The net increase in tax for the taxable years specified in subdivisions (i), (ii), and (iii) of this subparagraph shall be computed as if the amount of the adjustments for the prior taxable years to which properly allocable in accordance with section 481(b)(2) had been received or accrued, or paid or incurred, as the case may be, in such prior years and the balance of the adjustments in the taxable year of the change. The amount of tax attributable to such adjustments for the taxable years specified in subdivisions (i), (ii), and (iii) of this subparagraph is the aggregate of the differences (increases and decreases) between the tax for each such year computed by taking into account the allocable portion of the adjustments in computing taxable income and the tax computed without taking into account any portion of the adjustments in computing taxable income. Generally, where there is an increase in taxable income for a preceding consecutive taxable year established under the new method of accounting, computed without regard to adjustments attributable to any preceding taxable year, the amount of the adjustments to be allocated to each such year shall be an amount equal to such increase. However, where the amount of the adjustments to be allocated to a prior taxable year is less than the increase in taxable income for such year established under the new method of accounting, the amount of the increase in such taxable income for purposes of determining the increase in tax under section 481(b)(2) for such year shall be considered to be the amount so allocated. For example, if the amount of the adjustments required by section 481(a) for 1958 (the taxable year of the change) is $60,000, and the increase in taxable income is determined by the taxpayer to be $40,000, $5,000, and $35,000, computed under the new method of accounting, for the taxable years 1957, 1956, and 1955, respectively, then the amount of the adjustments to be allocated to 1955 will be the balance of the adjustments, or $15,000.
Net sales | $32,000 | |
Opening inventory | $11,000 | |
Purchases | 22,500 | |
Total | 33,500 | |
Less closing inventory | 12,500 | |
Cost of goods sold | 21,000 | |
Gross profit | 11,000 | |
Business expenses | 5,000 | |
Business income | 6,000 | |
Personal exemption and itemized deductions | 1,600 | |
Taxable income | 4,400 |
Under the cash receipts and disbursements method of accounting, only $9,000 of the $11,000 opening inventory had been included in the cost of goods sold and claimed as a deduction for the taxable years 1954 through 1957; the remaining $2,000 had been so accounted for in pre-1954 years. In order to prevent the same item from reducing taxable income twice, an adjustment of $9,000 must be made to the taxable income of 1958 under the provisions of section 481(a) and § 1.481-1 . Since the change in method of accounting was not initiated by the taxpayer, the $2,000 of opening inventory which had been included in cost of goods sold in pre-1954 years is not taken into account. Taxable income for 1958 is accordingly increased by $9,000 under section 481(a) to $13,400. Assuming that the tax on $13,400 is $4,002 and that the tax on $4,400 (income without the adjustment) is $944, the increase in tax attributable to the adjustment, if taken into account for the taxable year of the change, would be the difference between the two, or $3,058. Since the adjustment required by section 481(a) and § 1.481-1 ($9,000) increases taxable income by more than $3,000, the increase in tax for the taxable year 1958 attributable to the adjustment of $9,000 (i.e., $3,058) may be limited under the provisions of section 481(b) (1) or (2). See examples (2) and (3).
Taxable year | Taxable income before adjustment | Taxable income with adjustment | Assume total tax | Assumed tax before adjustment | Increase in tax attributable to adjustment |
1956 | $4,000 | $7,000 | $1,660 | $840 | $820 |
1957 | 6,000 | 9,000 | 2,300 | 1,360 | 940 |
1958 | 4,400 | 7,400 | 1,780 | 944 | 836 |
Total | 2,596 |
Since this increase in tax of $2,596 is less than the increase in tax attributable to the inclusion of the entire adjustment in the income for the taxable year of the change ($3,058), the limitation provided by section 481(b)(1) applies, and the total tax for 1958, the taxable year of the change, if section 481(b)(2) does not apply, is determined as follows:
Tax without any portion of adjustment | $944 |
Increase in tax attributable to adjustment computed under section 481(b)(1) | 2,596 |
Total tax for taxable year of the change | 3,540 |
Taxable year | Taxable income | Increase or (decrease) in taxable income | |
Determined under cash receipts and disbursements method | Established under new method | ||
1953 | $5,000 | $7,000 | $2,000 |
1954 | 6,000 | 7,000 | 1,000 |
1955 | 5,500 | (1) | |
1956 | 4,000 | (1) | |
1957 | 6,000 | 10,000 | 4,000 |
1 Undetermined.
As in examples (1) and (2), the total adjustment under section 481(a) is $9,000. Of the $9,000 adjustment, $4,000 may be allocated to 1957, which is the only year consecutively preceding the taxable year of the change for which the taxpayer was able to establish his income under the new method. Since the income cannot be established under the new method for 1956 and 1955, no allocation may be made to 1954 or 1953, even though the taxpayer has established his income for those years under the new method of accounting. The balance of $5,000 ($9,000 minus $4,000) must be allocated to 1958.
