Proposed Removal of Section 451 Regs Resulting From Changes Made Under Tax Reform, To Limit Advance Payment Deferral to One Year
Summary
On October 15, the IRS released proposed regulations (REG-104872-18) to remove Section 1.451-5 of the regulations as a result of the changes made to Section 451 under tax reform, or what is known as the Tax Cuts and Jobs Act (TCJA). Under pre-TCJA law, Section 1.451-5 of the regulations currently provides rules for treating advance payments for goods and long-term contracts, including the ability for accrual method taxpayers to defer advance payments for inventorial goods for up to two years. However, these rules are overridden by new Section 451(c) which permits taxpayers to elect to include the advance payments in gross income or to defer advance payments for at most one year. Accordingly, for tax years beginning after December 31, 2017, affected taxpayers that are presently deferring advance payments longer than one year will need to change their method of accounting to a proper method consistent with the new rules once the proposed regulations are finalized.
Background
The new proposed regulations propose to remove Section 1.451-5 of the regulations, and its cross-references, relating to the treatment of advance payments for goods and long-term contracts under Section 451 of the Internal Revenue Code (Code). Section 451 provides the general rules for the timing of recognizing income as a cash or accrual basis taxpayer. Under Treas. Reg. Section 1.451-1, accrual method taxpayers must include items of income in the taxable year when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy (the “all-events” test).
Although neither the Code nor the regulations provide specific rules for determining when a taxpayer has a fixed right to income, the courts and the IRS have generally concluded that the all-events test is met at the earliest of (1) required performance by the taxpayer; (2) the date a payment becomes due; or (3) the date the payment is received by the taxpayer. Thus, under the all-events test, an accrual basis taxpayer generally must include advance payments in income in the year of receipt, even if the amount hasn’t been earned yet and/or is deferred for financial statement purposes.
Treas. Reg. Section 1.451-5(c) provides an exception to this general rule by permitting an accrual method taxpayer to defer substantial advance payments (as defined in Treas. Reg. Section 1.451-5(c)(3)) for inventoriable goods up to the second taxable year following receipt of the substantial advance payments. Substantial advance payments received under an agreement are recognized for tax purposes as they are included in gross receipts for financial statement purposes. Any remaining advance payment not yet included in taxable income is included in the second taxable year following receipt of the advance payment. In particular, this two-year deferral method was especially favored by taxpayers that sold gift cards that were later redeemable for inventoriable goods.
Tax Reform and Action Steps
Under the TCJA, Section 451(c) was added to codify the treatment of advance payments for accrual basis taxpayers for years beginning after December 31, 2017. Section 451(c) generally requires a taxpayer to include any advance payment in income in the year of receipt or make an election to (1) include any portion of the advance payment in income in the taxable year of receipt to the extent the amount is taken into account as revenue in a taxpayer’s applicable financial statement, and (2) include the remaining portion of the advance payment in income in the following taxable year. This election to defer advance payments of goods and services under new Section 451(c) is similar to the one-year deferral method provided in Revenue Procedure 2004-34, which presently remains applicable under IRS Notice 2018-35 issued this past April.
In the Joint Explanatory Statement issued with the TCJA, the government explicitly noted that new Section 451(c) is intended to override any deferral method provided by Treas. Reg. Section 1.451-5 for advance payments received for goods. Thus, once the proposed regulations are finalized, taxpayers that are currently on Section 1.451-5 will be required to change to another proper method (e.g., to include advance payments in income in the year of receipt or to defer advance payments in accordance with books up to one year under Rev. Proc. 2004-34). Presumably, this will necessitate the filing of a Form 3115, Application for Change in Method of Accounting.
As part of the proposed regulations, the Treasury Department and IRS request comments from the public on whether any changes to the existing procedural rules under Section 446 for changes in methods of accounting are necessary or desirable as a result of removing Treas. Reg. Section 1.451-5. Although such procedural guidance has yet to be issued, it is likely that changing from a method of accounting described in Treas. Reg. Section 1.451-5 to a proper method of accounting for advance payments will be automatic. That said, Rev. Proc. 2018-31, the current procedural guidance listing the automatic consent method changes, allows taxpayers to file an automatic Form 3115 to change to either the full inclusion method (automatic change #83) or the one-year deferral method (automatic change #84) for advance payments under Rev. Proc. 2004-34. For a taxpayer’s first or second taxable year ending on or after May 9, 2018, the IRS has specially waived the limitation that would normally preclude a taxpayer from filing an automatic method change if a prior method change was filed for the same item within a five-year period. This waiver is especially helpful for taxpayers that previously filed a Form 3115 in recent years to use the two-year deferral under Treas. Reg. Section 1.451-5, but find themselves now having to change to a method of accounting for advance payments to comply with new Section 451(c). As an automatic change, the Form 3115 must be attached to the timely filed (including extensions) federal income tax return for the year of the change and a copy of the Form 3115 must be mailed to the IRS Covington, Kentucky office on or before the filing date of that return.
BDO Insights
Taxpayers should continue to monitor the status of the proposed regulations and familiarize themselves with the issuance of any future procedural guidance related to the treatment of advance payments in order to determine what action items they must take to properly comply with Section 451. On the one hand, accrual method taxpayers that have previously adopted a method of accounting described in Treas. Reg. Section 1.451-5 for advance payments are advised to change to a proper method under Section 451(c) for tax years beginning after December 31, 2017. On the other hand, any accrual method taxpayers that are receiving advance payments for goods for the first time should ensure that they elect a method of accounting that is consistent with new Section 451(c) for tax years beginning after December 31, 2017.
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.
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