Editor: Kevin D. Anderson, CPA, J.D.
Effective for tax years beginning on or after Dec. 31, 2017, accrual-method taxpayers with an applicable financial statement (AFS) may not recognize income for tax purposes later than the tax year in which that income is taken into account as revenue in the taxpayer's AFS. Under Sec. 451(b), as amended by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, accrual-basis taxpayers that are currently deferring income to a tax year later than when it is recognized on the books are generally required to change their existing tax method of accounting.
To help ease the administrative burden faced by taxpayers that are currently not in compliance with Sec. 451(b), the IRS issued Rev. Proc. 2018-60 in November 2018 to enable those taxpayers to file Form 3115, Application for Change in Accounting Method, under the automatic consent change procedures. For certain taxpayers, the revenue procedure provides a streamlined procedure to comply with Sec. 451(b), which does not involve filing Form 3115 or attaching a separate statement to the tax return.
While Rev. Proc. 2018-60 primarily applies to revenue recognition method changes resulting from the Sec. 451(b) rule, an IRS Chief Counsel Advice issued in January (CCA 201852019) confirmed that the automatic change could be used in other fact patterns, particularly where an accrual-basis taxpayer wishes to change from an improper to a proper method of accounting for income recognition. Due to its simplified approach, Rev. Proc. 2018-60 is welcome news to many taxpayers and demonstrates the IRS's ongoing commitment to issue additional clarifying guidance on revenue recognition in the near future.
To appreciate the significance of Sec. 451(b), one starts with the general rules for the timing of income recognition for federal income tax purposes. Once an item of gross income is determined to be clearly realized, Sec. 451 and the underlying regulations provide the general rules for when that item is to be included in gross income. Taxpayers on the overall cash method recognize revenue when it is actually or constructively received. In contrast, accrual-method taxpayers have historically recognized revenue when all the events have occurred to fix the right to receive the revenue, and the amount thereof can be determined with reasonable accuracy (the "all-events test").
Based on case law and IRS authorities, it is well-established that all the events that fix the right to receive income generally occur at the earliestof when (1) the payment is earned through performance; (2) payment is due to the taxpayer; or (3) payment is received by the taxpayer. In determining whether the right to receive the revenue has become fixed during a tax year, the taxpayer must also consider whether any contingencies or conditions precedent occur after year end. Revenue arising from the rendition of services or the sale of goods is not accruable for tax purposes if the right to receive that revenue is subject to conditions precedent or other contingencies. Therefore, in certain instances, a taxpayer may have properly recognized revenue at a later point in time than for financial reporting under the "old" Sec. 451 rules prior to the TCJA.
Another situation where revenue is recognized for books earlier than for tax is a taxpayer's implementation of the new revenue recognition standard for financial reporting purposes: FASB Accounting Standards Codification Topic 606, Revenue From Contracts With Customers. Under Topic 606, a taxpayer generally recognizes revenue for financial accounting purposes when the taxpayer satisfies a performance obligation by transferring a promised good or service to a customer and in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services based on a five-step process. Companies that have implemented, or are in the process of implementing, the updated Topic 606 may find that a performance obligation is satisfied at a point in time, and the resultant income is taken into revenue for book purposes, earlier than when all events have been met for federal income tax purposes. The introduction of Sec. 451(b) by the TCJA serves to bridge the gap between the timing of recognizing the item of income for both book and tax purposes.
New revenue recognition rule
Under the new Sec. 451(b)(1)(A), for an accrual-method taxpayer:
[T]he all events test with respect to any item of gross income (or portion thereof) shall not be treated as met any later than when such item (or portion thereof) is taken into account as revenue in—
(i)an applicable financial statement of the taxpayer, or
(ii)such other financial statement as the Secretary may specify for purposes of this subsection.
Stated another way, an accrual-method taxpayer with an AFS must include an item of income under Sec. 451 upon the earlier of when the all-events test is met or when the taxpayer includes the item in revenue in its AFS.
