Editor: Greg A. Fairbanks, J.D., LL.M.
Sec. 451 addresses the timing of recognition of gross income. New Sec. 451(b), added by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, may require accrual-method taxpayers with applicable financial statements (AFS) to accelerate the recognition of gross income in certain situations compared to pre-TCJA law.
Although the application of Sec. 451(b) may appear straightforward on the surface, questions abound. Recently issued Prop. Regs. Sec. 1.451-3 (REG-104870-18) provides needed clarification, but important questions remain unanswered. This discussion explores some of the key provisions and unanswered questions.
Under Sec. 451(a) and Regs. Sec. 1.451-1(a), the amount of any item of gross income is included in gross income for the tax year in which the taxpayer receives it, unless it is properly accounted for in a different period under the accounting method used in computing taxable income. Under an accrual method of accounting, income is includible in gross income when all the events have occurred that fix the right to receive the income and the amount thereof can be determined with reasonable accuracy (Regs. Sec. 1.451-1(a)). Pre-TCJA law said that all the events that fix the right to receive income occur when (1) the required performance takes place; (2) payment is due; or (3) payment is received, whichever happens first (see, e.g., Schlude, 372 U.S. 128 (1963)).
New Sec. 451(b), added by the TCJA, modifies the historical all-events test by requiring taxpayers to recognize an item of gross income no later than when the item (or portion thereof) is taken into account as revenue in the taxpayers' AFS (AFS income-acceleration rule). The AFS income-acceleration rule does not provide strict financial and tax accounting conformity. Rather, Sec. 451(b) operates in one direction, requiring taxpayers to recognize an item of gross income when that item is taken into account as revenue in the AFS if that point in time precedes recognition under the historical all-events test. Taxpayers cannot use Sec. 451(b) to defer the recognition of gross income beyond the tax year the income would have been recognized under the historical all-events test.
Some key provisions of the proposed regulations are discussed below, along with several unresolved issues.
Scope of coverage
First, the AFS income-acceleration rule does not apply unless the taxpayer has an AFS for the entire tax year (Prop. Regs. Sec. 1.451-3(d)). The proposed regulations generally define AFS (consistent with Rev. Proc. 2004-34) to include:
- Certain audited financial statements prepared in accordance with U.S. GAAP (e.g., Forms 10-K or financial statements used for credit purposes, reporting to owners or beneficiaries, or any other substantial nontax purpose);
- Certain audited financial statements prepared in accordance with IFRS (e.g., financial statements filed with an agency of a foreign government that is equivalent to the SEC); and
- Financial statements (other than a tax return) filed with the federal government or any federal agency, a state government or state agency, or a self-regulatory organization (e.g., financial statements filed with a state agency that regulates insurance companies) (Prop. Regs. Sec. 1.451-3(c)(1)).
Under statutory exceptions, the AFS income-acceleration rule does not apply to an item of gross income earned in connection with a mortgage servicing contract or any item of gross income for which the taxpayer uses a so-called special method of accounting (Sec. 451(b); Prop. Regs. Sec. 1.451-3(d); Prop. Regs. Sec. 1.451-3(c)(5)). The proposed regulations provide a nonexclusive list of special methods of accounting, including, for example, methods of accounting provided in Secs. 453-460, 467, and 475 and the timing rules for accrued market discount on bonds and original issue discount (OID) that is treated as discount for AFS purposes (Prop. Regs. Sec. 1.451-3(c)(5)). However, consistent with the TCJA's legislative history, Prop. Regs. Sec. 1.451-3(i) provides that specified credit card fees (e.g., credit card late fees, credit card cash advance fees, and interchange fees) are subject to the AFS income-acceleration rule (see H.R. Conf. Rep't No. 115-466, 115th Cong., 1st Sess., at 429 (Dec. 15, 2017)). Specified credit card fees subject to Sec. 451(b) are not taken into account in determining whether a debt instrument associated with them has OID (preamble to REG-104870-18; Prop. Regs. Sec. 1.1275-2(l)).
Furthermore, the AFS income-acceleration rule does not require taxpayers to recharacterize a transaction for federal income tax purposes to conform to the characterization of the transaction in the AFS (Prop. Regs. Sec. 1.451-3(e)). For example, a rental agreement that is treated as a lease for federal income tax purposes is not recharacterized under Sec. 451(b) because it is treated as a sale or financing for AFS purposes. Similarly, a deposit or conduit payment excluded from gross income for federal income tax purposes is not recharacterized under Sec. 451(b) because it is treated as revenue for AFS purposes. The AFS income-acceleration rule also does not change the applicability of any exclusion provision (e.g., Secs. 101-140) or the treatment of nonrecognition transactions (e.g., Secs. 332, 351, 368, 721, and 1031) under the Code, regulations, or other administrative guidance (Prop. Regs. Sec. 1.451-3(f)).
Gross income versus gross receipts
While providing helpful guidance, the proposed regulations leave certain key issues unresolved. For one thing, Sec. 451(b) and Prop. Regs. Sec. 1.451-3(b) provide that the AFS income-acceleration rule applies to any item of gross income, but the proposed regulations effectively require the acceleration of gross receipts, as is clear from the definitional provisions.
