United States

Change from open transaction treatment is a change in accounting method


The IRS recently released a Chief Counsel advice memorandum (CCA 201403015) ruling that a change from treating a transaction as an open transaction to treating it as a closed transaction constituted a change in accounting method that necessitated a section 481(a) adjustment. While the facts in the CCA are heavily redacted, the change in method appears to have been initiated by the IRS as a result of a federal income tax examination of the taxpayer and serves as a reminder that the IRS will closely scrutinize transactions accounted for under the open transaction doctrine.

In the CCA, the IRS ruled that a change from open transaction treatment to realization treatment constitutes a change in method of accounting under section 446, notwithstanding that the change alters the character of the related items of income and expense. Under the open transaction doctrine, a transaction is generally treated as ongoing, or “open,” until payments exceeding the basis of the transferred property are received.1 Payments received are first treated as reducing the taxpayer’s basis in the transferred property, and gain is not recognized until the payments exceed such basis. Because such treatment delays gain recognition, it is often favorable for taxpayers. The installment sale regulations govern contingent payment transactions,2 and though the IRS continues to recognize the open transaction doctrine, it will do so only in rare and extraordinary cases where the realized value provided in exchange for the transferred property cannot be ascertained or reasonably estimated.3

Generally, a change in the treatment of an item of income or expense will be treated as an accounting method change if the change involves the timing of when the item of income or expense is recognized. Because a change from open transaction treatment to realization (or completed transaction) treatment results in such a change in timing (i.e., recognizing gain in the tax year the amounts received exceed basis versus recognizing gain in the year the transaction is entered into), the IRS ruled that such a change is a change in method of accounting that necessitates a section 481(a) adjustment.4The IRS stated that there is no characterization exception to accounting method changes; rather, the key determination is whether the taxpayer’s lifetime income is permanently impacted. Because the change here did not result in a permanent alteration of the taxpayer’s lifetime income, the change was properly treated as an accounting method change. Further, the IRS’s ruling was not impacted by the fact that by virtue of the change, the taxpayer’s originally reported long-term capital gain would be recharacterized into “several types of income and deduction and short-term gains and losses.”  


The ruling in the CCA was unfavorable to the taxpayer at issue since, by virtue of categorizing the change in treatment as a change in method of accounting, the taxpayer became subject to a section 481(a) adjustment that took into account amounts in tax years otherwise closed by statute. However, the CCA does serve as a good reminder for taxpayers that the IRS is generally skeptical of and will closely scrutinize open transaction treatment. Taxpayers that are presently using an open transaction method should consult with their tax advisors to assess if their fact patterns truly meet the “rare and extraordinary” circumstances sought by the IRS and whether open transaction treatment is therefore permissible. If not, a voluntary accounting method change may be a good option to obtain prior-year audit protection and a four-year spread on any resulting unfavorable section 481(a) adjustment.

[1] See Burnet v. Logan, 9 AFTR 1453.

[2] See Reg. section 15a.453-1(c)(1).

[3] See Rev. Rul. 58-402 and Reuben v. U.S., 111 AFTR 2d 2013-620. “Accordingly, it is the [Senate Finance] Committee’s intent that the cost-recovery method not be available in the case of sales for a fixed price (whether the seller’s obligation is evidenced by a note, contractual promise, or otherwise), and that its use be limited to those rare and extraordinary cases involving sales for a contingent price where the fair market value of the purchaser’s obligation cannot reasonably be ascertained,” S. Rep. No. 1000, 96th Cong., 2d Sess., at 24 (1980).

[4] The section 481(a) adjustment is generally required to avoid omissions or duplications of income or expenses that may otherwise result from a change in method of accounting.   

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