New Automatic Method Change for Accrual Method Taxpayers with Applicable Financial Statements to Comply with Section 451(b)
New Automatic Method Change for Accrual Method Taxpayers with Applicable Financial Statements to Comply with Section 451(b)
Last December, Congress enacted several changes to the timing of income recognition in the 2017 tax reform, also known as the Tax Cuts and Jobs Act (P.L. 115-97), including a rule that prevents accrual method taxpayers with applicable financial statements from recognizing income for tax purposes later than the tax year in which that income is taken into account as revenue in the taxpayer’s applicable financial statement or such other financial statement as the Secretary may specify. Under this new Section 451(b) of the Internal Revenue Code, which takes effect for taxable years beginning on or after December 31, 2017, accrual-basis taxpayers that are currently deferring income to a tax year later than when books recognize such income are generally required to change the existing method of accounting to comply with Section 451(b). Fortunately, to ease the administrative burden faced by taxpayers that are currently not in compliance with Section 451(b), the IRS has issued Rev. Proc. 2018-60 to enable taxpayers to file a Form 3115, Application for Change in Accounting Method, under the automatic consent change procedures (automatic change #239). For certain taxpayers, the revenue procedure even provides a streamlined procedure which does not involve filing Form 3115 or attaching a separate statement to the tax return. Rev. Proc. 2018-60 is welcome news for affected taxpayers that no longer have to rush to file nonautomatic method changes before the end of the 2018 tax year, and further shows the government’s ongoing commitment to issue additional clarifying guidance on revenue recognition in the near future.
To appreciate the significance of Section 451(b), it is useful to start with the general rules for the timing of income recognition. Once an item of gross income is determined to be clearly realized for federal income tax purposes, Section 451 and the underlying regulations provide the general rules as to the timing of when such item is to be included in gross income. Taxpayers on the overall cash method recognize income when actually or constructively received. In contrast, accrual method taxpayers have historically recognized income when all the events have occurred to fix the right to receive such income and the amount thereof can be determined with reasonable accuracy (referred to as the “all events test”). Based on case law and IRS authorities, it is well established that all the events that fix the right to receive income generally occur at the earliest of when (1) the payment is earned through performance, (2) payment is due to the taxpayer, or (3) payment is received by the taxpayer. In determining whether the right to receive has become fixed during a taxable year, the taxpayer must also consider whether any contingencies or conditions precedent occur after year-end. Income arising from the rendition of services or the sale of goods is not accruable for tax purposes if the right to receive that income is subject to conditions precedent or other contingencies. Therefore, in certain instances, a taxpayer may have properly recognized income at a later point in time than for financial reporting under the “old” Section 451 rules prior to tax reform.
Another situation where income is recognized for books earlier than for tax is a taxpayer’s implementation of the new revenue recognition standard for financial reporting purposes. On May 28, 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standard Board (IASB) jointly announced new ﬁnancial accounting standards for recognizing revenue, titled “Revenue from Contracts with Customers (Topic 606)” (the “New Standards”). Under the New Standards, a taxpayer generally recognizes revenue for financial accounting purposes when the taxpayer satisfies a performance obligation by transferring a promised good or service to a customer. An entity will recognize revenue for promised goods and services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services based on the following five sequential steps: (i) identify the contracts with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligation; and (v) recognize revenue as the entity satisfies a performance obligation. The New Standards are eﬀective for publicly-traded entities, certain not-for-proﬁt entities, and certain employee beneﬁt plans for annual reporting periods beginning after December 15, 2017. For all other entities, the New Standards are eﬀective for annual reporting periods beginning after December 15, 2018. Early adoption is allowed for reporting periods beginning after December 15, 2016. Companies that have implemented, or are in the process of implementing, the New Standards may well find that a performance obligation is satisfied at a point in time, and the resultant income is taken into revenue for book purposes, earlier than when all events have been met for federal income tax purposes. The introduction of Section 451(b) by the Tax Cuts and Jobs Act serves to help bridge the gap between the timing of recognizing the item of income for both book and tax purposes.
