Editor: Lori Anne Johnston, CPA, J.D.
In recent years, the topic of financial statement revenue recognition and its effect on the timing of taxable income has become increasingly complex. In 2014, FASB's issuance of Accounting Standards Update No. 2014-09, Revenue From Contracts With Customers (Topic 606), wreaked havoc in the world of financial reporting with a brand-new framework for revenue recognition that superseded nearly all prior guidance on the subject under U.S. GAAP. Many financial statement issuers have made extensive changes to the timing and manner in which they recognize revenue and related costs under the new guidance. In 2017, historic tax law changes in the law commonly referred to as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, further complicated the landscape with the addition of Secs. 451(b) and (c) to the Code.
Sec. 451(b), without eliminating the all-events test for taxable income recognition, requires an accrual-method taxpayer to recognize taxable income at least as early as the year in which the income is first included in revenue for the organization's applicable financial statements (AFS). Sec. 451(c), while nuanced in certain finer details, largely codifies the tax deferral of certain advance payments previously allowed under Rev. Proc. 2004-34. All of these recent changes offer the potential to shift the timing or manner in which a taxpayer identifies its items of income inclusion for a given tax year.
In general, any change to the timing of income recognition for tax purposes is a change in accounting method requiring IRS approval. In some situations, the IRS issues automatic consent procedures allowing taxpayers to voluntarily change their method of accounting without a user fee by simply filing Form 3115, Application for Change in Accounting Method, by the extended due date of the tax return for the year of change. Accounting method changes that do not fall under the IRS automatic consent procedures require the filing of Form 3115 and the payment of a user fee exceeding $10,000 during the year of change, and taxpayers may not implement accounting method changes in their tax returns until they receive consent from the IRS (Rev. Procs. 2015-13 and 2020-1).
To ease the compliance burden for taxpayers, the IRS issued new automatic change numbers for most of the changes to taxable income required by FASB Accounting Standards Codification Topic 606, Revenue From Contracts With Customers, and the TCJA updates to Sec. 451. However, taxpayers must carefully examine their facts to ensure that they fall within the scope of the automatic change. For example, Section 16.11 of Rev. Proc. 2019-43 provides designated change number (DCN) 231 for taxpayers whose income recognition timing has changed due to their efforts to comply with the new standards under Topic 606.
Under DCN 231, taxpayers may change their method of accounting for income recognition to match their new financial reporting method regarding (1) their identification of their performance obligations under a contract with a customer; (2) their allocation of a transaction price to multiple performance obligations; or (3) their determination of the satisfaction of performance obligations, but only if the new method is both a permissible method for taxable income and the method change is made in the tax year in which the taxpayers adopt Topic 606 for their financial reporting. For early adopters of Topic 606 (permissible for reporting periods beginning after Dec. 15, 2016) and public companies (required for reporting periods beginning after Dec. 15, 2017), the window has generally closed to apply DCN 231.
Section 16.12 of Rev. Proc. 2019-43 offers additional opportunities for automatic changes related to the timing of taxable income recognition. For tax years beginning after Dec. 31, 2017, DCN 239 allows taxpayers with AFSs — generally, audited GAAP or IFRS financials or a financial statement used for nontax governmental reporting — to make accounting method changes to the timing of taxable income for Sec. 451(b). These changes include the recognition of taxable income at least as early as the item is taken into revenue for financial statement purposes under Sec. 451(b)(1)(A) and the allocation of transaction price to multiple performance obligations under Sec. 451(b)(4) outside of the year of adoption of Topic 606. For taxpayers with an AFS, DCN 242 encompasses changes that comply with Prop. Regs. Sec. 1.451-3, including changes for specified credit card fees and changes related to the treatment of advance payments under Prop. Regs. Sec. 1.451-8(c). Taxpayers without an AFS may make changes to the treatment of advance payments under Prop. Regs. Sec. 1.451-8(d).
While DCN 239 specifically excludes taxpayers making changes to their financials to comply with Topic 606 in the year of change, taxpayers that make changes to income related to financial reporting standards in subsequent years may fall under its umbrella. Changes to special methods of accounting for taxable income mentioned in Sec. 451(b)(2), changes related to the method of accounting for specified fees other than credit card fees, and certain changes related to the deferral of advance payments based on when the payment is earned for taxpayers without an AFS under Prop. Regs. Sec. 1.451-8(d)(4)(ii) are also excluded from DCNs 239 and 242.