Increase in tax attributable to adjustment computed under section 481(b)(2) ($1,280 + $1,492) | $2,772 |
Increase in tax attributable to adjustment computed under section 481(b)(1) (Example 2) | 2,596 |
Increase in tax if the entire adjustment is taken into account in the taxable year of the change (Example 1) | 3,058 |
The final tax for 1958 is then $3,540 computed as follows:
Tax before inclusion of any adjustment | $944 |
Increase in tax attributable to adjustments (smallest of $2,772, $2,596 or $3,058) | 2,596 |
Total tax for 1958 (limited in accordance with section 481(b)(1)) | 3,540 |
Year | Taxable income under the cash receipts and disbursements method | Taxable income established under accrual method | Increase or (decrease) attributable to change | Changes in taxable income due to changes in net loss carryback | |
Before application of net operating loss carryback | After application of net operating loss carryback | ||||
1953 | $2,000 | 0 | (1) | $2,000 | |
1954 | 4,000 | $1,000 | (1) | 3,000 | |
1955 | (5,000) | $1,000 | $6,000 | ||
1956 | 80,000 | 80,000 | 77,000 | (3,000) | |
1957 | 90,000 | 90,000 | 96,000 | 6,000 | |
1958 | 100,000 |
1 Not established.
As indicated above, taxable income for 1953 and 1954, as determined under the cash receipts and disbursements method of accounting, was $2,000 and $4,000, respectively, and after application of the net operating loss carryback from 1955, the taxable income was reduced to zero in 1953 and to $1,000 in 1954. The taxpayer was unable to establish taxable income for these years under an accrual method of accounting; however, under section 481(b)(3)(A), increases or decreases in the tax for taxable years to which no adjustment is allocated must, nevertheless, be taken into account to the extent the tax for such years would be affected by a net operating loss determined with reference to taxable years to which adjustments are allocated. The total amount of the adjustments required under section 481(a) and attributable to the taxable years 1953 through 1957 in this example is assumed to be $10,000. The redetermination of taxable income established by the taxpayer for the taxable years 1955, 1956, and 1957 appears under the heading "Taxable income established under accrual method" in the above tabulation. The tabulation assumes that the taxpayer has been able to recompute the income for those years so as to establish a net adjustment of $9,000, which leaves a balance of $1,000 unaccounted for. In accordance with the requirements of section 481(b)(2), the $1,000 amount is allocated to 1958, the taxable year of the change. The following computations are necessary in order to determine the tax attributable to the adjustments under section 481(a):
Increase in tax attributable to inclusion in 1958 of the entire $10,000 adjustment
Tax on income of 1958 increased by entire amount of adjustment ($100,000 + $10,000) | $51,700 |
Tax on income of 1958 without adjustment ($100,000) | 46,500 |
Increase in tax attributable to inclusion of entire adjustment in year of the change | 5,200 |
Increase in tax attributed to adjustment computed under section 481(b)(1)
Year | Amount of adjustment | Tax before adjustment | Tax after adjustment | Increase in tax liability attributable to adjustment |
1958 | $3,334 | $46,500 | $48,234 | $1,734 |
1957 | 3,333 | 41,300 | 43,033 | 1,733 |
1956 | 3,333 | 36,100 | 37,833 | 1,733 |
Increase in tax attributable to adjustment computed under section 481(b)(1) | 5,200 | |||
Increase in tax attributed to adjustment computed under section 481(b)(2) | ||||
1953 | 1 $2,000 | 0 | 1 $600 | $600 |
1954 | 1 3,000 | $300 | 11,200 | 900 |
1955 | 6,000 | 0 | 300 | 300 |
1956 | (3,000) | 36,100 | 34,540 | (1,560) |
1957 | 96,000 | 41,300 | 44,420 | 3,120 |
1958 | 2 1,000 | 46,500 | 2 47,020 | 520 |
Increase in tax attributable to the adjustment computed under section 481(b)(2) | 3,880 |
1 Attributable to recomputations of net operating loss carrybacks determined with reference to net operating loss in 1955.
2 Attributable to the inclusion of $1,000 in the year of the change which represents the portion of the $10,000 adjustment not allocated to taxable years prior to the year of the change for which taxable income is established under the new method.
Since the limitation under section 481(b)(2) ($3,880) on the amount of tax attributable to the adjustments is applicable, the final tax for the taxable year of the change is computed by adding such amount to the tax for that year computed without the inclusion of any amount attributable to the adjustments, that is, $46,500 plus $3,880, or $50,380.
26 C.F.R. §1.481-2