"Revenue" is defined broadly under the proposed regulations to include all transaction price amounts includible in gross income under Sec. 61. The characterization of a transaction price in the AFS is not determinative for these purposes (Prop. Regs. Sec. 1.451-3(c)(4)). "Transaction price" is generally defined as the gross amount of consideration to which a taxpayer expects to be entitled for AFS purposes in exchange for transferring goods, services, or other property promised under the contract (Prop. Regs. Sec. 1.451-3(c)(6)). Consistent with current law, the transaction price excludes amounts collected on behalf of third parties that are otherwise not income to the taxpayer (e.g., sales taxes) and certain contingent consideration (discussed below) (Prop. Regs. Secs. 1.451-3(c)(6)(i) and (ii)). Notably, however, there are no cost offsets for amounts subject to Sec. 461 (e.g., allowances, adjustments, rebates, refunds, etc.) or for amounts included in cost of goods sold (COGS) (Prop. Regs. Sec. 1.451-3(c)(6)(iii)).
Because of the lack of cost offsets, the proposed regulations significantly depart from the plain language of the statute ("gross income"), creating disparity between the tax and financial accounting rules. While the preamble to the proposed regulations characterizes the AFS income-acceleration rule as increasing financial and tax accounting conformity, this conformity is largely superficial. As proposed, the AFS income-acceleration rule may result in taxpayers' recognizing income earlier for tax purposes than for AFS purposes.
The new financial accounting revenue recognition rules under FASB Accounting Standards Codification Topic 606, Revenue From Contracts With Customers, may exacerbate this outcome. For example, upon adopting Topic 606, taxpayers with multi-unit production contracts may be required to change their pattern of revenue recognition for AFS purposes from a units-of-delivery method to an over-time percentage-of-completion method based on costs incurred. Taxpayers in this situation may be required to recognize revenue earlier for tax purposes under the AFS income-acceleration rule and may not be able to recover the associated costs until a later year under Secs. 461, 471, and 263A.
Such a construction of the AFS income-acceleration rule appears to conflict with the long-standing definition of gross income for manufacturers and merchandisers under Regs. Sec. 1.61-3(a) ("'gross income' means the total sales, less the cost of goods sold, plus any income from investments and from incidental or outside operations or sources"). It also seems inconsistent with the legislative history of the TCJA, which states, "an accrual method taxpayer with an applicable financial statement will include an item in income under section 451 upon the earlier of when the all events test is met or when the taxpayer includes such item in revenue in an [AFS]" (H.R. Conf. Rep't No. 115-466, at 428 fn. 874).
The proposed regulations' interpretation of revenue and transaction price may significantly increase the compliance burden for tax departments. Taxpayers may need to examine AFS revenue on a transaction-by-transaction basis with more care and scrutiny, ensuring appropriate adjustments are made for tax purposes under Prop. Regs. Sec. 1.451-3(c)(6). Commentators suggested several proposals to alleviate this burden for cost offsets, for example, offsets for future COGS, a safe harbor to follow the AFS percentage-of-completion method, and the optional application of the Sec. 460 percentage-of-completion method rules to contracts that are not long-term contracts under Sec. 460. The government declined to adopt these proposals in the proposed regulations. The government's failure to provide an AFS percentage-of-completion method safe harbor is particularly disappointing. Without this relief, certain taxpayers will be required to establish and maintain inventory costing systems for tax purposes without corresponding systems for AFS purposes. However, the proposed regulations request additional comments regarding the government's authority to grant one or more of these proposals.
Realization vs. recognition
Where realization ends and recognition begins may be the most controversial topic under the AFS income-acceleration rule. The proposed regulations unfortunately fail to provide clear standards or definitions for distinguishing realization from recognition.
The legislative history of the TCJA states, "[the AFS income-acceleration rule] does not revise the rules associated with when an item is realized for Federal income tax purposes and, accordingly, does not require the recognition of income in situations where the Federal income tax realization event has not yet occurred" (H.R. Conf. Rep't No. 115-466, at 428 fn. 872). Yet, the preamble to the proposed regulations, despite explicitly acknowledging this legislative history, provides that the AFS income-acceleration rule applies to unbilled receivables for services and goods — if the customer controls the asset created or enhanced or the taxpayers have a right to partial payment even if the contract requires delivery, acceptance, and title transfer before the taxpayers have the right to bill. An example in the proposed regulations addresses the treatment of unbilled receivables for goods and concludes the AFS income-acceleration rule applies because the taxpayer can be paid for work performed to date even if the contract is not completed for reasons other than the taxpayer's failure to perform (Prop. Regs. Sec. 1.451-3(m)(3), Example (3)). This result appears to be inconsistent with the government's stated position in the preamble that realization must precede application of the AFS income-acceleration rule. In particular, the example does not reconcile how the taxpayer has realized gross income when the taxpayer has not had an accession to wealth and the customer does not have control or benefits and burdens of ownership of the goods.