While taxpayers with or without an AFS may adopt a new deferral method under Prop. Regs. Sec. 1.451-8 using automatic change number 242, Section 16.07 of Rev. Proc. 2019-43 also allows for automatic changes to either the full inclusion (DCN 83) or deferral methods (DCN 84) described in Rev. Proc. 2004-34. Per the IRS, taxpayers with or without an AFS may continue to rely on the deferral guidance under Rev. Proc. 2004-34 until final guidance for Sec. 451(c) is effective (Notice 2018-35). In addition, for the first or second tax year ending on or after May 9, 2018, taxpayers may make an automatic change under these change numbers even if they have previously made a change for the same item within the last five years. DCN 84 does exclude deferral methods for allocable payments, as discussed under Rev. Proc. 2004-34, Section 5.02(4)(a), and specific changes related to the deferral of advance payments by taxpayers without an AFS based on when the payment is earned under Rev. Proc. 2004-34, Section 5.02(3)(b)(i) or (iii) (Rev. Proc. 2019-43).
The final automatic change offered by Rev. Proc. 2019-43 related to revenue recognition allows taxpayers that make changes to the timing of an advance payment in their AFS to shift their tax treatment to match. For example, DCN 153 allows taxpayers that are currently under a deferral method for advance payments as described by either Section 5.02(3)(a) of Rev. Proc. 2004-34 or Prop. Regs. Sec. 1.451-8(c), that recognize advance payments in gross income in accordance with their AFS, and that change the manner in which they recognize advance payments in their AFS to change their corresponding method of accounting for tax. The automatic change also allows taxpayers currently recognizing taxable income when taken into revenue by their AFS under Sec. 451(b) or Prop. Regs. Sec. 1.451-3 and that change the manner in which the item is taken into revenue in their AFS to change their method of accounting for taxable income. The method change does not apply to taxpayers that do not currently use a deferral method for advance payments, taxpayers whose methods of accounting are not affected by their current AFS under Sec. 451(b) or Prop. Regs. Sec. 1.451-3 or 1.451-8, or taxpayers making changes to their AFS to comply with Topic 606 (Rev. Proc. 2019-43).
The IRS has made efforts to minimize the compliance burden for all four of these automatic accounting method changes. For a period of time, the five-year waiting period to requalify for an automatic method change for the same item does not apply for DCNs 83 and 84. The five-year rule is also temporarily waived for DCNs 231, 239, and 242 and is permanently waived for DCN 153. Changes made under DCN 153 allow taxpayers to attach a statement to their tax return for the year of change in lieu of a Form 3115, but changes must be made on a cutoff basis, meaning only items resulting from the beginning of the year of change or later are treated under the new accounting method, and taxpayers will not receive audit protection.
For DCNs 231, 239, and 242, taxpayers may file short Forms 3115 and may choose to make their changes on either a cutoff basis or by using a Sec. 481(a) adjustment, which requires the taxpayer to recompute income for the tax year preceding the year of change and on as if the new method had always been used. DCNs 239 and 242 also allow for a streamlined method change procedure for Sec. 448(c) small business taxpayers with Sec. 481(a) adjustments of zero making changes to their methods of accounting related to Sec. 451(b)(1)(A) or 451(b)(4) in the first tax year beginning after Dec. 31, 2017, or Prop. Regs. Secs. 1.451-3, 1.451-8(c), and 1.451-8(d) in the first or second tax year beginning after Dec. 31, 2017. Under these measures, taxpayers need not file Form 3115 or a statement with their return in the year of change, but they will not receive audit protection (Rev. Proc. 2019-43).
The automatic method change procedures provided by Rev. Proc. 2019-43 offer taxpayers many chances to ease their compliance burden as they consider the timing and method of their recognition of taxable income, but the change procedures also offer many new considerations and much potential for missteps. For example, a taxpayer that failed to apply the automatic change procedures in the year the taxpayer changed its financial reporting revenue under Topic 606 using DCN 231 may be required to make a method change using the costly nonautomatic change procedures. Could the requirements under Sec. 451(b)(1)(A) to recognize taxable income at least as early as the financial statements or the requirement to allocate a transaction price as such items are allocated in the taxpayer's AFS under Sec. 451(b)(4) provide another opening for an automatic change to bring taxpayers into compliance? DCN 239 may offer such opportunities.
In another scenario, taxpayers who have always used a full inclusion method as their treatment for advance payments may not have given much thought to when they were due or when they were earned. Absent an express method that deviates from the financial statement treatment, the taxpayer may have adopted its financial statement method of determining when the taxpayer earns an income item. If the taxpayer changes its financial statement determination of when it earns an income item, a change of accounting method under DCN 83 is required even if a Sec. 481(a) adjustment would be zero. In this era of increasing Code complexity, taxpayers must carefully examine their revenue line items to ensure that financial accounting changes or new tax laws have not exposed them to compliance risk while they remained unaware.
Lori Anne Johnston, CPA, J.D., is a manager, Washington National Tax for RSM US LLP.
Unless otherwise noted, contributors are members of or associated with RSM US LLP.