rr-08-30.pdf

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Part I

Section 446.—General Rule for Methods of Accounting

26 CFR 1.446-1: General rule for methods of accounting.
(Also § 118)

Rev. Rul. 2008-30

ISSUE
Does the change from (1) treating certain payments received from customers as
contributions to capital under § 118(c) of the Internal Revenue Code to (2) treating the
payments as taxable customer connection fees constitute a change in method of
accounting within the meaning of §§ 446 and 481 and the regulations thereunder?
FACTS
U
corporation is a regulated public utility that operates and maintains sanitary
sewer lines and sewerage disposal plants. U
charges a “customer connection fee” to
certain customers when U
must build lines to extend its existing infrastructure to the
customer in order to start sewerage disposal services. These customer connection fees
finance U’s construction of sewer line extensions to the customer.

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In Years 1, 2 and 3, U
treats the customer connection fees as contributions in aid
of construction (CIACs) within the meaning of § 118(c) and excludes the customer
connection fees from U
’s gross income as contributions to capital under § 118(a). As
required by § 118(c)(4), U
takes an adjusted basis of zero in the sewer line extensions
that it constructs and finances with the customer connection fees.
In Year 4, U concludes that its customer connection fees are properly includible
in gross income because the exclusion provided by § 118(c) does not apply. Beginning
in Year 4, U
includes customer connection fees in gross income and capitalizes the cost
of the sewer line extensions constructed and financed with these fees. U claims
depreciation deductions for the capitalized cost of these sewer line extensions over the
recovery period prescribed under § 168.
LAW
Section 61(a) and the regulations thereunder define gross income to mean,
except as otherwise provided, all income from whatever source derived.
Section 118(a) provides that, in the case of a corporation, gross income does not
include any contribution to the capital of the taxpayer.
Section 118(c)(1) provides that the term “contribution to the capital of the
taxpayer” includes certain amounts received by regulated public water and sewerage
disposal utilities as a CIAC. Under § 118(c)(4), the adjusted basis of any property
acquired with a CIAC that is excludable from gross income under § 118(c) is zero.
Section 446(e) requires a taxpayer who changes its method of accounting to
secure the consent of the Commissioner before computing its taxable income under the

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new method. Under § 1.446-1(e)(2)(ii)(a) of the Income Tax Regulations, a change in a
method of accounting includes a change in the overall plan of accounting for gross
income or deductions or a change in the treatment of any material item used in the
overall plan of accounting. A material item is any item the treatment of which affects the
proper time for including income or taking a deduction. § 1.446-1(e)(2)(ii)(a). The key
characteristic of a material item “is that it determines the timing of income or
deductions.” Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781, 798 (11th
Cir. 1984).
The relevant question is generally whether the treatment of the item permanently
changes the amount of taxable income over the taxpayer’s lifetime. If the treatment
does not permanently affect the taxpayer’s lifetime taxable income, but does or could
change the taxable year in which taxable income is reported, the treatment affects
timing and is therefore a method of accounting. See
Knight-Ridder Newspapers, Inc.,
743 F.2d at 799; Peoples Bank & Trust Co. v. Commissioner
, 415 F.2d 1341, 1344 (7th
Cir. 1969); Primo Pants Co. v. Commissioner, 78 T.C. 705, 723 (1982); Rev. Proc. 91-
31, 1991-1 C.B. 566, § 3.02.
A change in method of accounting does not include an adjustment of any item of
income or deduction that does not affect the proper time for including the item in income
or taking a deduction. § 1.446-1(e)(2)(ii)(b). For example, corrections of items that are
deducted as interest or salary, but that are in fact payments of dividends, and
corrections of items that are deducted as business expenses, but that are in fact
personal expenses, are not changes in method of accounting. Id
.

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Section 481(a) requires a taxpayer to take into account any adjustment to taxable
income necessary to prevent amounts from being duplicated or omitted as a result of a
change in method of accounting.
In Saline Sewer Co. v. Commissioner, T.C. Memo. 1992-236, the Tax Court held
that a change from excluding customer connection fees from gross income, as
nontaxable CIACs under § 118, to including the customer connection fees in gross
income was not a change in method of accounting because, according to the court, “no
timing issue [wa]s involved.” 63 T.C.M. (CCH) 2834. The taxpayer in Saline Sewer

treated customer connection fees as an excludable CIAC under § 118, which required
an adjusted basis of zero in the improvements constructed with these fees. Upon
examination of the taxpayer’s income tax return, the Service determined that the
customer connection fees did not qualify for the exclusion under § 118. The Service
proposed to change the taxpayer’s method of accounting to include customer
connection fees in income and increase the depreciable basis of the improvements
constructed with these fees.
In reaching its conclusion that the change imposed by the Service did not
constitute a change in method of accounting, the court analyzed the receipt of the
customer connection fees independently from the effect on depreciable basis of the
improvements constructed with those fees. The court concluded that a change from
excluding customer connection fees from income to including them in income gives rise
to a permanent difference in lifetime income, not a timing difference, and therefore is not
a change in accounting method. Similarly, the court concluded that a change in the