Under the new Section 451(b)(1)(A), for an accrual method taxpayer, “the all events test with respect to any item of gross income (or portion thereof) shall not be treated as met any later than when such item (or portion thereof) is taken into account as revenue in (i) an applicable financial statement of the taxpayer, or (ii) such other financial statement as the Secretary may specify for purposes of this subsection.”
Stated another way, an accrual method taxpayer with an applicable financial statement must include an item of income under Section 451 upon the earlier of when the all events test is met or when the taxpayer includes such item in revenue in an applicable financial statement. The following example demonstrates how Section 451(b)(1)(A) applies:
Example: ABC, an accrual basis taxpayer that purchases and resells high-end widgets online, implements the New Standards in 2018 and recognizes revenue on the Form 10-K from the sale of the goods when shipped because the performance obligation is satisfied at that point. For federal income tax purposes, ABC’s established method of accounting is to recognize the income when the goods are delivered to the customer under the rationale that all events under Section 451 have not occurred to fix the right to receive the income until title and risk of loss transfers upon delivery. For the tax year beginning January 1, 2018, ABC is not in compliance with Section 451(b)(1)(A) and cannot continue to defer the income later than when books recognizes the income in revenue. For the 2018 tax year, ABC should change its method of accounting for such income to comply with Section 451(b)(1)(A) and take action steps under the automatic procedures of Rev. Proc. 2018-60.
Further, based on a literal reading of Section 451(b), while income for tax cannot be deferred beyond the tax year that such income is recognized as revenue, it is certainly possible that income recognized under the all events test could be included in income for tax earlier than for financial reporting purposes.
Additionally, it is important to note some special rules under Section 451(b). First, Section 451(b)(4) provides that, “in the case of a contract which contains multiple performance obligations, the allocation of the transaction price to each performance obligation shall be equal to the amount allocated to each performance obligation for purposes of including such item in revenue in the applicable financial statement of the taxpayer.” Second, in the case of income from a debt instrument having original issue discount (OID), the Section 451(b) rules apply to tax years beginning after December 31, 2018. The provision directs accrual method taxpayers with an applicable financial statement to apply the income recognition rules under Section 451 before applying the special rules under part V of subchapter P, which, in addition to the OID rules, also includes rules regarding the treatment of market discount on bonds, discounts on short-term obligations, OID on tax-exempt bonds, and stripped bonds and stripped coupons. For example, to the extent amounts are included in revenue for financial statement purposes when received (e.g., late-payment fees, cash-advance fees, or interchange fees), such amounts generally are
includible in income at such time in accordance with the general recognition principles under Section 451.
Applicable Financial Statements
An applicable financial statement includes, in part, a financial statement which is certified as being prepared in accordance with generally accepted accounting principles and which is (1) a 10–K, or annual statement to shareholders, required to be filed by the taxpayer with the United States Securities and Exchange Commission, (2) an audited financial statement of the taxpayer which is used for credit purposes, reporting to shareholders, partners, or other proprietors, or beneficiaries, or any other substantial nontax purpose, or (3) filed by the taxpayer with any other federal agency for purposes other than federal tax purposes. Thus, a review or a compilation would not be considered an applicable financial statement for purposes of Section 451(b).
With respect to a group of entities, if the financial results of a taxpayer are reported on the applicable financial statement for a group of entities, Congress made clear that such statement shall be treated as the applicable financial statement of the taxpayer. For example, if the taxpayer is one of several subsidiaries in a consolidated group and the taxpayer’s activity is reported on both an individual and consolidated financial statement, the latter is treated as the applicable financial statement for purposes of Section 451(b).
