Nonaccrual-Experience Method of Accounting Under Section 448(d)(5), 52430-52444 [06-7446]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 71, Number 172 (Wednesday, September 6, 2006)]
[Rules and Regulations]
[Pages 52430-52444]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 06-7446]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9285]
RIN 1545-BB43


Nonaccrual-Experience Method of Accounting Under Section 
448(d)(5)

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the use 
of a nonaccrual-experience method of accounting by taxpayers using an 
accrual method of accounting and performing services. The final 
regulations reflect amendments under the Job Creation and Worker 
Assistance Act of 2002. The final regulations affect qualifying 
taxpayers that want to adopt, change to, or change a nonaccrual-
experience method of accounting under section 448(d)(5) of the Internal 
Revenue Code (Code).

DATES: Effective Date: These regulations are effective September 6, 
2006.
    Applicability Date: These regulations are applicable for taxable 
years ending on or after August 31, 2006.
    Comment Date: Written comments must be received by January 4, 2007. 
These regulations require that a taxpayer's nonaccrual-experience 
method must be self-tested against the taxpayer's actual experience to 
determine whether the nonaccrual-experience method clearly reflects the 
taxpayer's experience. The determination of actual experience is 
reserved in these regulations. Comments are requested concerning how to 
determine actual experience for purposes of timely performing self-
testing. Send submissions to: CC:PA:LPD:PR (REG-141402-02), Internal 
Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. 
Taxpayers also may submit comments electronically to the IRS internet 
site at https://www.irs.gov/regs.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, W. Thomas 
McElroy, Jr., (202) 622-4970; concerning submission of comments, Kelly 
Banks, (202) 622-0392 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in these final regulations 
has been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
3507(d)) under control number 1545-1855.
    The collection of information in these final regulations is in 
Sec.  1.448-2(d)(8) and (e)(5). This information is required to enable 
the IRS to verify that a taxpayer is reporting the correct amount of 
income or gain or claiming the correct amount of losses, deductions, or 
credits from the taxpayer's use of the nonaccrual-experience method of 
accounting. The collection of information is required to obtain a 
benefit.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number.
    The estimated annual burden per respondent is 3 hours.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, 
SE:W:CAR:MP:T:T:SP, Washington, DC 20224, and to the Office of 
Management and Budget, Attn: Desk Officer for the Department of the 
Treasury, Office of Information and Regulatory Affairs, Washington, DC 
20503.
    Books and records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information

[[Page 52431]]

are confidential, as required by 26 U.S.C. 6103.

Background

    This document contains amendments to the Income Tax Regulations (26 
CFR part 1) under section 448(d)(5). Section 448(d)(5) was enacted by 
section 801 of the Tax Reform Act of 1986 (Pub. L. 99-514, 100 Stat. 
2085) and was amended by section 403 of the Job Creation and Worker 
Assistance Act of 2002 (Pub. L. 107-147, 116 Stat. 21) (JCWA), 
effective for taxable years ending after March 9, 2002. On September 4, 
2003, the IRS and Treasury Department published in the Federal Register 
(68 FR 52543) proposed amendments to the regulations under section 
448(d) by cross-reference to temporary regulations (REG-141402-02) and 
temporary regulations (68 FR 52496) (TD 9090) (collectively, the 2003 
regulations) relating to the limitation on the use of the nonaccrual-
experience method of accounting under section 448(d)(5). A public 
hearing was held on December 10, 2003. Written and electronic comments 
responding to the proposed regulations were received. After 
consideration of all of the comments, the proposed regulations are 
adopted as revised by this Treasury decision, and the corresponding 
temporary regulations are removed. The revisions are discussed below.

Explanation of Provisions and Revisions and Summary of Comments

1. Overview

    These final regulations generally follow the rules in the 2003 
regulations. The final regulations include the four safe harbor 
nonaccrual-experience methods provided in the 2003 regulations, but 
those methods have been modified to provide more flexibility. Unlike 
the 2003 regulations, the final regulations do not require as a general 
rule that a taxpayer's nonaccrual-experience method be tested against 
one of the safe harbor nonaccrual-experience methods. Instead, the 
final regulations adopt, with modifications, the general rule from the 
2003 regulations as a fifth safe harbor. The final regulations also 
adopt a new general rule that requires a taxpayer's nonaccrual-
experience method be tested against actual experience unless the 
taxpayer has adopted one of the five safe harbor methods. These final 
regulations apply to taxable years ending on or after August 31, 2006.
    Certain portions of the 2003 regulations have been removed or 
incorporated into other paragraphs of the final regulations. Section 
1.448-2T(d) regarding certain receivables for which the nonaccrual-
experience method is not allowed has been combined with Sec.  1.448-
2(c) in the final regulations. Special rules in various parts of the 
2003 regulations such as Sec.  1.448-2T(e)(2)(ii) and (iii), 1.448-
2T(e)(3)(iii), 1.448-2T(e)(4)(ii) and (iii), and 1.448-2T(e)(5)(ii) and 
(iii), have been combined with the special rules in Sec.  1.448-
2T(e)(7) and are now in Sec.  1.448-2(b), (c), and (d) of the final 
regulations. Most of Sec.  1.448-2T(g), (h), and (j) of the 2003 
regulations relating to methods of accounting and audit protection have 
been removed. The IRS and Treasury Department intend to issue 
administrative guidance that will contain procedures for certain 
changes in a nonaccrual-experience method of accounting. The general 
rule that a nonaccrual-experience method is a method of accounting to 
which sections 446 and 481 apply has been moved to Sec.  1.448-2(b).
    Other portions of the 2003 regulations have been moved to a new 
definitions and special rules paragraph in Sec.  1.448-2(c) of the 
final regulations. Section 1.448-2T(d) regarding accounts receivable is 
included in a definition of accounts receivable in Sec.  1.448-2(c)(1) 
of the final regulations. Other terms in the definitions paragraph 
include applicable period, bad debts, charge-offs, determination date, 
recoveries, and uncollectible amount. The final regulations incorporate 
these definitions, as appropriate, throughout. For example, in the 2003 
regulations the four safe harbor methods include bad debts in the 
numerator; however, safe harbor 2 did not refer to bad debts, but 
instead described them as ``accounts receivable actually determined to 
be uncollectible and charged off * * *'' These descriptions should not 
be interpreted differently. Therefore, the final regulations use the 
defined term bad debts in each numerator. Finally, the examples are 
changed to conform to other changes within the final regulations.

