Revenue Recognition for the tech industry
New standards mean new federal income tax challenges
INSIGHT ARTICLE |
Reporting for the 2017 tax year is coming to a close, but the accounting work is just beginning—revenue recognition is upon all companies. Going forward, there are new standards for when businesses recognize revenue into income for book and tax purposes. Although many companies have planned for the financial accounting impacts, there are major tax implications that every tech business should be planning for. Add the recently passed tax legislation, which introduces new rules that haven’t been defined yet, to the mix, and business planning becomes even more important. As with any change in accounting systems, the new standards mean pitfalls for tax exposure, as well as opportunities for deferring income and increasing cash flow.
The new standards
In May 2014, the authorities that set standards for financial reporting—the Financial Accounting Standards Board (FASB), and the International Accounting Standards Board (IASB)—issued joint guidance. The FASB issued ASC 606, Revenue from Contracts with Customers, and ASC 340-40, Other Assets and Deferred Costs—Contracts with Customers, and the IASB issued IFRS 15, Revenue from Contracts with Customers (collectively referred to as the new revenue standards).
The new revenue standards apply to reporting periods beginning after Dec. 15, 2017 for publicly-traded companies, some non-profits, and some employee benefit plans. The new revenue standards become effective for all other entities for annual reporting periods beginning after Dec. 15, 2018. Early adoption is possible for periods beginning after Dec. 15, 2016.
Importantly for tech companies, the new revenue standards replace a series of particularized rules for different types of contracts and industries. Software companies, for example, have typically had to navigate a patchwork of standards with varying rules for revenue recognition. The new standards collapse most revenue recognition guidance into one body of rules for all industries.
Reconizing income for Federal income tax purposes has its own separate tests that may differ from the new revenue standards. Some tax rules reference the timing required by financial reporting, so the new financial standards may change the Federal Income tax reporting period for income items for many businesses. The recently signed tax bill sets forth a new criteria for tax revenue recognition. These new rules may limit the potential tax deferral, making it critical to understand both tax and financial reporting schemes.
The cash method of accounting
By default, section 451 prescribes the cash method of accounting, requiring that income items be included in gross income in the year they are received, unless the rules prescribe a different period. In practice, the rules prescribe that most middle market companies use the accrual method.
Most of the complicated rules related to revenue recognition concern accrual basis taxpayers. Cash basis taxpayers are not beholden to the all-events test—instead cash basis taxpayers recognize income when they actually receive it or if the taxpayer has constructive receipt of the income. Some taxpayers may want to avoid the complications of the new rules by using the overall cash method. The cash method of accounting is thought to only apply to small companies, but many tech industry companies may qualify regardless of their size. For S corporations and professional services corporations, the cash method is available as an attractive way to simplify Federal Income tax reporting and tracking of revenue.
Service based C corporations, partnerships with C corporation partners, and tax shelters are generally not permitted to use the cash method of accounting. Section 448 provides an exception for service based C corporations and partnerships that would otherwise not be able to use the cash method (i.e., those entities with average annual gross receipts less than $5 million). The new tax law increased this gross receipts threshold for small businesses to $25 million, expanding the availability of the cash basis to more businesses.
The code does not prohibit S corporations from using the cash method, no matter their size. Many software companies, IT servicers, IP licensers, and other tech industry companies are primarily service providers or sellers of intangible property that does not qualify as inventory. If a service based business structures itself as an S corporation, it can likely qualify to use the cash method of accounting without regard to the size of its gross receipts.
Qualified personal service corporations (also referred to as professional service corporations) are also permitted to use the overall cash method with no limit on annual gross receipts. A company may be a qualified personal service corporation if: (1) substantially all of the corporation's activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting (the function test); and (2) at least 95 percent of the corporation's stock, by value, is owned, directly or indirectly, by current or former employees performing those services (the ownership test). The United States Tax Court has specifically rejected restrictive definitions of services in these fields, so tech companies that may exist in the margins are encouraged to consult a tax professional.
General rules of revenue recognition for accrual taxpayers
Under the accrual method of accounting, the all events test determines when income should be included—namely, when all events have occurred which fix the right to receive income, and the amount is reasonably determinable. The IRS has stated that all of the events that fix the right to receive income occur at the earliest date at which (1) required performance occurs, (2) payment is due, or (3) payment is received by the taxpayer. The new tax law adds a new criteria to these tests – (4) has the amount been recognized in a taxpayer’s financial books and records, provided the taxpayer has an audited financial statement, or a financial statement used for SEC reporting. However, test four, shall not apply to special methods of accounting (i.e. percentage of completion under sec 460).
Determining the moment that the right to receive income becomes fixed is a factual question that involves many factors. This can be even trickier for tech companies, as they often have ongoing contracts or deliver products and services over a period of time. One must look to the substance of the transaction, the agreement of the parties, the point in time that delivery actually occurs, the existence of conditions or approvals, and whether the right is contested to make the call.