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depreciable basis of the improvements results in a permanent difference in the amount
of depreciation deductions allowed, and that this change is not a change in accounting
method. The court did not consider the effect of the combined changes in income,
basis, and depreciation on the taxpayer’s lifetime taxable income. See also Florida
Progress Corp. v. United States, 156 F.Supp.2d 1265, 1276 (M.D. Fla. 1999) (relying
upon Saline Sewer and holding that the change in treatment of customer connection
fees was not a change in method of accounting), aff’d per curiam on other issues, 264
F.3d 1313 (11th Cir. 2001).
ANALYSIS
Whether U
’s change to the treatment of its customer connection fees is a change
in method of accounting depends upon whether the change permanently affects U’s
lifetime taxable income. If U
’s change has no effect on its lifetime taxable income, but
affects only the timing of that income, then it is a change in method of accounting.
“Taxable income,” as defined in § 63, means gross income minus allowable deductions.
Therefore, an analysis of the effect of U
’s change on lifetime taxable income must
consider the effect on both income and deductions.
Section 118 affects both the gross income and the deduction of CIACs qualifying
under § 118(c). Section 118(c)(1) excludes the customer connection fees from
gross income, and § 118(c)(4) mandates a depreciable basis of zero for the
improvements constructed with these customer connection fees, resulting in no
depreciation or other deduction. The net effect of § 118(c) is to deny depreciation
deductions for infrastructure developed with funds previously excluded from income.

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See
Small Business Job Protection Act of 1996, H.R. Rep. No. 104-737, at 316 (1996)
(indicating that the designation “contributions in aid of construction” impacts both gross
income and basis).
U
’s lifetime taxable income with respect to its customer connection fees is the
same whether those fees are treated as (1) gross income followed by allowable
depreciation deductions or (2) nontaxable CIACs resulting in zero basis and no
depreciation deductions. Under its existing treatment, U excludes the customer
connection fees from gross income and can take no depreciation deductions because
the customer connection fees are not included in the depreciable basis of the assets
constructed with the fees. See
§ 118(c). Under its contemplated treatment, U includes
the customer connection fees in gross income and may take depreciation deductions
(over the assets’ recovery periods) because the customer connection fees create
depreciable basis in the assets constructed with the fees. Thus, U
’s lifetime taxable
income will be the same under either treatment because there are corresponding and
offsetting changes in U
’s gross income and deductions. Accordingly, U’s change from
treating customer connection fees as nontaxable CIACs under § 118(c) to treating the
payments as includible in gross income constitutes a change in method of accounting
within the meaning of §§ 446 and 481 and the regulations thereunder. See
Johnson v.
Commissioner, 108 T.C. 448, 495 (1997) (both income and related offsetting deductions
are considered when determining if lifetime income is affected), aff’d in part, rev’d in
part, 184 F.3d 786, 790 (8th Cir. 1999); Rankin v. Commissioner
, 138 F.3d 1286, 1289
(9th Cir. 1998) (combined effect of current-year deductions and offsetting income in

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future years must be considered in determining whether a change in method of
accounting occurs); see
also Rev. Proc. 2002-9, 2002-1 C.B. 327, §§ 1.01, 1A.01 of the
APPENDIX.
The legislative history of § 118 supports this conclusion. When originally
enacted, § 118 functioned much as it does today: it allowed certain regulated public
utilities to exclude CIACs from gross income (and required a reduction in depreciable
basis). The legislative history is clear that Congress viewed the exclusion as a method
of accounting. See
S. Rept. No. 94-938, at 436 (1976) (“If a taxpayer wishes to change
its present practice of treating contributions in aid of construction to a practice which is
consistent with this provision, such change constitutes a change in method of
accounting”). The exclusion for CIACs was repealed but reenacted in 1996. In
reenacting the exclusion, Congress did not address or revisit the question of whether a
change to or from § 118 treatment is a change in method of accounting. See
H.R. Rep.
No. 104-737, at 316 (1996).
HOLDING
A change from treating certain payments received from customers as nontaxable
contributions to capital under § 118(c) to treating the payments as taxable customer
connection fees is a change in method of accounting under §§ 446 and 481. Similarly,
a change from treating customer connection fees as taxable customer connection fees
to nontaxable contributions to capital under § 118(c) constitutes a change in method of
accounting under §§ 446 and 481.

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For the foregoing reasons, the Service does not acquiesce in the holdings on this
issue in Saline Sewer Co. v. Commissioner
, T.C. Memo. 1992-236, and Florida
Progress Corp. v. United States, 156 F.Supp.2d 1265 (M.D. Fla. 1999).
DRAFTING INFORMATION
The principal author of this revenue ruling is Karla M. Meola of the Office of
Associate Chief Counsel (Income Tax & Accounting). For further information regarding
this revenue ruling, contact Ms. Meola at (202) 622-4930 (not a toll-free call).