2. Self-Testing Requirement

    The 2003 regulations provide that a taxpayer may use any 
nonaccrual-experience method of accounting, provided the taxpayer's 
method meets the self-test requirements. The self-testing in the 2003 
regulations requires a taxpayer to compare its proposed nonaccrual-
experience method with one of the four safe harbor methods to determine 
whether the taxpayer's proposed method clearly reflects experience. 
Self-testing is required in the first taxable year to determine whether 
the proposed method is allowed (first-year self-testing requirement) 
and, if allowed, self-testing is required every three taxable years 
thereafter (three-year self-testing requirement). The final regulations 
provide, as a general rule, that a taxpayer may use any nonaccrual-
experience method of accounting that clearly reflects the taxpayer's 
experience. The final regulations provide that taxpayers must self-test 
against the taxpayer's actual experience to determine whether a method 
clearly reflects the taxpayer's experience unless the taxpayer has 
adopted one of the five safe harbor methods. The final regulations 
reserve on the definition of actual experience.
a. Appropriateness of Self-Testing Requirement
    Many commentators suggested that taxpayers should not be required 
to incur additional expenses to develop a separate system for 
performing the self-test, noting that it would be burdensome and 
impractical for the majority of taxpayers using an alternative 
nonaccrual-experience method to conduct the self-test due to the 
limitations of their existing automated recordkeeping systems. One 
commentator suggested that the self-test was outside the scope of the 
JCWA and legislative intent. These commentators all recommended that 
the final regulations omit the self-testing requirement.
    The JCWA provides that ``[a] taxpayer may adopt, or * * * change 
to, a computation or formula that clearly reflects the taxpayer's 
experience,'' and that ``[a] request [to change] shall be approved if 
such computation or formula clearly reflects the taxpayer's 
experience.'' Public Law 107-147, section 403(a). Taxpayers and the IRS 
must be able to determine whether a nonaccrual-experience method 
clearly reflects the taxpayer's experience. The Secretary has broad 
authority to determine whether a method of accounting clearly reflects 
the taxpayer's income. A self-testing requirement is consistent with 
the statute, because it is the manner by which taxpayers and the IRS 
determine whether a nonaccrual-experience method clearly reflects the 
taxpayer's experience, and thus, clearly reflects the taxpayer's 
income. Taxpayers must be able to show that a nonaccrual-experience 
method clearly reflects experience prior to adopting or changing to the 
method. The requirement to self-test provides an objective standard for 
making the determination. Therefore, the final regulations do not adopt 
the

[[Page 52432]]

recommendation to omit a self-testing requirement and retain the rule 
that a taxpayer must maintain books and records sufficient to prove 
that the taxpayer's nonaccrual-experience method clearly reflects its 
experience for the taxable year of the exclusion.
b. Standard for Comparison
    Commentators stated that the self-testing requirements do not allow 
taxpayers the opportunity to demonstrate that a proposed method clearly 
reflects their experience, because under the 2003 regulations all 
methods must be compared to one of the safe harbors. The commentators 
stated that none of the safe harbors reflect actual experience, because 
all of the safe harbors are moving averages rather than a comparison of 
the estimated uncollectible amount for a taxable year under the 
taxpayer's nonaccrual-experience method to the actual collection 
experience of that taxable year's accounts receivable. Thus, the 
commentators stated, the safe harbors may or may not reflect actual 
experience as well as the proposed method.
    The final regulations modify the self-testing requirements in 
response to these comments and eliminate the requirement in the 2003 
regulations that a taxpayer's nonaccrual-experience method must be 
tested against one of the four safe harbor methods. The final 
regulations require that the taxpayer's nonaccrual-experience method 
must be tested against the taxpayer's actual experience, unless the 
taxpayer is using one of the safe harbor nonaccrual-experience methods, 
which are deemed to clearly reflect experience.
    For taxpayers and the IRS to implement and administer the 
nonaccrual-experience method, the determination of actual experience is 
necessary. Although commentators stated that taxpayers should be 
allowed to use hindsight and that actual experience would require the 
use of data reflecting the portion of the subject accounts receivable 
that remain uncollectible, the commentators did not elaborate regarding 
what ``remain uncollectible'' means, nor did the commentators set the 
date at which accounts receivable ``remain uncollectible.'' The 
determination and proof of actual experience generally is a simple 
matter for taxpayers whose collection process with respect to the 
subject receivables is complete by the time the Federal income tax 
return is filed. The collection cycle for some taxpayers, however, may 
routinely span several taxable years. The commentators did not 
elaborate how such a factual determination could be made prior to 
filing the Federal income tax return for the applicable taxable year 
(or alternatively, prior to filing the method change request for the 
applicable taxable year) in cases in which a taxpayer's collection 
cycle for the receivables goes beyond the date for the filing of the 
return (or method change). For taxpayers with a longer collection 
process, the determination of the final actual experience is not 
possible by the time the Federal income tax return is filed, and may 
continue to be incomplete upon examination by the IRS, if the 
taxpayer's collection process with respect to receivables is still in 
process. Additionally, it is possible that accounts receivable written 
off in one taxable year may be recovered several taxable years later, 
even for taxpayers whose average collection cycle is short. Therefore, 
the final regulations reserve the determination of actual experience.
    The IRS and Treasury Department anticipate providing future 
guidance that may change or restrict the rules for self-testing and may 
address the determination of actual experience. In the meantime, 
taxpayers may request advance consent to use a method other than a safe 
harbor method, but in the request taxpayers must establish to the 
satisfaction of the Commissioner how the determination of actual 
experience is made. Comments are requested concerning how to determine 
actual experience. Specifically, the IRS and Treasury Department seek 
comments on how the use of hindsight data can be made administrable. 
For example, how will the IRS National Office have the necessary data 
furnished with the application for change in method of accounting, and 
how will the taxpayer be able to timely perform the self-testing? In 
particular, should one, fixed determination date be used as a cut-off 
for all information included in the determination of actual experience? 
What facts and circumstances, known by the filing deadline for a change 
in method of accounting and the filing deadline for an original Federal 
income tax return, can a taxpayer and the IRS rely on to determine the 
taxpayer's actual experience for purposes of the first-year self-
testing requirements for the application for change in method of 
accounting and for purposes of the three-year self-testing requirements 
for the filing of the Federal income tax return? For a taxpayer that is 
applying to adopt or change to a nonaccrual-experience method of 
accounting, should the taxpayer be allowed to rely on the results under 
the proposed method for the current taxable year compared to actual 
experience for old taxable years rather than a comparison of the 
results under the proposed method for the current taxable year compared 
to actual experience for the current taxable year at the time of 
filing, provided the taxpayer can demonstrate that there is not a 
change in the type of a substantial portion of the outstanding accounts 
receivable such that the risk of loss is substantially decreased? What 
standards should apply to a taxpayer who has had a change in the type 
of a substantial portion of the outstanding accounts receivable? If a 
taxpayer's business has changed in a manner that impacts a substantial 
portion of its outstanding accounts receivable, the taxpayer's 
historical data for its receivables could lose much of their relevance 
in determining the taxpayer's current nonaccrual experience.
c. Safe Harbor Comparison Method
    The final regulations retain a modified version of the self-test 
from the 2003 regulations, which required the comparison of a 
taxpayer's method against one of the safe harbors. The safe harbor 
comparison method in the final regulations is used in conjunction with 
the fifth safe harbor nonaccrual-experience method, which allows a 
taxpayer to use any nonaccrual-experience method provided the method 
meets the safe harbor comparison method of self-testing. The safe 
harbor comparison method provided in the final regulations allows a 
taxpayer to compare the taxpayer's method against any of the safe 
harbors 1 through 4 during any self-testing period, rather than 
requiring the safe harbor chosen for comparison to be treated as a 
method of accounting. Because any of the safe harbors 1 through 4 are 
deemed to clearly reflect experience, a taxpayer should be able to 
compare its method against any of the safe harbors 1 through 4 to 
determine whether its method clearly reflects experience. The IRS and 
Treasury Department anticipate that the procedures for changes in 
method of accounting to use the new safe harbor nonaccrual-experience 
method will be provided in administrative guidance, and that these 
changes will be made with automatic consent.
d. Methods That Do Not Clearly Reflect Experience
    The 2003 regulations provide, as part of the three-year self-test 
requirement, that if the taxpayer's cumulative alternative nonaccrual-
experience amount excluded from income during the test period exceeds 
the taxpayer's cumulative safe harbor nonaccrual-experience amount, the 
taxpayer must

