Final Section 451 Regulations Provide Additional Clarity and Limited Relief for Accrual Method Taxpayers
Final Section 451 Regulations Provide Additional Clarity and Limited Relief for Accrual Method Taxpayers
On December 21, 2020, the IRS and Treasury released final regulations (TD 9941) addressing the timing of income recognition for accrual method taxpayers under Internal Revenue Code (IRC) Sections 451(b) and 451(c), as amended by the 2017 Tax Cuts and Jobs Act (TCJA). These regulations supersede proposed guidance issued in September 2019 and provide taxpayers with additional clarity and limited relief related to the acceleration of income and corresponding cost offset, as well as addressing key interactions with ASC 606 (the new revenue recognition standard for financial reporting purposes). Changes to comply with the final regulations constitute changes in methods of accounting to which Sections 446 and 481 apply. The preamble to the regulations notes that the IRS and Treasury anticipate issuing procedural guidance to assist taxpayers with complying with these final rules, which will likely result in new and/or modified accounting method changes that taxpayers will be required to file for their 2021 tax year.
The regulations are generally applicable for taxable years beginning on or after January 1, 2021. However, taxpayers have the option of applying the rules in the final regulations for taxable years beginning after December 31, 2017 and before January 1, 2021, provided that the rules are applied in their entirety and in a consistent manner to all subsequent taxable years.
While several of the provisions outlined in the final regulations skew favorably for taxpayers in comparison to the proposed regulations by decreasing, to some degree, the divergence between book and tax accounting, the implementation of these regulations can be complex for many taxpayers. In many instances, taxpayers will still be required to calculate a book/tax difference in determining the proper amount of gross revenue to report for tax purposes. As such, technical uncertainties will likely continue to exist even after the effective date of the final regulations.
Highlights of Section 451(b) Regulations
Prior to the enactment of Section 451(b) under the TCJA, an accrual method taxpayer recognized income in the tax year in which all the events occurred to fix the right to receive such income (the “all events test”) and the amount was determinable with reasonable accuracy. The courts and the IRS have historically held that the all events test is met at the earliest of when the income is earned, due or received. However, based on the changes made to Section 451 in the TCJA, an accrual method taxpayer with an Applicable Financial Statement (AFS) must recognize an item of income, or portion thereof, upon the earlier of when the all events test is met or when the item of income, or portion thereof, is taken into revenue in its AFS. This so-called “AFS income inclusion rule” operates only in one direction, namely, to accelerate the timing of the recognition of gross income for tax purposes. Thus, an accrual method taxpayer with an AFS that is deferring the recognition of income to a tax year later than in which such income is taken into account as AFS revenue may be required to change its method of accounting to comply with Section 451(b).
The following are significant highlights of Treas. Reg. §1.451-3:
- According to the legislative history to the TCJA, Section 451(b) was not intended to revise the rules associated with when an item of income is realized for federal income tax purposes. Declining to define realization, the IRS and Treasury state that providing rules on realization is beyond the scope of the final regulations. The preamble to the final regulations states that “[t]he statute thus reflects Congress’ intent to incorporate timing concepts from the financial reporting rules in the tax timing rules for including items in gross income. It does not seek to answer whether the AFS income inclusion has been realized.” To this end, the final regulations provide a new rule that an item of gross income is “taken into account as AFS revenue” only if taxpayer has an enforceable right to recover the AFS amounts if the customer were to terminate the contract on the last day of taxable year. Whether the taxpayer has an enforceable right to recover amounts of AFS revenue is governed by the terms of the contract and applicable federal, state or international law, and includes amounts recoverable in equity and liquidated damages. This new rule replaces the concept in the proposed regulations that had resulted in variable consideration included in the transaction price for book purposes being included for Section 451(b) purposes based on a presumption that the taxpayer’s entitlement to the amount was not contingent, unless the facts and circumstances indicated otherwise. Therefore, the new rule allows taxpayers to remove income included in AFS revenue that the taxpayer does not have an enforceable right to recover if the customer were to terminate the contract at the end of the taxable year.
