On March 28, 2017, the IRS issued Notice 2017-17 providing proposed procedures that, if finalized, may be used in certain circumstances to request consent to change a method of accounting for recognizing income related to the adoption of the new financial accounting revenue recognition standards. In addition, the notice requested comments on the proposed procedures plus various issues, including several raised previously in Notice 2015-40 published on June 15, 2015. The comment period closed July 24, 2017.
New accounting standard
On May 28, 2014, new financial accounting standards were issued for recognizing revenue from contracts with customers. The new standards are effective for annual reporting periods beginning after Dec. 15, 2018, for most taxpayers. However, publicly traded entities, certain not-for-profit entities, and certain employee benefit plans must implement the standards one year earlier (i.e., for annual reporting periods beginning after Dec. 15, 2017). FASB Accounting Standards Update No. 2014-09, Revenue From Contracts With Customers (Topic 606), applies a five-step analysis to all contracts with customers to transfer goods and services (other than leases, insurance, financial instruments, guarantees, and nonmonetary exchanges between entities in the same line of business, as described in ASC Paragraph 606-10-15-2. (For more on the five steps required to determine the amount of revenue to recognize under the new standard, see Bocchino, et al., "Evolving Revenue Recognition Issues: Manufacturers," The Tax Adviser (June 2016).)
Revenue recognition principles and accounting method change procedures
Under federal tax principles, revenue is generally recognized using the "all-events" test under Sec. 451 when the taxpayer has (1) a fixed right to receive the revenue (usually the earliest of when the revenue is due, received, or earned) and (2) the amount can be determined with reasonable accuracy. In some circumstances, certain advance payments received from the provision of goods, services, and other eligible sources may be deferred for one to two tax years.Changing how revenue and/or advance payments are recognized for tax purposes often constitutes a change in accounting method that requires IRS consent to implement (i.e., by filing Form 3115, Application for Change in Accounting Method). In general, IRS consent is requested under the advance consent procedures described in Rev. Proc. 2015-13, which require Form 3115 to be filed with the IRS National Office by the last day of the year of change, along with the user fee payment outlined in Rev. Proc. 2017-1. However, changes the IRS designated as "automatic" (currently, in Rev. Proc. 2017-30) must be requested using the "automatic" consent procedures, which do not require a user fee and are filed in duplicate with the timely filed (including extensions) federal income tax return for the year of change and with the IRS Service Center in Covington, Ky.
Potential tax implications
Software, entertainment, manufacturing, and construction taxpayers may be particularly affected by the new revenue recognition standards due to the prevalence in those industries of certain business practices and accounting methods such as:
- The percentage-of-completion method;
- Income from services;
- Revenue from bill-and-hold sale transactions;
- Sales and returns of goods; and
- Income from the sale of warranties.In addition to the impact on the timing of recognizing revenue, the new standards may have implications for other tax and business areas such as:
- Tax payments and cash flow planning due to the expected acceleration of taxable income under the new rules;
- Income tax provisions, which may need to reflect additional temporary differences and deferred taxes (e.g., if the timing of revenue recognition differs for book and tax purposes under the new standards);
- State apportionment, which may require additional analysis to determine sales data by state;
- Indirect taxes, especially for states that tax gross receipts and net worth;
- Foreign subsidiaries' earnings-and-profits calculations and foreign tax credits;
- Transfer-pricing agreements, especially those based on revenue or profit measures reported in financial statements; and
- Compensation agreements tied to revenue.
IRS guidance and proposed automatic accounting method change procedures
In Notice 2015-40 the IRS requested comments on federal tax accounting issues related to the adoption of the new standards, including:
- Whether the new standards are permissible methods of accounting for federal income tax purposes;
- The types of accounting method change requests likely to result from adopting the new standards; and
- If the current accounting method change procedures adequately accommodate such requests.