[[Page 52433]]

recapture the excess into income in the third taxable year of the 
three-year self-test. The IRS and Treasury Department intended this 
recapture provision to allow minor variances or fluctuations produced 
by the taxpayer's nonaccrual-experience method without prohibiting 
continued use of the method. However, when the taxpayer's nonaccrual-
experience method produces results that are more than minor variations 
or fluctuations from the three-year self-test amounts, the method does 
not clearly reflect the taxpayer's experience. The recapture provision 
addresses situations in which the taxpayer's nonaccrual-experience 
method generally clearly reflects experience, but the taxpayer has an 
anomalous taxable year in which the method does not clearly reflect 
experience. However, methods may consistently provide large distortions 
from the taxpayer's actual experience in future taxable years despite 
meeting the requirements of the first-year self-test. Consequently, the 
final regulations include a limit in the three-year self-testing 
provisions that, if exceeded, deems the taxpayer's nonaccrual-
experience method to not clearly reflect the taxpayer's experience. 
Because the taxpayer must recapture the difference between the 
uncollectible amount under the taxpayer's nonaccrual-experience method 
and the taxpayer's actual experience, a change from the taxpayer's 
nonaccrual-experience method to a permissible method in the subsequent 
taxable year does not require a section 481(a) adjustment and is made 
on a cut-off basis.
    Additionally, to provide transparency, the IRS and Treasury 
Department intend to provide in future guidance descriptions of methods 
and characteristics of methods combined with specific taxpayer 
circumstances that do not clearly reflect experience.
e. Other
    Commentators suggested that the self-test was not administrable in 
the context of consolidated groups. The IRS and Treasury Department 
believe that the final regulations do not impose more burden than any 
other method of accounting in the context of a consolidated group. 
Generally, methods of accounting, including the nonaccrual-experience 
method with its self-testing requirement, are adopted and applied 
separately by each entity within the consolidated group (or to separate 
trades or businesses within an entity), not at the consolidated group 
level.

3. Safe Harbor Methods

    The 2003 regulations have four safe harbors: Safe harbor 1 (the 
six-year moving average method), safe harbor 2 (the actual experience 
method), safe harbor 3 (the modified Black Motor method), and safe 
harbor 4 (the modified moving average method). Comments were received 
regarding safe harbors 1, 2, and 4. No comments were received regarding 
safe harbor 3.
a. General Issues
    Commentators questioned the need to impose different time periods 
for different safe harbor methods. For example, in the 2003 
regulations, safe harbors 1, 3 and 4 are based on a six-year period 
(the current taxable year and the five immediately preceding taxable 
years), whereas safe harbor 2 is based on a three year period (the 
current taxable year and the two immediately preceding taxable years). 
These commentators recommended that, for consistency, the safe harbor 
methods should permit taxpayers to compute the uncollectible amounts 
using a period consisting of the current taxable year and no fewer than 
the two immediately preceding taxable years and no more than the five 
immediately preceding taxable years.
    Providing options among the safe harbors, including those with 
different time periods, is consistent with legislative intent to 
provide taxpayers ``with alternative computations or formulas that 
taxpayers may rely upon.'' Different taxpayers may choose different 
methods with different time periods based on their individual 
circumstances and experience. The final regulations allow taxpayers 
flexibility to choose a period of at least three taxable years, but not 
more than six taxable years (applicable period), for purposes of the 
computations in each of the safe harbors. The taxable years included in 
the applicable period must be the most recent (which may or may not 
include the current taxable year, as applicable) and must be 
consecutive.
    Additionally, commentators stated that including the current 
taxable year in computations can cause difficulties when preparing 
computations for estimated taxes. Therefore, the final regulations 
allow taxpayers flexibility with regard to whether the current taxable 
year is included in the applicable period. The choice of which taxable 
years and how many are included in the applicable period is part of the 
taxpayer's method of accounting under a safe harbor, and can be changed 
only with the consent of the Commissioner. Taxpayers making such a 
change may not have all the historical data necessary to compute a 
section 481(a) adjustment. Therefore, the final regulations provide 
that the change is done on a cut-off basis rather than with a section 
481(a) adjustment.
    Finally, some commentators reiterated their earlier suggestion that 
the Black Motor formula should be permitted as an additional safe 
harbor method. The IRS and Treasury Department continue to conclude 
that the Black Motor formula should not be provided as an additional 
safe harbor method because the formula overstates the uncollectible 
amount in many circumstances. The final regulations add a fifth safe 
harbor, which, as discussed above, allows taxpayers to use any 
alternative nonaccrual-experience method provided the method meets the 
requirements of the safe harbor comparison method under the self-
testing requirements. The IRS and Treasury Department may provide 
additional safe harbors through future published guidance. In addition, 
if a taxpayer does not wish to rely on one of the safe harbors, the 
final regulations provide that a taxpayer may use any other alternative 
nonaccrual-experience method provided the method clearly reflects its 
experience and the taxpayer requests and receives consent from the 
Commissioner to use such method.
    Commentators requested that the regulations specifically include a 
statement that unintentional or immaterial variances will not cause a 
taxpayer to be changed to the specific charge-off method. As discussed 
in the preamble to the 2003 regulations, the IRS and Treasury 
Department do not contemplate that a taxpayer be changed to the 
specific charge-off method due to unintentional or immaterial 
variances, especially if a taxpayer is disadvantaged by the variances. 
Such a rule is unnecessary, particularly with the flexibility added to 
each of the safe harbors
b. Safe Harbor 1--Revenue-Based Moving Average Method
    Safe harbor 1 in the 2003 regulations was referred to as the six-
year moving average method. It is renamed the revenue-based moving 
average method in the final regulations to reflect the flexibility to 
choose between three to six taxable years for the applicable period. 
The final regulations provide that the revenue-based moving average 
percentage of safe harbor 1 (the ratio of net write-offs for the 
applicable period over accounts receivable earned over the same 
applicable period) is multiplied by a taxpayer's accounts receivable 
balance at the end of the taxable year to determine the taxpayer's 
nonaccrual-experience amount.
    A commentator suggested that a safe harbor method should be added 
that