- In addition to the rule discussed above permitting a taxpayer to exclude AFS revenue that a taxpayer does not have an enforceable right to recover if the customer were to terminate the contract on the last day of the taxable year, two other adjustments to AFS revenue are required. These adjustments are: (i) to increase the AFS revenue for amounts excluded for cost of goods sold and liabilities that are required to be accounted for under other provisions of the IRC, such as Section 461 (including allowances, rebates, chargebacks, rewards issued in credit card transactions, and other reward programs and refunds), and amounts anticipated to be in dispute or anticipated to be uncollectable; and (ii) to decrease any AFS revenue attributable to revenue from a significant financing component that is deemed to exist under the standards the taxpayer uses to prepare its AFS. The second adjustment is new and welcome, as it resolves questions about whether deemed financing income should be included for tax purposes.
- Taxpayers have the option of using the “alternative AFS revenue method” under which the adjustments discussed above are made, except that AFS revenue is not reduced for amounts for which the taxpayer lacks an enforceable right to recover if the customer were to terminate the contract on the last day of the year. If used, it applies to a trade or business and to all items of gross income in the trade or business that are subject to the AFS income inclusion rules. Thus, no “cherry-picking” of amounts for different types of revenue will be permitted. This alternative AFS revenue method provides administrative simplicity for taxpayers that prefer to minimize book/tax differences but results in income being recognized earlier for tax purposes.
- One of the most significant developments in the final regulations is the introduction of a “cost offset” method to reduce the amount of income a taxpayer must recognize under Section 451(b). Specifically, the regulations offer taxpayers the option of applying an offset for costs actually incurred to date against AFS income inclusions from the future sale of inventory. This optional method mitigates, in certain instances, the potentially harsh result arising from situations involving taxpayers being required to include income from the sale of inventory under an “over-time” methodology (e.g., in accordance with their ASC 606 income recognition method for AFS purposes), but not being able to recognize the related cost of goods sold amount until the year the inventory is sold. Under the optional AFS cost offset method, a taxpayer reduces the amount of gross income inclusion by the cost of goods incurred through the last day of the taxable year, as determined under Sections 461, 471 and 263A. Importantly, the cost of goods in progress offset does not affect how and when costs are capitalized to inventory under the taxpayer’s existing methods of accounting; rather, the offset serves only to defer the recognition of income to the year in which the inventory is sold.
In general, if an accrual method taxpayer’s contract contains more than one performance obligation, the transaction price is allocated to each corresponding item of gross income for tax purposes in accordance with how the transaction price amount is allocated to each performance obligation for AFS purposes. However, the final regulations provide some additional clarifying rules regarding the application of this provision. First, if a single performance obligation (as determined for AFS purposes) yields more than one corresponding item of gross income, the transaction price amount must be further allocated among the corresponding items of gross income using any reasonable method.
The final regulations also address the allocation of the transaction price to contracts that include both income subject to Section 451 and income subject to a special method of accounting provision (e.g., percentage-of-completion under Section 460). In these instances, the regulations provide that the transaction price is first allocated to items of gross income subject to a special method of accounting, with the remaining residual amounts allocated to the item(s) of gross income subject to Section 451.
- The preamble to the final regulations briefly discusses the evaluation of a book percentage-of-completion method (“book PCM”), which was suggested by a commenter as a simplifying provision to allow taxpayers to follow their AFS treatment of both the recognition of revenue and costs over time. Treasury and the IRS declined to adopt this suggestion in the regulations but noted that they will continue studying the feasibility and efficacy of the book PCM method. However, the cost offset method described above should provide some relief to taxpayers in the absence of a book PCM method, although taxpayers will still need to consider any relevant book/tax differences in applying the cost offset method.
Highlights of Section 451(c) Regulations
Section 451(c) generally permits a taxpayer using an accrual method of accounting that has an AFS to use the deferral method of accounting for advance payments for goods, services and other specified items. Under this “AFS deferral method,” a taxpayer includes in its gross income any portion of an advance payment that is recognized in its AFS in the year of receipt and includes the remaining portion of the advance payment in gross income in the following taxable year. Although Congress intended Section 451(c) to generally codify the existing one-year deferral method under Rev. Proc. 2004-34, the statutory language does not contain some of the special rules prescribed by the revenue procedure and excludes from its scope accrual taxpayers without an AFS. The provisions under Treas. Reg. §1.451-8 are now substantially similar to those outlined under Rev. Proc. 2004-34 (obsolete for years beginning on or after January 1, 2021), and in some cases expand beyond what was offered by the revenue procedure.
