On September 6, 2019, the IRS released the long-awaited proposed regulations under Section 451(b) and Section 451(c) for new rules from the 2017 tax reform reconciliation act, also known as the Tax Cuts and Jobs Act (TCJA). The following day, it released Revenue Procedure 2019-37, modifying previously issued guidance for taxpayers requesting tax accounting method changes due to either their adoption of Accounting Standards Codification (ASC) 606 for financial statement purposes or conformity to Section 451(b).
Each proposed regulation is effective for tax years beginning on or after the date that the regulation is finalized, although each can generally be relied upon for tax years beginning after December 31, 2017. An overview of the new proposed regulations follows.
Proposed Regulations Under Section 451(b)
As enacted by the TCJA, Section 451(b) requires taxpayers with an applicable financial statement (AFS) to recognize gross income for tax purposes at the earlier of when the all-events test is satisfied, or when the revenue is recognized in the taxpayer’s AFS.
The proposed regulations refer to this as the AFS income inclusion rule. This rule can’t cause income inclusion for tax to occur later than when the all-events test is satisfied. Therefore, it’s not a true book conformity requirement, but rather can only serve to accelerate, and not defer, taxable income.
It’s important to note that the AFS income inclusion rule doesn’t apply to any item of gross income in which the timing is determined under a special method of accounting. The proposed regulations provide a nonexclusive list of several special methods of accounting which include:
- The installment method
- The percentage-of-completion method (PCM)
- The crop method
- Methods used under Section 467 for rent
In addition, the AFS income inclusion rule doesn’t alter the treatment of a transaction for:
- Federal income tax purposes
- Application of an exclusion provision
- Treatment of a nonrecognition transaction
Finally, it doesn’t apply to any item of income in connection with a mortgage servicing contract.
The proposed regulation broadly defines an AFS to include certain financial statements prepared under either generally accepted accounting principles (GAAP) or international reporting financial standards (IFRS). In general, these include:
- A Form 10-K filed with the SEC
- Audited financial statements used for credit, shareholder reporting, or any other nontax purpose
- A financial statement filed with a federal agency other than the SEC or IRS, as well as other financial statements provided to federal or state governmental agencies or self-regulatory organizations
If the taxpayer’s AFS doesn’t cover the taxpayer’s entire tax year, the AFS income inclusion rule doesn’t apply for that year.
For taxpayers included in an AFS for a group of entities, the taxpayer’s AFS will generally be the group’s AFS.
There are three permissible methods to determine what revenue is recognized to apply the AFS income inclusion rule if the taxpayer has a different tax year than its AFS reporting period. These include:
- Interim closing of the books
- Pro rata allocation
- Use of revenue reported on the AFS for financial accounting year that ends within the tax year, but only if there’s a difference of five months or more in year-ends
Revenue and Transaction Prices
Revenue is broadly defined in the proposed regulation as all transaction price amounts included in gross income under Section 61.
Transaction price is defined as the gross amount of consideration to which a taxpayer expects to be entitled for AFS purposes in the exchange for transferring promised goods, services, or other property.
Notably, the transaction price for AFS purposes can be different from the transaction price determined for tax purposes. The proposed regulation explicitly excludes these items from the transaction price:
- Amounts collected on behalf of third parties
- Increases to consideration in which a taxpayer’s entitlement of the income is contingent on the occurrence or nonoccurrence of a future event
- Reductions for liabilities under Section 461, including allowances, adjustments, rebates, chargebacks, refunds, rewards, and amounts included in cost of goods sold
Contingent income included in the transaction price for AFS purposes is presumed to not be contingent income for tax purposes unless the taxpayer can’t establish to the satisfaction of the IRS that such amount is, in fact, contingent.
As expected, the proposed regulations conclude that costs or potential reductions associated with income accelerated due to the AFS income inclusion rule may not reduce the accelerated revenue until deductible under Section 461.
This could present a significant cash flow challenge to taxpayers where the AFS income inclusion rule will trigger an accelerated recognition of income—for instance, if ASC 606 is shifting revenue recognition to a book PCM approach—but without the corresponding acceleration of related expenses.
