Editor: Kevin D. Anderson, CPA, J.D.
On Dec. 21, 2020, the IRS and Treasury released final regulations (T.D. 9941) addressing the timing of income recognition for accrual-method taxpayers under Secs. 451(b) and 451(c), as amended by the 2017 law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. The final regulations apply for tax years beginning on or after Jan. 1, 2021, but can be applied to tax years beginning after Dec. 31, 2017, provided the rules are applied in their entirety and in a consistent manner for all subsequent tax years. This item discusses key highlights of the Sec. 451(b) regulations, which address the timing of income recognition for accrual-method taxpayers with an applicable financial statement (AFS).
Highlights of Sec. 451(b) regulations
Sec. 451(b)(1)(A) requires an accrual-method taxpayer with an AFS to treat the right to income as fixed, under the all-events test, no later than the time at which the item (or portion thereof) is taken into account in its AFS. While this rule generally results in increased instances of financial accounting and tax accounting conformity, it operates in one direction only, namely, to accelerate the timing of income recognition for tax purposes in accordance with books.
As noted in the preamble to the final Sec. 451 regulations, several commenters raised concerns that the income-inclusion rule was overly broad and could in some circumstances require taxpayers to incur a tax liability without having the cash to pay the liability. Accordingly, the final regulations now limit the scope of Sec. 451(b) by clarifying that for purposes of determining when income is "taken into account as AFS revenue," the amount of revenue determined for financial reporting purposes is reduced by amounts that the taxpayer does not have an enforceable right to recover if the customer were to terminate the contract on the last day of the tax year. The determination of whether a taxpayer has an enforceable right to recover is governed by the terms of the contract and applicable federal, state, or international law, and includes amounts recoverable in equity and liquidated damages.
In addition, taxpayers must increase AFS revenue to the extent the amount reflects a reduction for cost of goods sold (COGS) or liabilities that are required to be accounted for under other provisions of the Code, such as Sec. 461 (including allowances, rebates, chargebacks, rewards issued in credit card transactions, and other reward programs and refunds), in addition to amounts anticipated to be in dispute or anticipated to be uncollectible. Similarly, if there is a financing component that results in imputed interest income or expense being calculated for AFS purposes (which usually occurs when there is a significant lag between when payment is received and when a performance obligation is satisfied), the final regulations require a taxpayer to make adjustments to its AFS revenue to remove the impact of imputed interest.
In general, all of these adjustments to AFS revenue can be computed fairly easily if a taxpayer accounts for these amounts in separate trial balance accounts from gross revenue (e.g., through the use of a contra-revenue account). On the other hand, if the gross revenues and the reduction for COGS or other liabilities subject to Sec. 461 are combined into one trial balance account, taxpayers would be required to perform an additional analysis to remove the nonrevenue items from the account balance for tax purposes.
To reduce administrative complexity, the final regulations provide an "alternative AFS revenue method," which allows a taxpayer to forgo reducing AFS revenue by amounts for which the taxpayer does not have an enforceable right to recover by year end. However, a taxpayer must still make adjustments to remove any financing component, expenses, and COGS from the transaction price under the alternative AFS revenue method.
Many taxpayers had hoped to see a provision in the final regulations that would allow the acceleration of certain expenses or estimated cost of goods in situations involving the acceleration of income under Sec. 451(b). While the final regulations clarify that allowing a true cost offset would be inconsistent with Secs. 461, 263A, and 471, they do offer taxpayers the option of applying the "AFS cost offset method," which permits taxpayers to net their AFS revenue inclusion amount under Sec. 451(b) with the amount of COGS "in progress" — e.g., the amount of cost of goods incurred through the last day of the tax year reduced by the cumulative cost of goods in progress offset amounts that were taken into account in prior tax years, if any. Importantly, this offset does not actually impact the timing of COGS for tax purposes, which generally will still be recognized in the year the inventory is sold to the customer. Rather, the cost offset only serves to reduce the amount of AFS income inclusion required to be recognized for tax purposes.
Further, the final regulations specify that the cost-offset amount must be computed based on amounts that were incurred during the year under Sec. 461 and have been capitalized and included in inventory under Secs. 471 and 263A (if applicable). In the majority of instances, this will result in a difference between the COGS expensed for book purposes and the amount of cost offset allowed for tax purposes under the final regulations, due to book-tax differences associated with capitalizable costs (e.g., depreciation expense for assets used in the production process), as well as the nature and amounts of costs required to be capitalized for tax purposes under Sec. 263A. A simplified example illustrating the cost-offset method is provided below.
Cost offset: A closer look
Consider, for example, a taxpayer that enters a contract in 2021 with a customer to manufacture and deliver inventory for a total contract price of $100. For AFS purposes, the revenue will be recognized over time, with $20 being recognized in 2021 and $80 being recognized in 2022. Assume the taxpayer has an enforceable right to the AFS income amount at the end of 2021 and, therefore, must include $20 of income for tax purposes in 2021 under Sec. 451(b)(1)(A). The inventory production process spans from 2021 to 2022, with ownership transferring to the customer by the end of 2022. The taxpayer incurs costs to produce the inventory of $8 in 2021 and $32 in 2022, which are expensed as incurred on the taxpayer's AFS.
Next, assume the taxpayer's uniform capitalization (UNICAP) absorption ratio under the simplified production ratio is 12.5% in 2021, resulting in a cumulative amount of UNICAP costs to be capitalized at the end of 2021 of $1. Absent the availability of a cost-offset method, for tax purposes the taxpayer would recognize $20 of revenue in 2021 and $80 in 2022. For COGS, however, the taxpayer would have to wait until 2022 to recognize the entire $40, plus any UNICAP costs capitalized to the inventory to date.
In contrast, under the final regulations, the taxpayer may choose the optional cost-offset method and recognize only $11 of net revenue in 2021 ($20 of revenue less $8 of related production costs less $1 of capitalized UNICAP costs), with the remaining $89 of revenue in 2022. Again, the cost offset merely delays the taxpayer's determination of revenue recognition for tax purposes and has no impact on the timing of COGS the taxpayer recognized. Thus, the taxpayer will still need to wait until ownership is transferred in 2022 to recognize the full $60, plus any UNICAP costs capitalized to the inventory.
Note that the cost-offset adjustments apply to taxpayers that are required to recognize revenue for products produced over time for AFS purposes, rather than at a point in time. For example, a taxpayer selling generic widgets would not typically be required to recognize revenue prior to the delivery of the widgets to a customer. In comparison, a manufacturer that produces a customized product without an alternative use and that has an enforceable right to payment for performance completed to date would generally recognize the total contract price over time under FASB Accounting Standards Codification (ASC) Topic 606, Revenue From Contracts With Customers.
In practice, determining the actual COGS offset may prove to be overly burdensome for certain taxpayers. For instance, complexities may arise for taxpayers that produce inventory for which only a portion of the revenue is recognized using an over-time methodology for AFS purposes. In addition, COGS incurred to date may be difficult to isolate if not first capitalized to the balance sheet and/or tracked separately for book purposes. As there is no specific U.S. GAAP literature that requires a consistent approach in determining cost recognition for financial reporting purposes, taxpayers will have to apply a facts-and-circumstances approach in assessing the feasibility of the cost-offset method to their specific situation. As such, taxpayers looking to apply these rules must first familiarize themselves with the treatment of COGS for financial accounting purposes before making the appropriate determination as to whether the cost-offset method is worth the additional administrative burden.
Kevin D. Anderson, CPA, J.D., is a managing director, 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 email@example.com.
Contributors are members of or associated with BDO USA LLP.