Editor: Lori Anne Johnston, CPA, J.D.
The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, introduced new guidance under Sec. 451(b), which governs the timing of revenue recognition. The new revenue recognition standard requires that an accrual-method taxpayer recognize revenue no later than when recognized in the taxpayer's applicable financial statement (AFS) if all events have occurred that fix the right to receive income, and the amount can be determined with reasonable accuracy. The most common AFS is generally an audited financial statement prepared in accordance with generally accepted accounting principles (GAAP).
In certain circumstances, this new rule accelerates revenue recognition, but not expense recognition, to a period earlier than the taxpayer would have earned the revenue under federal income tax principles. The proposed regulations under Sec. 451 did not provide for a cost offset for costs incurred. Now, many affected accrual-method taxpayers may seek out practical and permissible methods that better align revenue and expense recognition.
GAAP and tax principles both permit taxpayers that receive upfront payments for future goods or services to defer revenue recognition to a later period. While GAAP allows for revenue deferral over multiple years, tax principles generally only permit a one-year deferral of advance payments under Regs. Sec. 1.451-8(a)(1)(i)(B). Accordingly, taxpayers may be required to accelerate revenue recognition compared to GAAP for multiyear contracts and defer expense recognition, as the related expenses would be deducted as incurred or title transfers.
The tax community lobbied the IRS to allow for a cost offset or cost-of-goods-sold acceleration in the final regulations. Without a cost offset, taxpayers with multiyear contracts may have to recognize income in earlier years and expenses in later years compared to GAAP, creating absurd results. The IRS responded to taxpayers' concerns by providing the AFS cost offset in Regs. Sec. 1.451-3(c) for AFS income inclusions in Regs. Sec. 1.451-3(b).
The preamble to Regs. Secs. 1.451-3 and 1.451-8 (T.D. 9941) states that the AFS cost-offset method is a method of accounting, meaning once it is adopted, taxpayers must remain on this method. Taxpayers with inventory may adopt this method of accounting at the trade or business level. However, if taxpayers adopt the cost-offset method, they must adopt it for all items of income eligible for this method. Taxpayers with inventory should weigh the costs and benefits of tracking the cost of goods in progress for each item of inventory, to calculate the AFS cost offset under Secs. 471 and 263A. Taxpayers may find that this creates an administrative burden that is not commensurate with the benefit of the offset.
While the IRS addressed the cost issue, the potential mismatch of GAAP and tax income recognition remains. Taxpayers with multiyear contracts involving the sale of goods may have another option available to them: the special rules for certain long-term contracts in Sec. 460. The Code and regulations regard Sec. 460 as a special method of accounting, and Sec. 451(b)(2) excepts taxpayers using a special method of accounting from the revenue recognition standard under Sec. 451(b). Because of this exception, Sec. 460 is receiving renewed interest.
The special rules related to long-term contracts found in Sec. 460 and the regulations thereunder require taxpayers to calculate the related taxable income under the percentage-of-completion method without regard to when taxpayers receive cash. This approach may better align with the GAAP treatment of income and expenses for certain types of long-term contracts. The Code and regulations define a long-term contract as any contract for the manufacture, building, installation, or construction of property that begins in one tax year and ends in a subsequent tax year. Under Sec. 460 and the percentage-of-completion method, taxpayers calculate current-year taxable income as the product of the gross contract price multiplied by the ratio of costs incurred to date to the estimated total contract costs. This method results in revenue recognition over the life of the long-term contract and better matching with expense recognition.
Two types of contracts fall within Sec. 460's purview: construction and manufacturing. Of the two contract types eligible for Sec. 460 treatment, construction contracts provide the least amount of uncertainty regarding what may qualify as a construction contract. Regs. Sec. 1.460-3(a) defines a construction contract as involving the building, construction, reconstruction, or rehabilitation of a property; the installation of an integral component to real property; or the improvement of real property, meaning land, buildings, and inherently permanent structures.
The regulations provide only two exemptions from Sec. 460's application. First, home construction contracts do not qualify as long-term construction contracts. Second, Sec. 460 exempts qualified small business taxpayers that are not tax shelters and have gross receipts less than $25 million, adjusted annually for inflation ($26 million in 2019, 2020, and 2021).
A manufacturing contract involves the manufacturing of personal property that is a unique item of a type that is not normally carried in the taxpayer's finished goods inventory or an item that normally requires more than 12 calendar months to complete, regardless of the contract's duration or the time to complete a deliverable quantity. Regs. Sec. 1.460-2(b) defines "unique" as designed for the needs of a specific customer. In determining whether an item is unique, taxpayers should consider the extent to which an item is customized and whether another customer would purchase the item with little or no modification.
The IRS provided three safe harbors for taxpayers to consider in determining whether an item is unique. Most safe harbors contained within the regulations grant taxpayers the ability to adopt specific treatment should the taxpayer satisfy the safe harbors as prescribed. The unique item safe harbors under Regs. Sec. 1.460-2(b)(2) accomplish the opposite and instead prohibit taxpayers from using the percentage-of-completion method if the safe harbors are satisfied; thus, taxpayers should focus on substantiating that the manufacturing contracts in question do not satisfy the safe harbors.
Under Regs. Secs. 1.460-2(b)(2)(i) and (ii), respectively, an item is not unique if it normally requires 90 days or less to complete, or if the costs attributable to customization do not exceed 10% of the estimated total allocable contract costs. Lastly, Regs. Sec. 1.460-2(b)(2)(iii) provides that an item ceases to be unique no later than when the taxpayer normally includes similar items in its finished goods inventory. Taxpayers should consider only the first item or unit when determining whether they have satisfied the safe harbor. Of equal importance, this is not an "and" test. This means that, if a taxpayer satisfies one of the safe harbors, the item is not unique. If none of the safe harbors are met, the determination of uniqueness will depend on the taxpayer's facts and circumstances.
The safe harbors under Regs. Sec. 1.460-2(b) may be particularly important to contract manufacturers. Contract manufacturers produce goods according to specifications outlined in a contract. Some contracts may require extensive research and development, while others may require little to no design and development.
For example, assume a contract manufacturer enters into a contract to produce four units of an item. The contract manufacturer promises to deliver the first unit within 24 months, including the time to research, design, and produce the first unit. Following the completion of the first unit, the contract manufacturer can produce each additional item in the course of three months. The production time is less than 12 months; however, the time to complete the first item exceeded 90 days, which does not satisfy the 90-day safe harbor. Under these circumstances, the contract manufacturer should consider all the facts and circumstances when determining if the item falls within the purview of Sec. 460, thus allowing for revenue recognition according to the percentage-of-completion method (see Regs. Sec. 1.460-2(e), Example 5).
Tax practitioners and taxpayers have yet to realize the full impacts of the new regulations under Sec. 451 with respect to the cost-offset method, including how to adopt and integrate the method. The cost offset may prove to be a taxpayer-favorable provision for some, while others may determine that it is administratively burdensome or impractical. If the latter rings true, taxpayers may reevaluate if the Sec. 460 long-term contract method applies.
As of the end of 2020, the IRS had not offered relief in the form of automatic method change procedures for taxpayers considering the adoption of a Sec. 460 long-term contract method. Sec. 460 may provide the greatest parity between revenue and expense recognition, especially in the context of the new revenue recognition guidance. Taxpayers should consider all available facts and circumstances when determining the suitability and permissibility of a Sec. 460 long-term contract method.
Lori Anne Johnston, CPA, J.D., is a manager, Washington National Tax for RSM US LLP.
For additional information about these items, contact the author at Lucy.Siegel@rsmus.com.
Contributors are members of or associated with RSM US LLP.