[[Page 52434]]

would modify safe harbor 1 to multiply the revenue-based moving average 
percentage by a taxpayer's total billings (accounts receivable earned 
during the taxable year in lieu of its accounts receivable balance at 
the end of the taxable year). The commentator suggested that this new 
safe harbor would provide symmetry between the denominator of the 
revenue-based moving average percentage and the amount against which 
the revenue-based moving average percentage is multiplied.
    The final regulations do not adopt this recommendation. The IRS and 
Treasury Department previously analyzed the effects of multiplying the 
revenue-based moving average percentage by the total billings during 
the taxable year and determined that this computation overstates that 
portion of the taxpayer's year-end accounts receivable balance that 
will not be collected. The existing formula is the method provided in 
former Sec.  1.448-2T(e)(2), as contained in TD 8194, 53 FR 12513 
(1988). Although the denominator and multiplicand are not symmetrical, 
the method accurately reflects the year-end receivables that will not 
be collected for taxpayers with a short collection cycle.
c. Safe Harbor 2--Actual Experience Method
    Under safe harbor 2 of the 2003 regulations, the taxpayer's 
adjusted nonaccrual-experience amount is determined by tracking the 
receivables in the taxpayer's accounts receivable balance at the 
beginning of the current taxable year to determine the dollar amount of 
the accounts receivable actually determined to be uncollectible and 
charged off and not recovered or determined to be collectible by the 
determination date. The determination date is the date selected by the 
taxpayer for the taxable year for purposes of safe harbor 2, and may 
not be later than the earlier of the due date, including extensions, 
for filing the taxpayer's Federal income tax return for that taxable 
year or the date on which the taxpayer timely files the return for that 
taxable year. Under Option A of safe harbor 2, the computation is 
repeated for the taxpayer's accounts receivable balance at the 
beginning of each of the two immediately preceding taxable years. Under 
Option B of safe harbor 2, taxpayers that do not have the information 
necessary to compute a three-year moving average in the first taxable 
year the method is used are allowed to transition into the method year-
by-year. The total of the amounts determined to be uncollectible is 
divided by the total beginning accounts receivable balance for those 
taxable years used in the computation to determine the taxpayer's 
three-year (Option A), or up to three-year (Option B), moving average 
percentage. This percentage is then multiplied by the taxpayer's 
current year-end accounts receivable balance to arrive at the 
taxpayer's actual nonaccrual-experience amount. The taxpayer's actual 
nonaccrual-experience amount is then multiplied by 1.05 to determine 
the taxpayer's adjusted nonaccrual-experience amount.
    As discussed above, the final regulations allow flexibility in the 
applicable period used in safe harbor 2. Additionally, because the 
final regulations provide definitions of terms used throughout the 
regulations for consistency, the terms used to describe the safe harbor 
2 formula were changed to conform to the definitions in the final 
regulations. Although the description of the method may look as though 
it has changed substantially, the safe harbor 2 method is not intended 
to operate differently than the 2003 regulations, other than the 
flexibility in the applicable period and, as discussed below, the 
flexibility in the determination dates and in tracing recoveries.
    Some commentators requested clarification as to whether safe harbor 
2 is based on a computation that takes into account all known 
information arising both before and after the determination date. The 
commentators suggested that the 2003 regulations may be interpreted as 
taking into account only all known information arising on or before 
determination dates for previous taxable years involved in the 
computation.
    The computation in safe harbor 2, Option A, in the final 
regulations, contemplates consideration of all known information 
arising on or before the determination date for the current taxable 
year, including beginning accounts receivable balances, charge-offs and 
recoveries, with respect to all taxable years included in the 
computation. For example, if an account receivable of a calendar year 
taxpayer exists on January 1, 2006, and is charged off as a bad debt on 
December 15, 2007, the bad debt should be included in the computation 
in the taxable year it is charged off and every subsequent taxable year 
for as long as the 2006 beginning of the year accounts receivable 
balance is part of the computation under this method. Consequently, the 
final regulations clarify that all known information arising on or 
before the determination date for the current taxable year, with 
respect to the taxable years included in the computation, should be 
considered.
    In the 2003 regulations, Option B allows a taxpayer to transition 
into the actual experience safe harbor method. The final regulations 
allow a new taxpayer with no beginning accounts receivable to 
transition under either Option A or Option B (see Sec.  1.448-2(d)(4) 
of the final regulations). Option B in the final regulations differs 
from Option A in that it allows a taxpayer to use multiple 
determination dates (one for each taxable year of the applicable 
period) instead of one determination date. Therefore, under Option B in 
the final regulations, a taxpayer has a choice of the applicable 
period, three to six taxable years, and the taxpayer uses separate 
determination dates for each taxable year in the applicable period. 
That is, a taxpayer must use bad debts sustained by the separate 
determination date of each taxable year during the applicable period 
rather than bad debts sustained by the determination date of the 
current taxable year. The determination date used for each taxable year 
must be the determination date originally used for each taxable year at 
the time the uncollectible amount for that taxable year was computed. 
For example, if an account receivable of a calendar year taxpayer 
exists on January 1, 2006, and is charged off as a bad debt on December 
15, 2007, and the determination date for the 2006 taxable year is 
September 1, 2007, the bad debt would never be included in the 
computation because it is charged off after the 2006 taxable year 
determination date. This method was requested by commentators to reduce 
the burden of having to update the total bad debts for a particular 
taxable year with every future computation that included that taxable 
year.
    Other commentators requested clarification as to whether the 
determination date used in safe harbor 2 may shift from year to year. 
These commentators recommended that the final regulations confirm that 
a taxpayer may use a different determination date each taxable year, 
and that a change of determination date is not a change in method of 
accounting. Safe harbor 2 contemplates that a taxpayer may file its 
Federal income tax return at different times from year to year, and 
that the choice of a determination date used in the computation is not 
a method of accounting. However, once a determination date is selected 
and used for a particular taxable year, it may not be changed for that 
taxable year. Therefore, the final regulations clarify that the 
determination date may be different from year to year, and that a