Taxpayers with multiyear contracts must take a cumulative approach rather than an annual approach to apply the AFS income inclusion rule. This requires taxpayers to consider cumulative amounts previously reported in prior taxable years when determining a given contract year’s income inclusion.
Proposed Regulation Under Section 451(c)
Section 451(c) provides a rule similar to the one-year deferral permitted by Rev. Proc. 2004-34 for certain advance payments, with some differences. As expected, the proposed regulation largely incorporates those differences into the application of the Section 451(c) deferral method.
It also expands the application of Section 451(c) to taxpayers without an AFS, aiming to ultimately revoke Rev. Proc. 2004-34.
The proposed regulation defines advance payments in a manner consistent with Rev. Proc. 2004-34. It does, however, leave room for the secretary to add additional types of eligible payments at a later date.
Similarly, the proposed regulation includes the same exclusions, but adds a new exclusion for amounts received at least two tax years prior to the contractual delivery date for a specified good. This is applicable only if the taxpayer doesn’t have the good, or a substantially similar good, on hand at the end of the year the payment is received and recognizes all revenue from the sale in its AFS in the year the item is delivered.
AFS Deferral Method
Similar to Rev. Proc. 2004-34, the AFS deferral method requires a taxpayer with an AFS that receives an advance payment to include:
- The advance payment in income in the taxable year of receipt, to the extent that it’s included in revenue in its AFS
- The remaining amount of the advance payment in income in the next taxable year
This provides for a maximum one-year deferral even if the AFS defers revenue for a longer period.
Non-AFS Deferral Method
Also similar to Rev. Proc. 2004-34, the non-AFS deferral method requires an accrual method taxpayer without an AFS that receives an advance payment to include:
- The advance payment in income in the taxable year of receipt, to the extent that it’s earned for tax purposes
- The remaining amount of the advance payment in income in the next taxable year
Payment is earned for tax purposes when the all-events test is met, without regard to when the amount is received.
Financial Statement Equity Adjustments
Finally, the proposed regulation provides guidance on the tax treatment of financial statement adjustments to retained earnings, or other equity account, for deferred revenue from advance payments using the deferral method.
In short, it provides that the remainder of advance payment must be picked up in the subsequent year regardless of any adjustment or write-down made for financial statement purposes. This rule applies to both the AFS and non-AFS deferral methods.
Revenue Procedure 2019-37
The new revenue procedure modifies the method change guidance provided previously for changes related to revenue recognition as well as provides new guidance for changes to the deferral method for advance payments consistent with the proposed regulation. Automatic consent is generally available for most changes and it’s generally applicable for tax years beginning after December 31, 2017.
The new procedure now permits more liberal use of the cut-off method for certain accounting method changes. Under the cut-off method, contracts or advanced payments prior to the adoption of the proposed regulations continue to use the old method of accounting, but any future contracts or payments would adopt the new method. Therefore, no catch-up adjustment exists for differences in reporting under the current and new accounting methods.
Tax Reporting Concerns
The proposed regulations shed light on how Section 451(b) and Section 451(c) apply to taxpayers. Unfortunately, many of the known challenges with Section 451(b) remain–notably the lack of a cost offset and questions surrounding contingent income.
If your company plans to or previously adopted ASC 606, you’ll need to consider how the Section 451 changes and related proposed regulations impact your tax reporting. Taxpayers not currently adopting ASC 606 will still need to address the Section 451 changes. You may be required to file one or more accounting method changes and may have new book-tax differences to track.
The first step is to understand what, if anything, is changing for financial statement purposes and then determine how those differences, as well as the new Section 451 rules, impact tax reporting. Only once this analysis is complete can you determine whether or not a change in method is needed and if there’s a new Schedule M adjustment to compute.
We’re Here to Help
To learn more about how the Section 451 changes and these proposed regulations may impact you or your business’s tax reporting, contact your Moss Adams professional.