Common transactions that may be adversely affected by the government's proposed interpretation of the AFS income-acceleration rule include (1) contracts to produce goods that are recognized in revenues in the AFS using an over-time percentage-of-completion method but are not subject to the percentage-of-completion method under Sec. 460 for tax purposes; (2) contracts to provide nonseverable services that are recognized in revenues in the AFS using an over-time percentage-of-completion method; and (3) term licenses for certain intellectual property that are recognized in revenues in the AFS at the beginning of the license term.
While clear guidance is lacking for unbilled receivables, the proposed regulations provide a framework for the treatment of "contingent" consideration. The proposed regulations do not explicitly state whether contingent consideration is realized for tax purposes, but they address whether contingent consideration can be excluded from the transaction price. Only amounts included in the transaction price may be subject to the AFS income-acceleration rule.
Under Prop. Regs. Sec. 1.451-3(c)(6)(ii), the transaction price does not include amounts contingent on the occurrence or nonoccurrence of a future event (e.g., bonuses contingent on performance or insurance contract commissions contingent on renewal) if the amount remains contingent as of the end of the tax year. However, amounts included in the transaction price for AFS purposes are presumed to not be contingent on the occurrence or nonoccurrence of a future event. This presumption may be rebutted by establishing to the government's satisfaction that the income remains contingent under all the facts and circumstances existing at the end of the tax year, for example through the terms of a written contract (see, e.g., Prop. Regs. Sec. 1.451-3(m)(10), Example (10)). However, an amount included in the transaction price that is actually or constructively received, that is due and payable, or for which the taxpayer has an enforceable right to payment for performance completed to date will not be treated as contingent on the occurrence or nonoccurrence of a future event.
Determining whether an amount is contingent on the occurrence or nonoccurrence of a future event will require the use of considerable judgment. The rebuttable presumption raises many questions regarding the level of documentation necessary to prevail. Further clarification and additional examples in the final regulations, including examples with fact patterns that succeed and fail to rebut the presumption, will reduce future controversy on examination and provide taxpayers with more certainty for their tax positions.
Sec. 451(b) does not address the application of the AFS income-acceleration rule and the historical all-events test to contracts spanning more than one tax year, but the proposed regulations do. Prop. Regs. Sec. 1.451-3(k) adopts a cumulative approach, which requires taxpayers to take into account the cumulative amounts included in income in prior tax years for a contract, if any, in order to determine the amount to be included in income for the tax years remaining under the contract. The cumulative approach appears to more clearly reflect income because an annualized approach may artificially accelerate income recognition or result in double-counting income. Taxpayers still need to track the cumulative sum of each prong of the all-events test (payment dates, due dates, and performance dates) for each contract to determine whether the amount of income recognized under the historical all-events test exceeds the amount of income recognized under the taxpayer's AFS (see, e.g., Prop. Regs. Sec. 1.451-3(m)(4), Example (4)). Although the cumulative approach is preferred to the annualized approach, taxpayers must still contend with the complexity of the pre-TCJA rules because the AFS income-acceleration rule only provides limited, one-directional financial and tax accounting conformity.
The proposed regulations would generally apply to tax years beginning on or after the date final regulations are published in the Federal Register. In the case of specified fees, Prop. Regs. Sec. 1.451-3(i)(2) would apply to tax years beginning one year after the date final regulations are published in the Federal Register. Taxpayers may rely on the proposed regulations for tax years beginning after Dec. 31, 2017, if they apply all the applicable rules contained in the proposed regulations and consistently apply the proposed regulations to all items of income during the tax year (excluding specified fees in both cases). In the case of specified credit card fees, taxpayers may rely on Prop. Regs. Sec. 1.451-3(i)(2) for tax years beginning after Dec. 31, 2018, if they apply all the applicable rules contained in the proposed regulations to specified credit card fees and consistently apply the proposed regulations to all items of income during the tax year (excluding other specified fees).
The proposed regulations provide needed clarity, but important questions remain unanswered. Taxpayers may rely on the proposed regulations for tax years beginning after Dec. 31, 2017, but must do so on an "all-or-nothing" basis. This may prove challenging for taxpayers that are adversely affected by some of the more controversial aspects of the proposed regulations, for example, the recognition of unbilled receivables for goods. Taxpayers in this situation may prefer to interpret the statute based on the legislative history while waiting for the final regulations, which may provide more clarity and administratively feasible rules (e.g., an AFS percentage-of-completion method safe harbor).
Sec. 451(b) is effective for tax years beginning after Dec. 31, 2017, whether or not a taxpayer chooses to rely on the proposed regulations. Many private entities will be adopting Topic 606 effective for 2019 and should consider the interaction between the proposed regulations and the tax implications of adopting Topic 606. Accounting for the differences can be burdensome, especially for taxpayers that no longer maintain the books and records necessary to continue appropriate federal income tax methods because the information is no longer required for AFS purposes.
Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or email@example.com.
Contributors are members of or associated with Grant Thornton LLP.