[[Page 52435]]

change in the determination date is not a change in method of 
accounting.
    Under Option B of safe harbor 2, the 2003 regulations provide that 
a newly formed taxpayer that chooses Option B and does not have any 
accounts receivable upon formation will not be able to exclude any 
portion of its year-end accounts receivable from income for its first 
taxable year because the taxpayer does not have any accounts receivable 
on the first day of the taxable year that can be tracked. Some 
commentators recommended that the final regulations either permit newly 
formed taxpayers using Option B to exclude a portion of their year-end 
accounts receivable balance, or in the alternative, clarify the rules 
for adopting this safe harbor in the taxpayer's first taxable year in 
order to eliminate the administrative burden of filing Form 3115, 
``Application for Change in Accounting Method,'' in the succeeding 
taxable year. The final regulations retain this special rule in Sec.  
1.448-(d)(4) for both safe harbor 2 and safe harbor 4, because the 
methods require a beginning accounts receivable balance to compute the 
uncollectible amount. Use of another method in the first taxable year 
may not clearly reflect experience. The final regulations clarify that 
the taxpayer must begin creating its moving average in its second 
taxable year by tracking the accounts receivable as of the first day of 
its second taxable year. The use of one of the safe harbor nonaccrual-
experience methods of accounting described in paragraph (f)(2), (f)(4), 
or (f)(5), if applicable, of the final regulations in a taxpayer's 
second taxable year in this situation is not a change in method of 
accounting. Although the taxpayer must maintain the books and records 
necessary to perform the computations under the adopted safe harbor 
nonaccrual-experience method, the taxpayer is not required to 
affirmatively elect the method on its Federal income tax return for its 
first taxable year.
    Commentators requested that safe harbor 2 be modified to permit 
taxpayers to use any reasonable method to determine recoveries. In 
response to commentators' concerns about whether taxpayers could use 
assumptions regarding recoveries rather than specifically trace, the 
preamble to the 2003 regulations stated that the IRS and Treasury 
Department do not intend that a taxpayer be changed to the specific 
charge-off method due to unintentional and/or immaterial variances, 
especially if the taxpayer is disadvantaged by such variances. Some 
commentators believe that despite the preamble, the 2003 regulations 
may require taxpayers to specifically trace 100% of recoveries. The IRS 
and Treasury Department did not intend to prevent taxpayers from using 
a method that allocates 100% of recoveries to current taxable year bad 
debts. Commentators also have stated that although some recoveries may 
be traceable, some recoveries may not be traceable due to lump sum 
recoveries from third parties.
    The final regulations provide that a taxpayer specifically should 
trace recoveries if the taxpayer is able to do so without undue burden. 
However, the IRS and Treasury Department believe if the taxpayer is 
unable specifically to trace all recoveries without undue burden, the 
taxpayer should be able to use any reasonable method in determining the 
amount of recoveries to be traced to each taxable year's bad debts. 
Therefore, the final regulations allow taxpayers to use a reasonable 
allocation method. A method will be considered reasonable if there is a 
cause and effect relationship between the allocation base or ratio and 
the recoveries. The final regulations also provide that a taxpayer may 
trace only recoveries that are traceable and allocate the remaining, 
untraceable, recoveries to charge-offs of amounts in the relevant 
beginning accounts receivable balances. Methods that include, for 
example, receivables for which the nonaccrual-experience method is not 
allowed to be used (see Sec.  1.448-2(c)(1)(ii)) generally will not be 
considered reasonable.
d. Safe Harbor 3--Modified Black Motor Method
    Safe harbor 3 is a variation of the formula addressed in Black 
Motor Co. v. Commissioner, 41 B.T.A. 300 (1940), aff'd, 125 F.2d 977 
(6th Cir. 1942). No comments were received regarding safe harbor 3. The 
final regulations adopt the method in the 2003 regulations, with minor 
revisions made to the terms used in the formulas to conform the terms 
used throughout the regulations.
e. Safe Harbor 4--Modified Moving Average Method
    The 2003 regulations provide that, for purposes of safe harbor 4, a 
taxpayer may determine the uncollectible amount by multiplying its 
accounts receivable balance at the end of the current taxable year by 
the ratio of total bad debts charged off for the current taxable year 
and the five preceding taxable years other than the credit charges 
(accounts receivable) that were charged off in the same taxable year 
they were generated, adjusted for recoveries of charge-offs during that 
period, to the sum of accounts receivable at the end of the current 
taxable year and the five preceding taxable years.
    Some commentators argued that, by eliminating credit charges that 
were written off in the same taxable year they were generated, the 
effect of this computation for a taxpayer's first taxable year is to 
eliminate the intended benefit of section 448(d)(5). These commentators 
recommended that the final regulations permit newly formed taxpayers 
using safe harbor 4 to exclude a portion of their year-end accounts 
receivable balance, or in the alternative, clarify the rules on 
adopting this safe harbor method in the taxpayer's first taxable year 
in order to eliminate the administrative burden of filing Form 3115 in 
the succeeding taxable year.
    This safe harbor method, like safe harbor 3, is a variation of the 
formula addressed in Black Motor Co. v. Commissioner. Safe harbor 4, by 
eliminating credit charges that were written off in the same taxable 
year they were generated, and thereby reducing the amount computed 
under the traditional Black Motor formula, remedies known shortcomings 
generally associated with the Black Motor formula, and as such, more 
accurately reflects a taxpayer's nonaccrual-experience. Therefore, the 
final regulations retain this rule.
    Another commentator pointed out that there is a mismatching in the 
comparison of write-offs to accounts receivable in the formula used in 
safe harbor 4 because it compares the total accounts written off in a 
taxable year after the year of sale to the ending balances in accounts 
receivable for the six-year period. For example, the sum of the write-
offs in each taxable year for the preceding taxable years' charges for 
services in year 7 is for services rendered in years 1 through 6, but 
the ending balances in accounts receivable are from years 2 through 7. 
This commentator opined that, if charges for services and accounts 
receivable are increasing, the ratio of write-offs from prior balances 
relative to current receivables would be understated and therefore the 
uncollectible amount would be understated. The commentator suggested 
that the sum of the write-offs in each taxable year for the preceding 
taxable years' charges for services should be divided by the sum of the 
beginning accounts receivable for the current and five preceding 
taxable years. The final regulations adopt this recommendation and, for 
purposes of safe harbor 4, the denominator is changed to reflect the 
beginning of the taxable year accounts receivable balances in lieu of 
accounts receivable balances at the end of the taxable year.