The following are significant aspects of Treas. Reg. §1.451-8:
- Under the AFS deferral method, an accrual method taxpayer must include all or a portion of the advance payment in gross income in the taxable year of receipt to the extent “taken into account as AFS revenue” as of the end of that year, and include the remaining portion of the advance payment in gross income in the next succeeding year. To determine the extent that an advance payment is treated as “taken into account as AFS revenue,” the taxpayer must make certain adjustments to the revenue reported on the taxpayer’s AFS, similar to the final regulations under Section 451(b) discussed above. Accordingly, adjustments should be made to (i) increase the AFS revenue for amounts reduced for liabilities that are accounted for under other IRC provisions (such as Section 461 or amounts anticipated to be in dispute or uncollectible) and (ii) decrease any AFS revenue attributable to revenue from a significant financing component deemed to exist under the standards used to prepare the AFS.
Consistent with the cost offset rule available for the sale of inventory under Section 451(b), the final regulations under Section 451(c) afford taxpayers the flexibility of applying an offset for costs incurred against advance payments for the future sale of inventory. This “advance payment cost offset method” allows taxpayers to offset advance payments included in income under either the deferral method or the full inclusion method. Accordingly, the portion of any advance payment that is reduced by a cost offset for a taxable year is deferred and generally included in gross income in the taxable year in which ownership of the item of inventory transfers to the customer.
Taxpayers that choose to use the advance payment cost offset method for a trade or business must also use the AFS cost offset method in Treas. Reg. §1.451-3 for that trade or business. Note that for a sale of a gift card or customer reward program points, no cost of goods offset is permitted.
- The final regulations clarify that a payment can qualify as an advance payment for definitional purposes, but if the amount is earned in the year of receipt, it cannot be deferred for tax purposes, even if the amount is deferred for AFS purposes. The example from the final regulations cites to the rules governing the acceleration of advance payments in gross income for the taxable year where, among other things, the taxpayer’s obligation for the advance payments is satisfied or otherwise ends in that taxable year.
- The final regulations retain the “specified goods” exception to the definition of advance payments that was offered in the proposed regulations but provides added flexibility. This is an upfront payment under a contract if (i) the contractual delivery date of the good occurs at least two taxable years after an upfront payment, (ii) the taxpayer does not have the goods or substantially similar goods on hand at the end of the year the upfront payment is received, and (iii) the taxpayer recognizes all of the revenue from the sale of the goods in its AFS in the delivery year. If a prepayment satisfies the specified goods exception, the prepayment is generally analyzed under Section 451(a) and (b), rather than the deferral method under Section 451(c). However, acknowledging that some taxpayers may prefer the latter, the final regulations allow taxpayers the flexibility of electing to treat all prepayments for specified goods under the deferral method (and to use the advance payment cost offset method described above, if applicable).
As the rules outlined in the final regulations offer some favorable provisions, taxpayers should carefully analyze their facts for taxable years beginning before 2021 to assess whether early adoption makes sense. Further, all accrual method taxpayers will need to consider the implications of the rules for purposes of calculating estimated tax payments for their 2021 tax year, as well as any financial reporting implications under ASC 740. Taxpayers are also encouraged to weigh the relative cost/benefit of adopting or changing to the optional methods (e.g., the alternative AFS revenue method or the AFS cost offset method) to assess whether the reduction in tax liability from the optional methods are worth the additional compliance burden of performing the analysis. Lastly, as the IRS and Treasury are expected to issue procedural guidance to assist taxpayers with implementing the final regulations in the near future, taxpayers should monitor this area for additional updates to determine which specific action items are necessary to comply with the new rules.
If you have any questions, please contact a member of the Accounting Methods group. The Accounting Methods group within BDO USA’s National Tax Office has extensive experience assisting taxpayers of all industries and sizes with their accounting method issues and filing accounting method change requests with the IRS.