On Sept. 9, 2019, the IRS published proposed regulations (Proposed section 1.451-3 Regulations) in the Federal Register regarding the overall timing of income recognition for accrual method taxpayers with an applicable financial statement (AFS). These proposed regulations clarify how taxpayers are to interpret the potential acceleration of taxable income under section 451(b), the AFS income inclusion rule.
The proposed regulations expand upon the statutory language of section 451(b), especially in the areas of defining a special method of accounting, clarifying what revenue is accelerated and when, addressing comments regarding a potential cost of goods sold offset, highlighting appropriate treatment when a taxpayer has an AFS in one year and no AFS in the following year, and issuing guidance where the taxpayer’s taxable year end may not match the financial reporting year end.
As stated above, the AFS income inclusion rule only applies to taxpayers that report income under the accrual method of accounting and have an AFS. The AFS income inclusion rule provides that a taxpayer subject to the rule must recognize gross income, or portion thereof, no later than when the item, or portion thereof, has been recognized as revenue in its AFS. With the adoption of the new financial reporting standards for revenue recognition, many taxpayers are finding this AFS income inclusion rule accelerates the recognition of revenue as compared with the tax all events test. The statute does provide an exception to the rule if the item is accounted for under a special method of tax accounting.
In a welcome item of guidance, the proposed regulations expand on the term special method of accounting and provide a non-exclusive list of special methods of accounting. The listing of many additional special methods of accounting will assist taxpayers as they continue to review items of revenue and determine appropriate tax treatment.
The guidance also addresses the treatment of variable consideration and whether taxpayers are required to include such amounts in taxable income prior to the point the event establishing a liability or the fixed right to income exists. Section 451(b) requires taxpayers to review whether a taxpayer must accelerate revenue and does not change the timing of a deduction for a liability. In determining whether taxpayers should accelerate revenue, taxpayers must first determine whether an amount is gross income before moving on to when to recognize such income. Complicating matters slightly for taxpayers is the government’s view that increases to the transaction price for variable consideration are presumed to be realized unless the taxpayer’s fact and circumstances can rebut such presumption.
As expected, the proposed regulations cement the view of the IRS that section 451(b) is intended to accelerate income in circumstances where financial accounting has accelerated revenue at a point prior to when delivery, acceptance, title transfer or the right to bill occurs. While financial accounting will recognize costs incurred to produce the asset, the regulations make clear that a cost offset provision to recognize future cost of goods sold deductions, future estimated costs or other cost offsets is inconsistent with the economic performance rules, rules for allocating costs to inventory, and rules for when a taxpayer recognizes the sale of inventory. In plain language, these rules could cause taxpayers to be taxed on revenue in one year without offsetting that revenue by incurred costs until a later year.
The proposed regulations address several other items, including the application of the rules to multi-year contracts, the inability of a taxpayer to use a method of tax accounting that simply ‘follows book’, and how taxpayers are to move between methods of accounting should they have an AFS in alternating years. Also addressed were rules for certain debt instruments, which we address here.
The regulations are effective for taxable years beginning on or after the date the final regulations are published in the Federal Register. Until such date, a taxpayer may rely on the proposed regulations for taxable years beginning after Dec. 31, 2017, provided that the taxpayer applies the proposed rules in total to all items of income during the taxable year (other than specified fees). For specified credit card fees, a taxpayer may rely upon the proposed regulations for all taxable years beginning after Dec. 31, 2018, provided that the taxpayer applies the proposed regulations for specified credit card fees and consistently applies the proposed regulations to all items of income during the taxable year (other than specified fees).
RSM will be issuing a series of in-depth guidance on these proposed regulations, proposed regulations under Reg. section 1.451-8 (the advance payment proposed regulations), the release of automatic change procedures to comply with the regulations and the overall impact and tie-ins to entities that are still in the process of adopting the financial accounting revenue recognition standard. Stay tuned for those release items.
The proposed regulations provide welcome interpretation of the AFS income inclusion rule and give taxpayers the opportunity to comment on proposed rule before final regulations are published. Significantly impacted industries include industrial products manufacturing, service based industries, and certain elements of the insurance industry. As revenue is perhaps the most critical material item in a company’s trial balance proper recognition and understanding of these new regulations is paramount to effective tax planning.