[[Page 52436]]

4. Special Rules

a. Acquisitions and Dispositions
    A commentator recommended that the final regulations clarify that 
newly formed or acquired taxpayers in a section 351(a) or 721(a) 
nontaxable transaction are allowed to use predecessor data to compute 
their uncollectible amount under the nonaccrual-experience method. The 
final regulations adopt this comment and provide special rules for 
acquisitions and dispositions. Taxpayers that acquire a major portion 
of a trade or business or a unit of a trade or business (for example, a 
hospital) should include the data from the predecessor in the 
computations to avoid potentially skewing the computations for the 
remainder of the applicable period. Additionally, taxpayers that 
dispose of a major portion of a trade or business or a unit of a trade 
or business should not use the data related to the disposed trade or 
business in the computations. For purposes of the nonaccrual-experience 
methods of accounting, a new, qualified taxpayer that acquires property 
in any transaction to which section 381(a) does not apply must adopt a 
nonaccrual-experience method on the basis of its own experience. 
However, to the extent predecessor information is available, the data 
must be used in the newly-adopted nonaccrual-experience method.
b. Reportable Transactions
    Some commentators recommended that the book-tax difference that may 
result from the use of the nonaccrual-experience method not be taken 
into account in determining whether a transaction is a reportable 
transaction for purposes of the disclosure rules under Sec.  1.6011-
4(b)(6). As a result of Notice 2006-6 (2006-5 I.R.B. 385), book-tax 
differences no longer create reportable transactions under Sec.  
1.6011-4(b)(6). Therefore, it is not necessary to adopt this 
recommendation.
c. Short Taxable Years
    As discussed, the 2003 regulations generally provide procedures for 
taxpayers that have fewer than the requisite number of taxable years to 
adopt or change to a safe harbor nonaccrual-experience method. Some 
commentators requested rules on how taxpayers may compute their 
nonaccrual-experience amount in the case of a short taxable year. 
Commentators opined that for certain safe harbors, such as safe harbors 
2, 3 and 4, inaccurate income exclusion can arise because a short 
taxable year will have a disproportionate effect on the numerator and 
denominator of the computations. For example, a taxpayer that has a 
relatively stable balance of accounts receivable but a short period, 
such as three months, may generate only one-fourth of the normal write-
offs. These commentators recommended that the final regulations provide 
that, if a taxpayer experiences a short taxable year, the net write-
offs for the short period should be annualized in order to prevent 
distortion of the safe harbor computation. Alternatively, these 
commentators suggested that taxpayers should be allowed to include data 
from the previous twelve months in the safe harbor computation. For 
example, for a calendar year taxpayer who experiences a short period 
ending March 31st, the taxpayer would use data from the twelve months 
prior to the period ending on March 31st to compute its nonaccrual-
experience amount.
    The final regulations provide that taxpayers must make appropriate 
adjustments for short taxable years for nonaccrual-experience methods 
that are based on a comparison of accounts receivable balance to total 
bad debts. The IRS and Treasury Department intend to issue 
administrative guidance on appropriate adjustments.
d. Periodic Systems
    As with the 2003 regulations, the final regulations provide, in 
Sec.  1.448-2(d)(2), that a taxpayer applies its nonaccrual-experience 
method with respect to each specific account receivable eligible for 
the method. The preamble to the 2003 regulations states that a taxpayer 
may continue to use the periodic system described in Notice 88-51 
(1988-1 C.B. 535) in conjunction with any permissible nonaccrual-
experience method used by the taxpayer. The use of a periodic method 
remains permissible under Sec.  1.448-2(d)(2) of the final regulations.

5. Effective Date

    These final regulations are applicable to taxable years ending on 
or after August 31, 2006. A commentator recommended that the final 
regulations be applied retroactively to allow taxpayers to settle any 
open taxable year in which the nonaccrual-experience method is an issue 
under consideration in examination, in Appeals, or before the U.S. Tax 
Court by using one of the safe harbor methods, and thus, avoid 
continued disagreements between the government and taxpayers. The final 
regulations do not adopt this recommendation. However, the Commissioner 
may settle an earlier taxable year on the basis of a safe harbor method 
that clearly reflects the taxpayer's experience.

6. Procedures for Adoption or Change in Method of Accounting

    The 2003 regulations include specific rules for filing an 
application to change to a nonaccrual-experience method of accounting. 
The final regulations omit these rules, which will be provided in 
administrative guidance. The guidance will include automatic consent 
procedures for filing an application to change to one of the safe 
harbor nonaccrual-experience methods of accounting.
    To adopt or change to a method other than one of the safe harbor 
nonaccrual-experience methods of accounting, a taxpayer must request 
advance consent under the current procedures for obtaining the consent 
of the Commissioner of Internal Revenue to change a method of 
accounting for Federal income tax purposes (see, for example, Rev. 
Proc. 97-27 (1997-1 C.B. 680) (as modified and amplified by Rev. Proc. 
2002-19 (2002-1 C.B. 696), as amplified and clarified by Rev. Proc. 
2002-54 (2002-2 C.B. 432)). In the interest of sound tax 
administration, a new taxpayer must request advance consent to adopt a 
method other than one of the safe harbor nonaccrual-experience methods 
to ensure that the method clearly reflects income and experience.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) and (d) of the Administrative Procedure 
Act (5 U.S.C. chapter 5) does not apply to these regulations. It is 
hereby certified that the collection of information contained in these 
regulations will not have a significant regulatory impact on a 
substantial number of small entities. This certification is based upon 
the fact that the estimated burden associated with the information 
collection averages three hours per respondent. Moreover, for taxpayers 
that are eligible to use these regulations and that follow these 
regulations, any burden due to the collection of information in these 
regulations will be outweighed by the benefit received by accruing less 
income than would otherwise be required. Accordingly, a regulatory 
flexibility analysis is not required. Pursuant to section 7805(f) of 
the Internal Revenue Code, the proposed regulations preceding these 
regulations were

[[Page 52437]]

submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on their impact on small business.