Notice 2017-17 provides proposed procedures to request consent to change a method of accounting for recognizing income related to the adoption of the new financial accounting revenue recognition standards. In addition, noting that very few comments had been received in response to Notice 2015-40, the notice once again requested comments on various technical and implementation issues, and on the proposed accounting method change procedures.
Key provisions in the proposed procedures include:
- Qualifying same-year method changes: The proposed automatic method change procedures apply only to a "qualifying same-year method change," which is defined as "a change of method of accounting for recognizing income that is made for the same year as the year the taxpayer adopts the new standards and made as a result of, or directly related to, the adoption of those standards.
- Existing automatic change: A qualifying same-year method change that is included in the list of automatic changes under Rev. Proc. 2017-30, and otherwise meets the automatic change eligibility requirements in Rev. Proc. 2015-13, must be implemented using the existing automatic change procedures.
- No existing automatic change: Alternatively, a taxpayer making a qualifying same-year method change that is not included in the list of automatic changes but that complies with Sec. 451 or other guidance, and meets the automatic change eligibility provisions in Rev. Proc. 2015-13, must file Form 3115 under the automatic change procedures, write "Rev. Proc. [and its number, when finalized]" followed by the applicable citation to Sec. 451 or other relevant legal authority on line 1(b) of Form 3115, and attach a brief description of the change and why it satisfies the authorities referenced in line 1(b).
- Cutoff method for small taxpayers: In an effort to reduce the administrative burden of implementing accounting method changes related to the new revenue recognition standards, certain small taxpayers are permitted to make the change on a cutoff basis (i.e., without a Sec. 481(a) adjustment). An eligible small taxpayer is a taxpayer with one or more separate trade(s) or business(es) that individually have (1) total assets of less than $10 million as of the first day of the tax year of change, or (2) average annual gross receipts of $10 million or less for the three tax years preceding the change year. For purposes of applying the small taxpayer exception, separate and distinct trades or businesses and average annual gross receipts are determined under Regs. Secs. 1.446-1(d) and 1.263(a)-3(h)(3) (substituting "separate and distinct trade or business" for "taxpayer").
- A Sec. 481(a) adjustment must be computed for the year of change for all separate and distinct trades or businesses other than those meeting the small taxpayer thresholds described above.
- Multiple requests to make qualifying same-year method changes may be made in one request.
Although the proposed guidance is not effective until finalized, it provides helpful insight into the approach the IRS intends to take with respect to granting tax accounting method changes related to the new revenue recognition standards. In particular, the ability to make changes using the more favorable automatic change procedures (which allow additional time to file Form 3115 and do not require payment of a user fee) and to permit small taxpayers to reduce the compliance burden using a cutoff method are welcome developments. Moreover, allowing the small taxpayer thresholds to be applied at the trade or business level, rather than in aggregate, should enable more taxpayers to qualify for the simplified cutoff approach. Note, however, that if finalized in their current form, these favorable procedures will be available only for a limited time (i.e., tax method changes must be implemented in the same year the new standards are adopted).
Presumably, taxpayers that fail to file otherwise nonautomatic method changes within the prescribed time frame would be required to apply for consent under the more onerous and costlier advance consent procedures. Therefore, taxpayers are advised to begin the process of assessing the impact of the new revenue standards on their current revenue recognition tax accounting methods so they are prepared to implement any necessary accounting method changes within the time specified in the final procedures. While the effective dates of the new revenue recognition standard may appear far off, the transition process is expected to require significant time to complete, given the broad scope and complexity of the new rules.
Therefore, taxpayers and their tax advisers should act now to evaluate and plan for the tax implications of the new financial revenue recognition standards, starting with identifying which revenue streams are affected by the new standards. Once the affected revenues are identified, taxpayers should then evaluate whether tax accounting method changes are necessary or desired to change to compliant methods or to follow the new book accounting method. At the same time, taxpayers can evaluate their systems and books and records to determine whether they currently track the necessary data to continue using the current revenue recognition methods.
Mark Heroux is a principal with the National Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.