction under the 12-month rule for a liability for which payment is economic performance under §1.461-4 should be able to take the deduction into account in the period in which the expense is incurred (i.e., when paid) because at that point, the expense would be incurred for purposes of section 461.

VI. Section 481(a) Adjustments

Prop. Reg. §1.6655-2(f)(2)(iv) provides that a taxpayer can only take into account a section 481(a) adjustment related to an automatic method change beginning in the annualization period in which a copy of the Form 3115 is filed with the IRS National Office.

The AICPA recommends that the IRS and Treasury modify this rule in the final regulations to allow taxpayers to take into account the section 481(a) adjustment related to an automatic accounting method change if the taxpayer anticipates that the change will be filed in the appropriate timeframe for the reasons discussed below. First, the AICPA proposal would eliminate the administrative burden of having to recompute taxable income using a different method of accounting than was used to calculate the taxpayer's tax provision for financial accounting purposes. For provision purposes, taxpayers are generally able to take into account the section 481(a) adjustment for an automatic accounting method change if they anticipate that the change will be timely filed. While the recommended rule is subjective in that it is based on the taxpayer's intent to file the accounting method change, the AICPA believes that the taxpayer's intent to file can be sufficiently demonstrated through the computation of the tax provision in accordance with the new method of accounting.

Second, the AICPA believes such a rule is appropriate particularly for taxpayers under examination because of their limited ability to file the accounting method change (i.e., because of window periods). In addition, the rule in the proposed regulations, if adopted in the final regulations, could create additional pressure to file an incomplete Form 3115 in order to be able to take the section 481(a) adjustment into account for estimated tax purposes. Finally, the AICPA also believes that the AICPA approach would be consistent with Prop. Reg. §1.6665-2(f)(2)(v), which allows taxpayers to take into account a proportionate amount of the taxpayer's estimated annual depreciation based on all of the information available to the taxpayer. If the IRS and Treasury will allow taxpayers to anticipate capital expenditures to estimate depreciation expense for the annualization period, taxpayers should similarly be able to anticipate filing an automatic accounting method change and take into account the corresponding section 481(a) adjustment.

VII. Depreciation and Amortization

Prop. Reg. §1.6655-2(f)(2)(v) provides that in determining the estimated annual depreciation expense, a taxpayer may take into account purchases, sales or dispositions, changes in use, depreciation deductions permitted under sections 168(k) and 1400L(b), and other similar events and provisions that, based on all the relevant information available as of the last day of the annualization period, are reasonably expected to occur or apply during the taxable year.

Prop. Reg. §1.6655-2(f)(2)(v) further provides that, as an alternative to estimating annual depreciation expense based on events that are reasonably expected to occur, a taxpayer may claim for an annualization period at least a proportionate amount of 50 percent of the taxpayer's estimated depreciation expense for the current taxable year attributable to assets that a taxpayer had in service on the last day of the preceding taxable year, that remain in service on the first day of the current taxable year, and that are subject to the half-year convention.

The general rule provided in the proposed regulations anticipates that taxpayers will prepare an actual depreciation calculation taking into account both currently owned assets and anticipated purchases for purposes of determining depreciation expense for the annualization period. However, the AICPA is concerned that this rule is impractical for many taxpayers because it is burdensome to compute actual and expected depreciation expense solely for estimated tax purposes. As a result, the AICPA recommends that the IRS and Treasury expand the alternative methodology for computing depreciation expense to provide alternative rules that are less burdensome for taxpayers.

As drafted, the alternative computation applies only to property subject to the half-year convention. Specifically, Prop. Reg. §1.6655-f(v)(A) provides that as an alternative to estimating annual depreciation expense based on events that are reasonably expected to occur, a taxpayer may claim for an annualization period at least a proportionate amount of 50 percent of the taxpayer’s estimated depreciation expense for the current taxable year attributable to assets that a taxpayer had in service on the last day of the preceding taxable year, that remain in service on the first day of the current taxable year, and that are subject to the half-year convention. The rule as drafted does not provide any alternative calculation methodology for assets subject to another convention or for intangible assets. If this rule is retained in the final regulations, the AICPA recommends that the rule be expanded to provide alternative computation methodologies for all depreciable and amortizable assets, not just those subject to the half-year convention. In addition, the AICPA recommends that the alternative computation allow taxpayers to take into account the section 179 deduction, if applicable.

