On Sept. 5, 2019, the Internal Revenue Service (IRS) released two proposed regulations that address changes in Section 451(b) and Section 451(c) implemented by the Tax Cuts and Jobs Act (TCJA), addressing the timing of income inclusion for taxpayers using the accrual method of accounting. Either of these provisions may lead taxpayers to recognize income sooner than they would have prior to the TCJA changes implemented to Section 451.
Section 451(B) – Income Inclusion Under an Accrual Method of Accounting
The TCJA revised Section 451(b) by requiring income to be recognized for federal income tax purposes no later than it is recognized in a taxpayer’s applicable financial statements (AFS) by providing that the all-events test cannot be considered as met any later than when an item is included in revenue on an AFS. The proposed regulations provide guidance for the inclusion of items of gross income in taxable income of a taxable year if the item is considered as revenue in an AFS. In other words, an item of income is recognized for tax purposes no later than when the income is recognized as revenue for financial statement purposes on an AFS. This income inclusion rule applies to accrual method taxpayers with an AFS.
The AFS conformity rule does not apply to gross income earned from a mortgage servicing contract or certain items accounted for using a special method of accounting.
The IRS has requested comments to address the AFS conformity rule to foreign persons and controlled foreign corporations.
In addition, the income inclusion rule does not affect thetreatment of a transaction for the purposes of federal income tax, meaning taxpayers generally are not required to recharacterize a transaction in order to conform to the characterization of the transaction in the AFS.
The definition of transaction price is also clarified in the proposed regulations as the amount of income a taxpayer expects to receive, excluding amounts contingent on the occurrence of future events and reductions for amounts subject to Section 461, including allowances, adjustments, rebates, refunds, rewards, chargebacks or amounts included in cost of goods sold.
The proposed regulations state the rule for income inclusion does not apply to items where a special method of accounting is used. In those instances, the specific method dictates when income is included. Some examples of special accounting methods include those for hedging transactions (Section 1.446-4), long-term contracts (Section 460), mark-to-market methods of accounting (Section 475) and the crop method of accounting (Sections 61 and 162).
In the proposed regulations, revenue is defined to include all items of income within Section 61 – gains, profits and income for federal income tax purposes. However, they do not include a cost offset provision – for example, cost of goods sold – due to concerns regarding potential distortions of income.
Section 451(C) – Advance Payment
Section 451(c) addresses the timing of income inclusion of advance payments for goods and services. Generally, Section 451(c) requires an advance payment to be included in income in the year of receipt but also codifies the current deferral method of accounting, allowing accrual method taxpayers to elect to defer including advance payments in taxable income to the taxable year following the year of receipt.
If income from advanced payments is deferred for AFS purposes, it can also be deferred to the tax year following the taxable year of receipt. Taxpayers receiving advanced payments without an AFS are required to include the payments as income in the receiving year (to the extent that it is earned) and may include the remainder in the next tax year’s income.
The proposed regulations state that the definition of advance payment for the AFS and non-AFS deferral methods is consistent with Revenue Procedure 2004-34. The IRS and Treasury Department state that their advance payment definition limits “additional tax compliance burden and cost, provides clarity to taxpayers” and uses familiar rules.
The proposed regulation lists excluded items from the advance payment definition, also in alignment with Revenue Procedure 2004-34, excluding rent (with some exceptions), certain insurance premiums, payments with respect to warranty and guaranty contracts (where a third party is the primary obligor) and others.
Guidance is effective for taxable years beginning on or after the release date of final regulations in the Federal Register. Until then, taxpayers may rely on the proposed regulations for taxable years beginning after Dec. 31, 2017, as long as the taxpayer applies all the rules in each respective proposed regulation.
Taxpayers required to make a change to their method or the timing of inclusion of an item in gross income as a result of these regulations are generally required to file a Form 3115 – Application for Change in Method of Accounting – with the IRS to request permission to change their method of accounting to comply with the new law
Following the release of the proposed regulations for Section 451, the IRS released Revenue Procedure 2019- 37 to provide accounting method change guidance for compliance with Section 451 and the proposed regulations. DHG has released a separate alert highlighting the guidance, which can be found here.
DHG will continue to monitor IRS updates related to section 451 as they are released. For more information, please reach out to us at firstname.lastname@example.org.