Drafting Information

    The principal author of these regulations is W. Thomas McElroy, Jr. 
of the Office of Associate Chief Counsel (Income Tax and Accounting). 
However, other personnel from the IRS and Treasury Department 
participated in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read, in 
part, as follows:

    Authority: 26 U.S.C. 7805 * * *


0
Par. 2. Section 1.448-2 is added to read as follows:


Sec.  1.448-2  Nonaccrual of certain amounts by service providers.

    (a) In general. This section applies to taxpayers qualified to use 
a nonaccrual-experience method of accounting provided for in section 
448(d)(5) with respect to amounts to be received for the performance of 
services. A taxpayer that satisfies the requirements of this section is 
not required to accrue any portion of amounts to be received from the 
performance of services that, on the basis of the taxpayer's 
experience, and to the extent determined under the computation or 
formula used by the taxpayer and allowed under this section, will not 
be collected. Except as otherwise provided in this section, a taxpayer 
is qualified to use a nonaccrual-experience method of accounting if the 
taxpayer uses an accrual method of accounting with respect to amounts 
to be received for the performance of services by the taxpayer and 
either--
    (1) The services are in fields referred to in section 448(d)(2)(A) 
and described in Sec.  1.448-1T(e)(4) (health, law, engineering, 
architecture, accounting, actuarial science, performing arts, or 
consulting); or
    (2) The taxpayer meets the $5 million annual gross receipts test of 
section 448(c) and Sec.  1.448-1T(f)(2) for all prior taxable years.
    (b) Application of method and treatment as method of accounting. 
The rules of section 448(d)(5) and the regulations are applied 
separately to each taxpayer. For purposes of section 448(d)(5), the 
term taxpayer has the same meaning as the term person defined in 
section 7701(a)(1) (rather than the meaning of the term defined in 
section 7701(a)(14)). The nonaccrual of amounts to be received for the 
performance of services is a method of accounting (a nonaccrual-
experience method). A change to a nonaccrual-experience method, from 
one nonaccrual-experience method to another nonaccrual-experience 
method, or to a periodic system (for example, see Notice 88-51 (1988-1 
C.B. 535) and Sec.  601.601(d)(2)(ii)(b) of this chapter), is a change 
in method of accounting to which the provisions of sections 446 and 481 
and the regulations apply. See also paragraphs (c)(2)(i), (c)(5), 
(d)(4), and (e)(3)(i) of this section. Except as provided in other 
published guidance, a taxpayer who wishes to adopt or change to any 
nonaccrual-experience method other than one of the safe harbor methods 
described in paragraph (f) of this section must request and receive 
advance consent from the Commissioner in accordance with the applicable 
administrative procedures issued under Sec.  1.446-1(e)(3)(ii) for 
obtaining the Commissioner's consent.
    (c) Definitions and special rules--(1) Accounts receivable--(i) In 
general. Accounts receivable include only amounts that are earned by a 
taxpayer and otherwise recognized in income through the performance of 
services by the taxpayer. For purposes of determining a taxpayer's 
nonaccrual-experience under any method provided in this section, 
amounts described in paragraph (c)(1)(ii) of this section are not taken 
into account. Except as otherwise provided, for purposes of this 
section, accounts receivable do not include amounts that are not billed 
(such as for charitable or pro bono services) or amounts contractually 
not collectible (such as amounts in excess of a fee schedule agreed to 
by contract). See paragraph (g) Examples 1 and 2 of this section for 
examples of this rule.
    (ii) Method not available for certain receivables--(A) Amounts not 
earned and recognized through the performance of services. A 
nonaccrual-experience method of accounting may not be used with respect 
to amounts that are not earned by a taxpayer and otherwise recognized 
in income through the performance of services by the taxpayer. For 
example, a nonaccrual-experience method may not be used with respect to 
amounts owed to the taxpayer by reason of the taxpayer's activities 
with respect to lending money, selling goods, or acquiring accounts 
receivable or other rights to receive payment from other persons 
(including persons related to the taxpayer) regardless of whether those 
persons earned the amounts through the provision of services. However, 
see paragraph (d)(3) of this section for special rules regarding 
acquisitions of a trade or business or a unit of a trade or business.
    (B) If interest or penalty charged on amounts due. A nonaccrual-
experience method of accounting may not be used with respect to amounts 
due for which interest is required to be paid or for which there is any 
penalty for failure to timely pay any amounts due. For this purpose, a 
taxpayer will be treated as charging interest or penalties for late 
payment if the contract or agreement expressly provides for the 
charging of interest or penalties for late payment, regardless of the 
practice of the parties. If the contract or agreement does not 
expressly provide for the charging of interest or penalties for late 
payment, the determination of whether the taxpayer charges interest or 
penalties for late payment will be made based on all of the facts and 
circumstances of the transaction, and not merely on the 
characterization by the parties or the treatment of the transaction 
under state or local law. However, the offering of a discount for early 
payment of an amount due will not be regarded as the charging of 
interest or penalties for late payment under this section, if--
    (1) The full amount due is otherwise accrued as gross income by the 
taxpayer at the time the services are provided; and
    (2) The discount for early payment is treated as an adjustment to 
gross income in the year of payment, if payment is received within the 
time required for allowance of the discount. See paragraph (g) Example 
3 of this section for an example of this rule.
    (2) Applicable period--(i) In general. The applicable period is the 
number of taxable years on which the taxpayer bases its nonaccrual-
experience method. A change in the number of taxable years included in 
the applicable period is a change in method of accounting to which the 
procedures of section 446 apply. A change in the inclusion or exclusion 
of the current taxable year in the applicable period is a change in 
method of accounting to which the procedures of section 446 apply. A

[[Page 52438]]