In lieu of the alternative computation provided in the proposed regulations, the AICPA recommends that the IRS and Treasury provide a safe harbor method for computing depreciation and amortization expense for estimated tax purposes. The AICPA recommends that the IRS and Treasury consider providing a rule that would allow taxpayers to claim a proportionate amount of 90% of prior year depreciation expense for all assets placed in service in an earlier year (adjusted for bonus depreciation). The AICPA believes that this safe harbor provision would be similar to the rule in Prop. Reg. §1.6655-1(d)(2), which allows taxpayers to pay 100% of the prior year's tax.

If, however, the current rules for the alternative computation of depreciation expense are retained as drafted in the proposed regulations, the AICPA suggests that the rule be clarified. The reference to "at least a proportionate amount" implies that there are situations where more than a proportionate amount of 50% of the current year depreciation expense could be claimed. If more than a proportionate amount of 50% of the current year depreciation expense could be claimed, the AICPA recommends that the IRS and Treasury clarify the situations in which claiming more than a proportionate amount of 50% of the current year depreciation expense would be appropriate.

VIII. Controlled Foreign Corporations, Partnerships and Other Pass-Through Entities

Section 6655(e)(4)(A) provides that amounts required to be included in gross income under sections 936(h) or 951(a) (and credits properly allocable thereto) shall be taken into account in computing any annualized income installment in a manner similar to the manner under which partnership income inclusions (and credits properly allocable thereto) are taken into account.

Section 6655(e)(5) provides that any dividend received from a closely held real estate investment trust (REIT) by any person which owns 10% or more (by vote or value) of the stock or beneficial interests in the trusts shall be taken into account in computing annualized income installments in a manner similar to the manner under which partnership income inclusions are taken into account.

Prop. Reg. §1.6655-2(f)(2)(vi) provides that in determining a partner's distributive share of partnership items that must be taken into account during an annualization period, the rules set forth in Reg. §1.6654-2(d)(2) are applicable.

The proposed regulations do not address how distributions from a section 936 corporation or a controlled foreign corporation (i.e., amounts includible in income under section 951(a)) should be taken into account in determining annualized taxable income for the installment period. Further, the proposed regulations do not address how a taxpayer's distributive share of income other pass-through entities (e.g., trusts, S corporations, REITs, etc.) should be taken into account during an annualization period. The AICPA recommends that the IRS and Treasury expand the scope of Prop. Reg. §1.6655-2(f)(2)(vi) in the final regulations to incorporate the statutory provisions for sections 936(h) or 951(a) as well as for closely-held REITs and provide appropriate rules to take into account the distributive share of income received from other types of pass-through entities.

IX. Items that Substantially Affect Taxable Income

A. LIFO

Prop. Reg. §1.6655-2(g) allows taxpayers to use reasonable estimates based on existing data for items that substantially affect income if the amount of such items cannot be determined accurately by the installment due date. Prop. Reg. §1.6655-2(g) provides simplifying rules to determine the internal inflation index for taxpayers using internal index dollar-value LIFO inventory methods, but there are no provisions for taxpayers to determine an external inflation index under the inventory price index computation (IPIC) LIFO method. The AICPA recommends that the IRS and Treasury include simplifying rules in the final regulations for taxpayers using the IPIC LIFO method to determine the value of LIFO inventory. Specifically, the AICPA recommends that the final regulations include a rule that will allow taxpayers to determine an estimated external inflation index by multiplying the prior year inventory mix by the applicable inflation index for the annualization period. Further, for taxpayers who have elected to use final indices, the AICPA recommends that the final regulations include a rule that will allow such taxpayers to use preliminary indices if the final indices for the appropriate month have not yet been published.

B. Section 199 Deduction

The proposed regulations do not specifically address how a taxpayer should account for the section 199 deduction in determining annualized taxable income. The AICPA recommends that the IRS and Treasury include a rule in the final regulations to address how taxpayers should account for the section 199 deduction in determining their annualized taxable income. The AICPA believes that the final regulations should treat the section 199 deduction as an item that substantially affects taxable income but cannot be accurately determined by the installment due date similar to the determination of LIFO inventory. In other words, the AICPA suggests that the IRS and Treasury allow taxpayers make a reasonable estimate of the section 199 deduction for purposes of determining the pro rata piece that should be taken into account in determining annualized taxable income.

C. Section 263A

The proposed regulations do not currently address how taxpayers should account for section 263A adjustments in computing annualized taxable income. The AICPA does not believe that the final regulations should require taxpayers to compute an actual section 263A adjustment for the installment period, as this would create a significant administrative burden for taxpayers. Rather, the AICPA recommends that the final regulations include simplifying rules that would allow taxpayers to compute the section 263A adjustment for the installment period by multiplying the prior year's absorption ratio by the inventory on hand at the end of the annualization period or by estimating the annual adjustment and prorating it to each annualization period, similar to the computation of the LIFO adjustment.