Contract conditions can prevent a right from becoming fixed, but it is important to separate conditions precedent from conditions subsequent. Conditions precedent are events that must occur before the right to receive can become fixed. For example, if a government contractor subcontracts out the creation of a software system, and the contract stipulates that the government must approve the work, the subcontractor’s right to receive income would likely not become fixed until that approval is granted. In contrast, a condition subsequent occurs after a taxpayer has accrued a fixed right to receive. A condition subsequent could require payment to be returned, or adjust the amount in question, but revenue must already have been recognized at the point the right to receive became fixed. While many would assume that invoicing is a condition precedent since payment may depend on it, courts have determined that invoicing is often a “ministerial” act, and taxpayers should recognize revenue when a taxpayer can invoice, not when a taxpayer actually invoices.
Courts have ruled that being unaware that the right to receive has become fixed is not a valid excuse for failing to recognize revenue. Failing to report taxable income in the required year could mean penalties, but reporting too early could deprive a company of much needed cash. It is essential for tech companies to review their contracts with a focus on tax.
Advance payments and deferral
The new tax law codified the Revenue Procedure 2004-34’s treatment of advance payments. The rules are new and have not been well defined, therefore it is advisable that businesses wanting to take advantage of this method contact their tax professionals to be certain and keep abreast of future IRS/Treasury guidance on the topic.
Revenue Procedure 2004-34 provides one mechanism for advance payments to be deferred, for certain qualifying activities. This method is generally available for service providers and purveyors of various kinds of intangible property. Qualifying activities include: (a) services; (b) certain sales of goods; (c) use (including by license) of intellectual property; (e) sale, lease or license of computer software; (f) guaranty or warranty contracts ancillary to these; and (g) certain subscriptions.
From software developers, to more passive holders of valuable IP, to manufacturers, to IT service providers, these categories offer opportunities for just about any type of company in the technology sector.
Revenue Procedure 2004-34 allows a taxpayer to defer the recognition of the advance payment to the next taxable year, to the extent it accords with revenues in the taxpayer’s Applicable Financial Statement (AFS) for that taxable year. Without an AFS, a taxpayer must use the normal accrual method rules as to when the amount is earned. Revenue under Revenue Procedure 2004-34 can be deferred to end of the following taxable year. In general, this means a portion of revenue received on Jan. 1, 2018 can be deferred to Dec. 31, 2019—a period of almost two years. For taxpayer without financial statements, Rev. Proc. 20040-34 may allow the deferral of income for up to one year for income not earned under sec. 451.
One of the biggest opportunities for creating flexibility and controlling cash flow through revenue recognition concepts is in the deferral of advance payments. The general idea is that tech companies often receive payment before they have provided the service or good required to earn that payment, and the tax code lets them put off recognition for a limited time, accordingly. The rules for deferring advance payments are particularly friendly to tech companies.
Regulations section 1.451-5: for manufacturing, construction, and sales of tangible goods
Another opportunity to defer advance payments for the sale of goods can be found in Reg. section 1.451‑5. Under that provision businesses can recognize income when earned, but cannot report it later than allowed by financial reporting. Manufacturers, sellers of goods, and construction companies may have the option of using Reg. section 1.451-5 to defer income even if Rev. Proc. 2004-34 is not available to them or could provide for a longer deferral than under Rev. Proc. 2004-34.
In the case of long term manufacturing or construction contracts, tax rules may require special methods of accounting that would recognize a portion of a contract in each year. Many builders of high tech or high precision facilities will complete a construction contract over several years. If financial reporting allows the contractor to defer the recognition of income until the contract is completed, it may be possible to match the deferral for tax purposes. However, in the case of multi-year contracts where tax rules might allow recognition in a later year than General Accepted Accounting Principles (GAAP), the financial accounting rules may accelerate recognition for tax purposes. Because of this fact, it is important to understand both tax and financial accounting principles when drafting contracts.
Tax reform creates a new landscape
The new rules introduced by the recent legislation include some big changes to revenue recognition. Perhaps most significantly, section 451 is amended to restrict the recognition of income items to no later than when they are recognized in applicable financial statements. The all events test is treated as met at that point. Of course, how this will play out in practice and whether it makes tax reporting simpler remains to be seen. Additionally, there are special methods of accounting that remain unaffected. Part of the planning process that companies undertake as a result of tax reform should include looking at the revenue recognition effects.
The new standards could simplify or further complicate the financial reporting rules, but it highlights the need to review revenue recognition from a tax-specific perspective. Tax reform will mean changes for nearly every company. New rules can create uncertainty with a lack of legal history to rely on in the case of issues with the IRS—and in an industry as dynamic and fast-moving as technology, the uncertainty is compounded. Tech companies are encouraged to consult with tax professionals to make sure they are taking advantage of the new opportunities for deferral and avoiding potential exposure.