Long-awaited rules issued on income recognition for accrual taxpayers
TAX ALERT |
Authored by RSM US LLP
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.
Call us at +1 213.873.1700, email us at email@example.com or fill out the form below and we'll contact you to discuss your specific situation.
This article was written by Christian Wood, Peter Pentland, Ryan Corcoran and originally appeared on 2020-12-22.
2020 RSM US LLP. All rights reserved.
The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.
RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each is separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/about us for more information regarding RSM US LLP and RSM International. The RSM logo is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.
Vasquez & Company LLP is a proud member of the RSM US Alliance, a premier affiliation of independent accounting and consulting firms in the United States. RSM US Alliance provides our firm with access to resources of RSM US LLP, the leading provider of audit, tax and consulting services focused on the middle market. RSM US LLP is a licensed CPA firm and the U.S. member of RSM International, a global network of independent audit, tax and consulting firms with more than 43,000 people in over 120 countries.
Our membership in RSM US Alliance has elevated our capabilities in the marketplace, helping to differentiate our firm from the competition while allowing us to maintain our independence and entrepreneurial culture. We have access to a valuable peer network of like-sized firms as well as a broad range of tools, expertise and technical resources.
For more information on how Vasquez & Company LLP can assist you, please call +1 213.873.1700.
Subscribe to receive important updates from our Insights and Resources.