An AFS includes, in part, a financial statement that is certified as being prepared in accordance with GAAP and that is (1) a Form 10-K, or annual statement to shareholders, required to be filed by the taxpayer with the SEC; (2) an audited financial statement of the taxpayer that is used for credit purposes; for reporting to shareholders, partners, other proprietors, or beneficiaries; or for any other substantial nontax purpose, but only if there is no statement described in (1); or (3) filed by the taxpayer with any other federal agency for purposes other than federal tax purposes, but only if there is no statement described in (1) or (2). In addition, if not covered above, an AFS includes a financial statement that is made on the basis of international financial reporting standards and is filed with an agency of a foreign government that is equivalent to the SEC and has reporting standards that are not less stringent than the SEC's.
Sec. 451(b)(1)(A) is effective for tax years beginning on or after Dec. 31, 2017.
Highlights of the automatic change procedure
Rev. Proc. 2018-60 prescribes a brand-new automatic change, No. 239, that is generally effective for tax years beginning after Dec. 31, 2017. This automatic change applies to an accrual-method taxpayer with an AFS that (1) wishes to change to a method of accounting that treats an item of gross income, or portion thereof, as meeting the all-events test no later than when such item, or portion thereof, is taken into account as revenue in its AFS under Sec. 451(b)(1)(A); and/or (2) is not adopting Topic 606 for the year of change and wants to allocate the transaction price to performance obligations under Sec. 451(b)(4).
Taxpayers filing Form 3115 receive prior-year audit protection for the item of income being changed and can implement the change with a Sec. 481(a) adjustment, calculated as of the beginning of the year of change. This is beneficial for taxpayers faced with the acceleration of significant revenue as a result of complying with Sec. 451(b), as any taxpayer-unfavorable Sec. 481(a) adjustments are generally taken into account ratably over four years, beginning with the year of change. A taxpayer may concurrently file automatic change No. 239 with automatic change No. 231 (changes in the timing of income recognition due to Topic 606) for the same year of change on a single Form 3115. In an effort to ease taxpayers' administrative burden, the usual requirement to mail a duplicate copy of the automatic Form 3115 to the IRS's Ogden, Utah, office is waived; therefore, Form 3115 need only be attached to the timely filed (including extensions) federal income tax return for the year of change.
Certain taxpayers wishing to change the method of accounting to comply with Sec. 451(b) are permitted to use a "streamlined" approach under which the requirement to file a Form 3115 or to attach a separate statement is waived. This approach is available only for the first tax year beginning after Dec. 31, 2017, and may be used only by: (1) a taxpayer, other than a tax shelter, that qualifies as a small business taxpayer under Sec. 448(c) by having average annual gross receipts for the three prior tax years of $25 million or less; or (2) a taxpayer making one or more changes to comply with Sec. 451(b)(1)(A) and/or Sec. 451(b)(4), and the total Sec. 481(a) adjustment is zero.
In CCA 201852019, the IRS confirmed the broad applicability of Rev. Proc. 2018-60 by concluding that an accrual-method taxpayer presently on an improper method of accounting could use the automatic change No. 239 procedures under Rev. Proc. 2018-60 to change its accounting method to comply with Sec. 451(b)(1)(A). The taxpayer's method was determined to be impermissible, as it did not comply with the all-events test of Sec. 451, as amended by the TCJA or prior to amendment. In its rationale, the IRS pointed to the applicability language provided in Rev. Proc. 2018-60, which permits an accrual-method taxpayer with an AFS to change its method for the recognition of income to a method of accounting that complies with Sec. 451(b)(1)(A). Sec. 451(b)(1)(A) includes the requirements of the all-events test under Sec. 451(b)(1)(C). Accordingly, taxpayers with historical methods of accounting that may not have complied with the all-events test (e.g., including an item in income in the year after the income has been earned, due, or received) can file an automatic method change under Rev. Proc. 2018-60 to change to a proper method that complies with Sec. 451(b)(1)(A), assuming the terms and conditions set forth in Rev. Proc. 2018-60 are met.
Kevin D. Anderson, CPA, J.D., is a partner, National Tax Office, with BDO USA LLP in Washington, D.C.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.