X. Events Arising After the Installment Due Date

Prop. Reg. §1.6655-2(h) provides that events arising subsequent to an installment due date that cause the taxpayer's computation of its taxable income for a prior installment period to be understated will not result in a recomputation of its taxable income for the prior installment period if it was not reasonably foreseeable that these subsequent events would occur.

The AICPA recommends that the IRS and Treasury consider providing examples in the final regulations of events that would arise after the due date that would be considered reasonably unforeseeable. For example, the final regulations should clarify that a failure to timely complete a like-kind exchange under section 1031, where there was a bona fide intent to do so as envisioned in Reg. §1.1031(k)-1(j), would be an example of an event arising after an installment due date that would not be reasonably foreseeable. Another example may be failure to acquire replacement property under section 1033 where there was a bona fide intent to do so.

XI. Extraordinary Items

The proposed regulations do not currently provide a rule for extraordinary items. The AICPA strongly believes that the IRS and Treasury should consider adding a rule to provide special treatment for extraordinary items for purposes of computing annualized taxable income. Specifically, the AICPA recommends that extraordinary items not be taken into account under the general rules in Prop. Reg. §1.6655-2(f), and thus annualized, as this treatment results in a distortion of annualized taxable income and thus is inconsistent with one of the stated purposes for updating the existing regulations under section 6655.

The AICPA believes that extraordinary items (favorable or unfavorable) should be taken into account after annualization of taxable income. A taxpayer should begin to account for the extraordinary item in the annualization period in which the extraordinary event occurs or, alternatively, in the annualization period in which it becomes reasonably foreseeable that the extraordinary event will occur. The AICPA also recommends that the IRS and Treasury provide an exclusive list of items of income or expense that would constitute "extraordinary items." The AICPA suggests that the IRS and Treasury consider referring to the list of extraordinary items in Reg. §1.1502-76(b)(2)(C) as examples of extraordinary items, with certain modifications.

Some of the items identified as extraordinary items in that list include: (1) any item from the disposition or abandonment of a capital asset as defined in section 1221; (2) any item from the disposition or abandonment of property used in a trade or business as defined in section 1231(b); (3) Any item from the disposition or abandonment of an asset described in section 1221(1), (3), (4), or (5), if substantially all the assets in the same category from the same trade or business are disposed of or abandoned in one transaction (or series of related transactions); and (4) Any item from assets disposed of in an applicable asset acquisition under section 1060(c). Treas. Reg. §1.1502-76(b)(2)(C) also includes as extraordinary items net operating loss carryforwards and section 481(a) adjustments, which are otherwise covered by Prop. Reg. §1.6655-2(f). The AICPA recognizes that the IRS and Treasury cannot adopt the list of extraordinary items in Treas. Reg. §1.1502-76(b)(2)(C) in its entirety (e.g., the treatment of section 951 income is inconsistent with section 6655); however, the AICPA believes that most of the extraordinary items identified in that regulation should similarly be treated as extraordinary items for estimated tax purposes.

XII. Adjusted Seasonal Income (Prop. Reg. §1.6655-3)

Prop. Reg. §1.6655-3(d)(1) provides that the base period percentage for any period of months shall be the average percent that the taxable income for the corresponding months in each of the three preceding taxable years bears to the taxable income for the three preceding taxable years. The AICPA recommends that the IRS and Treasury clarify in the final regulations whether the base period percentage could ever be negative.

XIII. Large Corporations (Prop. Reg. §1.6655-4)

A. Section 381 Transactions

Prop. Reg. §1.6655-4(c)(2) sets forth rules for computing taxable income in a taxable year in which there is a transaction to which section 381 applies. The AICPA recommends that the IRS and Treasury clarify that the adjustment for section 381 transactions relates only to the portion of taxable income applicable to the transferred assets.

B. Aggregation

Prop. Reg. §1.6655-4(d)(2) provides that for purposes of determining the taxable income of a controlled group, a taxable loss of any member of the controlled group for a taxable year during the testing period is not taken into account. The AICPA believes that this rule should be modified in the final regulations to permit taxpayers to take into account losses of a member of the controlled group when determining whether a corporation is considered a large taxpayer, as this is consistent with the principles for the computation of consolidated taxable income. To provide otherwise results in a distorted view of the taxable income of the controlled group.