Exceptions to Section 451(b)
Section 451(b) does not apply to:
- Cash method taxpayers
- Accrual method taxpayers without an applicable or other specified financial statement
- Accrual method taxpayers using a special method of accounting provided elsewhere in the Code (for example, installment method under Section 453 or the long-term contract methods under Section 460)
- Items of income in connection with a mortgage servicing contract
Highlights of the Automatic Change Procedure
Rev. Proc. 2018-60 prescribes a brand new automatic change #239 under Section 16.12 of Rev. Proc. 2018-31 that is effective for taxable years beginning after December 31, 2017 (for income from debt instruments having OID, after December 31, 2018). The following are key features of this new procedure:
- This automatic change applies to an accrual method taxpayer with an applicable financial statement that:
- wishes to change to a method of accounting that treats an item of gross income, or portion thereof, as meeting the all events test no later than when such item, or portion thereof, is taken into account as revenue in its applicable financial statement under Section 451(b)(1)(A), and/or
- is not adopting the New Standards for the year of change, and wants to allocate the transaction price to performance obligations under Section 451(b)(4).
- The requirement to mail a duplicate copy of the automatic Form 3115 to the IRS Covington, KY office is waived for this change. Therefore, the Form 3115 need only be attached to the timely filed (including extensions) federal income tax return for the year of change.
- The change in method of accounting triggers prior year audit protection for the item of income being changed and is implemented with a Section 481(a) adjustment, calculated as of the beginning of the year of change. This is beneficial for taxpayers faced with the acceleration of significant revenue as a result of complying with Section 451(b), as any taxpayer-unfavorable Section 481(a) adjustments are included in income ratably over four years, beginning with the year of change. In the case of income from a debt instrument having OID, the Section 481(a) adjustment period is six taxable years.
- A taxpayer may concurrently file automatic change #239 with automatic change #231 (changes in the timing of income recognition due to the New Topic 606 Standards) for the same year of change on a single Form 3115.
- Certain taxpayers wishing to change the method of accounting to comply with Section 451(b) are permitted to use a “streamlined” approach under which the requirement to file a Form 3115 or to attach a separate statement is waived. The streamlined method change procedure is only available to a taxpayer that meets one of the following requirements:
- the taxpayer, other than a tax shelter, qualifies as a small business taxpayer under Section 448(c) by having average annual gross receipts for the three prior taxable years of $25 million or less; or
- the taxpayer is making one or more changes to comply with Section 451(b)(1)(A) and/or Section 451(b)(4), and the total Section 481(a) adjustment is zero.
Audit protection is unavailable under this streamlined procedure. Notwithstanding, it affords qualifying taxpayers the administrative convenience of being able to comply with Section 451(b) simply by filing their federal income tax return. Qualifying taxpayers may, however, still choose to file a Form 3115 for the purposes of retaining a clear record of a method change, making permissible concurrent changes on the same Form 3115, or making a method change with audit protection. This streamlined procedure is only available for the first taxable year beginning after December 31, 2017.
- For the first, second, or third taxable year beginning after December 31, 2017 (after December 31, 2018, for income from debt instruments having OID), the IRS waives the automatic change eligibility rule that normally precludes taxpayers from filing an automatic change for the same item if it previously changed the method for that item in the prior five years.
Need For More Guidance
Although the issuance of Rev. Proc. 2018-60 is favorable to taxpayers, there remains a number of questions that need clarification from the IRS and Treasury. One of the priority areas is the interplay between Section 451(b) and the concept of a realization event. The legislative history to Section 451(b) provides that the provision is not meant to revise the rules associated with when an item is realized for federal income tax purposes, and therefore does not require the recognition of income in situations where the federal income tax realization event has not yet occurred. The question is whether the acceleration of income items into revenue under the New Standards (for example, variable consideration) causes tax to recognize income under Section 451(b)(1)(A) where the realization event has not yet occurred. Along the same lines, the definition of a realization event may need to be better defined. Another question is whether, in changing the method for revenue recognition to comply with Section 451(b)(1)(A), the IRS may permit taxpayers to take into account the net amount (i.e., gross sales less COGS) recognized for financial statement purposes. These questions and others not discussed herein demonstrate the need for further clarity from the IRS and Treasury, whether in the form of regulations or otherwise.
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.