change in the number of taxable years included in the applicable period 
or the inclusion or exclusion of the current taxable year in the 
applicable period is made on a cut-off basis.
    (ii) Applicable period for safe harbors. For purposes of the safe 
harbors under paragraph (f) of this section the applicable period may 
consist of at least three but not more than six of the immediately 
preceding consecutive taxable years. Alternatively, the applicable 
period may consist of the current taxable year and at least two but not 
more than five of the immediately preceding consecutive taxable years. 
A period shorter than six taxable years is permissible only if the 
period contains the most recent preceding taxable years and all of the 
taxable years in the applicable period are consecutive.
    (3) Bad debts. Bad debts are accounts receivable determined to be 
uncollectible and charged off.
    (4) Charge-offs. Amounts charged off include only those amounts 
that would otherwise be allowable under section 166(a).
    (5) Determination date. The determination date in safe harbor 2 
provided in paragraph (f)(2) of this section is used as a cut-off date 
for determining all known data to be taken into account in the 
computation of the taxable year's uncollectible amount. The 
determination date may not be later than the earlier of the due date, 
including extensions, for filing the taxpayer's Federal income tax 
return for that taxable year or the date on which the taxpayer timely 
files the return for that taxable year. The determination date may be 
different in each taxable year. However, once a determination date is 
selected and used for a particular taxable year, it may not be changed 
for that taxable year. The choice of a determination date is not a 
method of accounting.
    (6) Recoveries. Recoveries are amounts previously excluded from 
income under a nonaccrual-experience method or charged off that the 
taxpayer recovers.
    (7) Uncollectible amount. The uncollectible amount is the portion 
of any account receivable amount due that, under the taxpayer's 
nonaccrual-experience method, will be not collected.
    (d) Use of experience to estimate uncollectible amounts--(1) In 
general. In determining the portion of any amount due that, on the 
basis of experience, will not be collected, a taxpayer may use any 
nonaccrual-experience method that clearly reflects the taxpayer's 
nonaccrual-experience. The determination of whether a nonaccrual-
experience method clearly reflects the taxpayer's nonaccrual-experience 
is made in accordance with the rules under paragraph (e) of this 
section. Alternatively, the taxpayer may use any one of the five safe 
harbor nonaccrual-experience methods of accounting provided in 
paragraphs (f)(1) through (f)(5) of this section, which are presumed to 
clearly reflect a taxpayer's nonaccrual-experience.
    (2) Application to specific accounts receivable. The nonaccrual-
experience method is applied with respect to each account receivable of 
the taxpayer that is eligible for this method. With respect to a 
particular account receivable, the taxpayer determines, in the manner 
prescribed in paragraphs (d)(1) or (f)(1) through (f)(5) of this 
section (whichever applies), the uncollectible amount. The 
determination is required to be made only once with respect to each 
account receivable, regardless of the term of the receivable. The 
uncollectible amount is not recognized as gross income. Thus, the 
amount recognized as gross income is the amount that would otherwise be 
recognized as gross income with respect to the account receivable, less 
the uncollectible amount. A taxpayer that excludes an amount from 
income during a taxable year as a result of the taxpayer's use of a 
nonaccrual-experience method may not deduct in any subsequent taxable 
year the amount excluded from income. Thus, the taxpayer may not deduct 
the excluded amount in a subsequent taxable year in which the taxpayer 
actually determines that the amount is uncollectible and charges it 
off. If a taxpayer using a nonaccrual-experience method determines that 
an amount that was not excluded from income is uncollectible and should 
be charged off (for example, a calendar-year taxpayer determines on 
November 1st that an account receivable that was originated on May 1st 
of the same taxable year is uncollectible and should be charged off), 
the taxpayer may deduct the amount charged off when it is charged off, 
but must include any subsequent recoveries in income. The 
reasonableness of a taxpayer's determination that amounts are 
uncollectible and should be charged off may be considered on 
examination. See paragraph (g) Example 12 of this section for an 
example of this rule.
    (3) Acquisitions and dispositions--(i) Acquisitions. If a taxpayer 
acquires the major portion of a trade or business of another person 
(predecessor) or the major portion of a separate unit of a trade or 
business of a predecessor, then, for purposes of applying this section 
for any taxable year ending on or after the acquisition, the experience 
from preceding taxable years of the predecessor attributable to the 
portion of the trade or business acquired, if available, must be used 
in determining the taxpayer's experience.
    (ii) Dispositions. If a taxpayer disposes of a major portion of a 
trade or business or the major portion of a separate unit of a trade or 
business, and the taxpayer furnished the acquiring person the 
information necessary for the computations required by this section, 
then, for purposes of applying this section for any taxable year ending 
on or after the disposition, the experience from preceding taxable 
years attributable to the portion of the trade or business disposed may 
not be used in determining the taxpayer's experience.
    (iii) Meaning of terms. For the meaning of the terms acquisition, 
separate unit, and major portion, see paragraph (b) of Sec.  1.52-2. 
The term acquisition includes an incorporation or a liquidation.
    (4) New taxpayers. The rules of this paragraph (d)(4) apply to any 
newly formed taxpayer to which the rules of paragraph (d)(3)(i) of this 
section do not apply. Any newly formed taxpayer that wants to use a 
safe harbor nonaccrual-experience method of accounting described in 
paragraph (f)(1), (f)(2), (f)(3), (f)(4), or (f)(5) of this section 
applies the methods by using the experience of the actual number of 
taxable years available in the applicable period. A newly formed 
taxpayer that wants to use one of the safe harbor nonaccrual-experience 
methods of accounting described in paragraph (f)(2), (f)(4), or (f)(5) 
of this section in its first taxable year and does not have any 
accounts receivable upon formation may not exclude any portion of its 
year-end accounts receivable from income for its first taxable year. 
The taxpayer must begin creating its moving average in its second 
taxable year by tracking the accounts receivable as of the first day of 
its second taxable year. The use of one of the safe harbor nonaccrual-
experience methods of accounting described in paragraph (f)(2), (f)(4), 
or (f)(5) of this section in a taxpayer's second taxable year in this 
situation is not a change in method of accounting. Although the 
taxpayer must maintain the books and records necessary to perform the 
computations under the adopted safe harbor nonaccrual-experience 
method, the taxpayer is not required to affirmatively elect the method 
on its Federal income tax return for its first taxable year.
    (5) Recoveries. Regardless of the nonaccrual-experience method of 
accounting used by a taxpayer under this section, the taxpayer must 
take

[[Page 52439]]

recoveries into account. If, in a subsequent taxable year, a taxpayer 
recovers an amount previously excluded from income under a nonaccrual-
experience method or charged off, the taxpayer must include the 
recovered amount in income in that subsequent taxable year. See 
paragraph (g) Example 13 of this section for an example of this rule.
    (6) Request to exclude taxable years from applicable period. A 
period shorter than the applicable period generally is permissible only 
if the period consists of consecutive taxable years and there is a 
change in the type of a substantial portion of the outstanding accounts 
receivable such that the risk of loss is substantially increased. A 
decline in the general economic conditions in the area, which 
substantially increases the risk of loss, is a relevant factor in 
determining whether a shorter period is appropriate. However, approval 
to use a shorter period will not be granted unless the taxpayer 
supplies evidence that the accounts receivable outstanding at the close 
of the taxable years for the shorter period requested are more 
comparable in nature and risk to accounts receivable outstanding at the 
close of the current taxable year. A substantial increase in a 
taxpayer's bad debt experience is not, by itself, sufficient to justify 
the use of a shorter period. If approval is granted to use a