XIV. Short Taxable Years (Prop. Reg. §1.6655-5)

The proposed regulations generally provide clear rules on the due dates for required installments when a taxpayer has a tax year of less than 12 full calendar months, the amounts that would be due for each of those installments, and how to use the annualization method or the “preceding year’s tax” method in a short tax year. These rules are very welcome. However, these rules present problems for certain taxpayers in their first tax year, and for other taxpayers in a tax year that ends early. Accordingly, the AICPA recommends that certain modifications be made to address these situations.

A. New Taxpayers

Prop. Reg. §1.6655-5(b) requires a taxpayer in an initial tax year of four or more full calendar months but less than 12 full calendar months to pay its required installments on the due dates prescribed in Prop. Reg. §1.6655-1(f)(2). That is, for a calendar year taxpayer, on April 15, June 15, September 15, and December 15, and, for a fiscal year taxpayer, on the 15th day of the 4th, 6th, 9th, and 12th months of the taxable year. If the date for the first installment is earlier than the 15th day of the fourth month of the taxpayer’s actual short tax year, the first installment would be due on the first of these due dates that is on or after the 15th day of the fourth month of the short tax year. In other words, in a taxpayer’s first tax year, no required installment would be due before the 15th day of the 4th month of the actual short tax year.

Because a taxpayer is free to choose its taxable year, and is not bound to do so until it files a tax return on that basis in accordance with Treas. Reg. §1.441-1(c)(1), the AICPA suggests that Prop. Reg. §1.6655-5(c)(1)(ii) be modified to provide that taxpayers will not be penalized if, in their initial taxable year, estimated payments are made on the presumption that the taxpayer will have a taxable year that is a calendar year, and the taxpayer subsequently chooses a fiscal year as its taxable year. A taxpayer that desires to make payments in the first tax year on the schedule currently prescribed in Prop. Reg. §1.6655-5(c)(1)(ii) for all calendar year taxpayers should be allowed to do so, at its choice.

B. Terminations Of Tax Years

Prop. Reg. §1.6655-5(c)(2) specifies that a taxpayer whose tax year ends early will have a final installment on the “next required installment” due date that would have arisen without the termination, and if that due date is within 30 days of the end of the short year the final required installment is deferred to the 15th day of the second month following the month in which the tax year terminates. This is a useful and clear rule.

However, Prop. Reg. §1.6655-5(d)(3) provides that, if a taxpayer has less than four required installments on account of a short tax year, the percentage for each required installment will be increased, so that each of those installments will be scaled up to 33%, 50%, or 100% -- instead of 25% -- of the required annual payment.

A taxpayer that makes payments based on 25% per required installment, expecting to have four required installments, and then discovers, for example, that – due to an unforeseen termination of the tax year, such as an acquisition – it has only three required installments, each of which should have been based on 33 1/3 % of the required annual payment, may find that it has an underpayment for the installments prior to the final required installment.

The “subsequent events” rule in Prop. Reg. §1.6655-2(h) does not appear to protect a taxpayer that makes an annualization method payment based on 25% of its annualized tax, assuming it will have a 12-month year, and later discovers that it should have made a payment based on 33 1/3% of its annualized tax for a shorter tax year. The “subsequent events” rule, as drafted, protects the taxpayer’s computation of its taxable income for an annualization period, not the computation of the required installment due on that taxable income.

The AICPA recommends that the IRS and Treasury revise the rule requiring short year payments to be more than 25% each. Alternatively, the IRS and Treasury should revise the “subsequent events” rule to provide more protection in the event of unforeseen events that do not affect taxable income but otherwise affect estimated tax payments. At the very least, the AICPA recommends that a taxpayer in an unexpected termination be allowed to make a payment with its final required installment equal to the remaining portion of 100% of its required annual payment and thereby avoid a penalty on its earlier required installments (e.g., a calendar year taxpayer that suddenly terminates its tax year in July after making annualization payments based on 25% and 50% of the tax on the annualized taxable income for the first three months could be required to make a final payment based on 100% of annualized taxable income for the first six months.) Because of the administrative difficulties of administering this intent-based rule, the AICPA would prefer that the “acceleration rule” be made available to all taxpayers with a short tax year rather than requiring all taxpayers with a short tax year to make payments based on symmetric percentages of the required annual payment.

It should be noted that similar issues exist for taxpayers relying on the rule in Prop. Reg. §1.6655-5(d)(1) and Prop. Reg. §1.6655-5(d)(2). Prop. Reg. §1.6655-5(d)(1) provides that the amount due for any required installment determined under section 6655(d)(1)(B)(i) for a short taxable year shall be 100% of the required annual payment for the short taxable year divided by the number of required installments due for the short taxable year. Similarly, Prop. Reg. §1.6655-5(d)(2) provides that if the current taxable year is a short taxable year, the amount due for any required installment determined under section 6655(d)(1)(B)(ii) shall be based on 100% of the tax shown on the return of the corporation for the preceding taxable year, multiplied by the number of full calendar months in the current short taxable year and divide by 12, and then dividing that amount by the number of required installments due for the current short taxable year. Because these rules do not take into consideration the determination of the estimated tax liability in the event of an unforeseen event resulting in a termination of the taxable year, the AICPA recommends that the IRS and Treasury consider similar revisions to these rules as those discussed above.

