On the same day that Congress finalized an agreement on a new Coronavirus relief package and government-funding bill, the Treasury and IRS released what may have otherwise been the news of the day in the world of federal income tax: the long-awaited final regulations to implement changes to section 451 introduced by the Tax Cuts and Jobs Act.
The final regulations address the timing of income recognition under the new provisions of section 451(b) and (c), and finalize two sets of proposed rules issued in September 2019. Section 451(b) imposes an income inclusion rule for accrual method taxpayers that is pegged to revenue recognition in an applicable financial statement (AFS), whereas section 451(c) provides limited income deferral that largely codifies prior guidance under Rev. Proc. 2004-34.
Compared with the proposed rules, the final regulations are something of a compromise. They make certain provisions optional in an attempt to mitigate perceived inequities in the proposed rules, but appear to trade more taxpayer-favorable approaches for tracking, recordkeeping and documentation. Some of the more prominent features of the final regulations are summarized as follows:
Section 1.451-3 Timing of income inclusion for taxpayers with an AFS using an accrual method
- The general rule and enforceable right to recover. In general, income is recognized no later than the time such income is taken into account as AFS revenue, reduced by amounts for which taxpayers have no enforceable right to collect from their customers at year-end. The determination of enforceable right is factual, including analysis of the terms of the contract and applicable federal, state and local laws.
- Alternative AFS revenue method. Alternatively, taxpayers may forgo the factual determination of enforceable right to collect and instead follow AFS inclusion. This optional rule, which is a method of accounting that applies to all items of gross income within a taxpayer’s trade or business, is intended to reduce compliance burden in exchange for potentially less taxpayer-favorable results.
- Contingent consideration and the rebuttable presumption. The proposed rules presumed all amounts included in AFS revenue were not contingent consideration, unless the taxpayer could rebut this presumption based on the facts and circumstances. In response to numerous comments, the final regulations replace this rule entirely with the general rule and enforceable right to recover. We will continue to evaluate this substitution to determine the extent to which this is an improvement over the proposed rule and how the compliance considerations differ.
- Cost offset for AFS income inclusions. In general, and only for purposes of the AFS inclusion rule for the future sale of goods, taxpayers may determine a cost offset based on costs incurred, according to their tax method of accounting for inventories, prior to the year in which ownership of such inventory is transferred. The cost offset may not include estimates of future costs and does not extend to income from the provision of services (although the latter was perceived as less of an inequity in the proposed rules). We will continue to evaluate the level of detail required for purposes of allocating costs incurred to contracts for the sale of goods and differences between costs incurred for the AFS and tax.
Section 1.451-8 Advance payments for goods, services and certain other items
- Largely unchanged. The government mostly left the proposed rules for advance payments unchanged, declining many of the suggestions in comments received. However, the government did incorporate certain changes within the final regulations.
- Optional specified goods exception. The specified good exception that excludes certain payments for specified goods as advance payments subject to section 451(c) is now an optional method of accounting. The proposed rules excluded such payments altogether, but the final regulations permit taxpayers the option to include them as advance payments.
- Cost offset for advance payments. The government also included a cost offset for advance payments for the future sale of goods that is similar to the rule described above for AFS income inclusion. In fact, the final regulations stipulate that taxpayers opting to use the AFS cost offset method must use the method for both the AFS income inclusion rule and advance payments.
Unsurprisingly, the government declined to define realization in the context of gross income, but did offer some clarity for taxpayers to determine when income is not fixed at year-end and may therefore be excluded from the AFS income inclusion rule. The government also declined for now to incorporate an optional book percentage of completion method approach that would allow taxpayers to follow their book method for tax. However, the government indicated that they would continue studying the feasibility and efficacy of this approach, providing some glimmer of hope that more simplification could come in the future.
Taxpayers should generally welcome the final regulations, although some may do so reluctantly given certain tradeoffs in the form of tracking, recordkeeping and documentation. However, the final regulations offer taxpayers more options and the potential to achieve more equitable results than possible under the proposed rules.
The final regulations are generally effective for taxable years beginning on or after Jan. 1, 2021. A revenue procedure addressing the change in accounting method procedures necessary to implement the final regulations is expected early next year. Taxpayers should consult their tax advisors for tax considerations for both compliance and planning related to the final regulations.