XV. Methods of Accounting (Prop. Reg. §1.6655-6)

Prop. Reg. §1.6655-6(b) provides that if a taxpayer is making a change in method of accounting for the current taxable year that is permitted to be made with the automatic consent of the Commissioner, the new method of accounting shall be used in determining any required installment if, and only if, the copy of the Form 3115 has been mailed to the IRS National Office on or before the last day of the annualization period.

For reasons explained above in the comments addressing section 481(a) adjustments, the AICPA recommends that the IRS and Treasury modify the rules in Prop. Reg. §1.6655-6(b) to allow taxpayers to compute the taxable income for the installment period using the new method of accounting if they anticipate that an automatic accounting method change will be timely filed. Modifying the rule in this manner would eliminate the administrative burden of having to compute a different taxable income than is calculated for purposes of determining the taxpayer's current tax provision, as well as relieve the pressure to file an incomplete Form 3115.

XVI. Other Issues

A. Tax Rate Changes Affecting The “Preceding Year’s Tax” Exception”

Section 6655(d)(1)(B)(ii) currently permits a taxpayer (other than a large corporation) to determine its required annual payment as “100 percent of the tax shown on the return of the corporation for the preceding taxable year.”

For tax years beginning before January 1, 1988, section 6655(d)(2) permitted a corporation to determine its required annual payment as the “tax computed at the rates applicable to the taxable year but otherwise on the basis of the facts shown on the return of the corporation for, and law applicable to, the preceding taxable year.” This rule was repealed by the Revenue Act of 1987.

Prop. Reg. §1.6655-1(g)(3) provides that “If the tax rates for the current taxable year . . . differ from the rates applicable to the preceding taxable year, the tax determined for the preceding taxable year shall be recomputed using the rates applicable to the current taxable year.” This provision appears to be an attempt to revive the “preceding year’s facts, this year’s rates” rule in old section 6655(d)(2). It does not conform to the current Code, and should be eliminated from the final regulations. If tax rates are higher in the current year than in the preceding year, this provision could require taxpayers to make a larger estimated tax payment than the Code requires to avoid a penalty. Similarly, if the tax rates were lower, then taxpayers would make a lower estimated tax payment than required.

Similarly, Prop. Reg. §1.6655-5(h) provides a rule for applying the “preceding year’s facts, this year’s rates” exception in old section 6655(d)(2) where the “preceding taxable year” was a short tax year. As this exception was repealed by the Revenue Act of 1987, effective for tax years beginning after December 31, 1987, the AICPA recommends that this rule be removed from the final regulations.

B. Miscellaneous Issues Regarding Examples

1. The AICPA appreciates the fact that the proposed regulations include several examples to illustrate how the rules should be applied. However, the AICPA suggests that the IRS and Treasury consider adding labels to the examples in the final regulations to indicate the rule that is being illustrated to make the examples more user-friendly.

2. Prop. Reg. §1.6655-2(e)(5) provides an example intended to illustrate the application of the annualized income installment method. It is not clear why this example is included in subsection (e) of Prop. Reg. §1.6655-2, as -2(e) generally deals with the annualization rules for a 52-53 week taxable year. The AICPA recommends that this example be moved to the appropriate section of the regulations.

3. There appear to be several miscalculations of tax stated in Prop. Reg. §1.6655-5(g)(4) Example 2 (intended to illustrate the use of the annualized income or seasonal installment method in a short taxable year). In (i)(A)(2) and in (ii)(A)(2), the tax on the annualized income amount of $150,000 is stated to be $39,250. The correct tax amount in both places appears to be $41,750. Also, in (iii)(A)(2), the tax on annualized income of $240,000 is stated to be $56,100; the correct tax amount appears to be $76,850. The AICPA recommends that these examples be corrected in the final regulations.

4. The examples throughout the proposed regulations, which are proposed to be effective for tax years beginning more than 30 days after the publication of final regulations, contain many instances in which the rules are being applied in 2005 or earlier years. The AICPA recommends that IRS and Treasury revise the examples in the final regulations to illustrate the application of the rules in taxable years that would be subject to the final regulations.

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