Editor: Christine M. Turgeon, CPA
Sec. 451 governs the timing of including an item in income.
The 2017 law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, made significant changes to Sec. 451. The TCJA added new Sec. 451(b), which accelerates the recognition of income for certain accrual-method taxpayers, and Sec. 451(c), which codified the existing one-year deferral for certain advance payments but eliminated the longer deferral allowed under former Regs. Sec. 1.451-5. The IRS and Treasury issued final regulations under those provisions in December 2020 (T.D. 9941), providing clarity on matters of application and some relief for taxpayers required to accelerate income under the new rules.
The final regulations apply for tax years beginning on or after Jan. 1, 2021. Taxpayers generally may apply the regulations for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2021, if they (1) apply all the rules in the final regulations under both Secs. 451(b) and 451(c) consistently and in their entirety and (2) continue to apply all the rules to all later tax years. At present, early adoption of the final regulations generally would apply only to fiscal-year taxpayers.
This item first summarizes the TCJA's changes to Sec. 451 and then discusses the opportunities the December 2020 final regulations may provide to reduce income acceleration.
The TCJA's changes
Prior to the TCJA, a taxpayer using an accrual method of accounting generally included an item in income when all the events had occurred that fixed the right to receive the income and the amount thereof could be determined with reasonable accuracy (the all-events test). The all-events test generally was considered met at the earliest of when the item of income was due, paid, or earned.
New Sec. 451(b), added by the TCJA, provides that certain accrual-method taxpayers meet the all-events test no later than when an item of gross income is taken into account as revenue in the taxpayer's applicable financial statement (AFS) (the AFS-inclusion rule). Accordingly, Sec. 451(b) effectively requires taxpayers to include an item in gross income at the earliest of when the item is due, paid, earned, or taken into account as revenue in its AFS. This change in tax law coincided with the issuance of new financial accounting standards for recognizing revenue from contracts with customers, FASB Accounting Standards Codification (ASC) Topic 606, Revenue From Contracts With Customers, and the similarly titled International Financial Reporting Standard (IFRS) 15, which generally result in the acceleration of revenue recognition for financial statement purposes. Therefore, many accrual-method taxpayers must accelerate tax revenue to a year earlier than would have been required under the previous revenue recognition rules.
New Sec. 451(c) codifies, in part, the deferral provisions of Rev. Proc. 2004-34, which before the TCJA generally governed the federal income tax treatment of certain advance payments such as for goods, services, licenses, and subscriptions. Sec. 451(c)(1)(A) provides the general rule that an accrual-method taxpayer must include an advance payment in gross income in the tax year of receipt. However, Sec. 451(c)(1)(B) permits a taxpayer to elect to include a portion of the advance payment in gross income in the tax year following the year of receipt to the extent the income is not included in revenue in the taxpayer's AFS in the year of receipt.
Potential income acceleration mitigation opportunities
As discussed below, the final regulations issued in December 2020 may provide some opportunities to mitigate the income-acceleration effect of Sec. 451(b) and Sec. 451(c), including by using the enforceable-right provision and the cost-offset method.
Enforceable-right provision: Under the enforceable-right provision, a taxpayer may reduce AFS revenue otherwise required to be recognized under Sec. 451(b) (AFS income inclusion) for amounts that the taxpayer would not have an enforceable right to recover if the customer terminated the contract on the last day of the tax year. The determination of whether the taxpayer has an enforceable right to recover is governed by the terms of the contract and applicable law and includes amounts recoverable in equity and liquidated damages. As quantifying the amount to which the taxpayer does not have an enforceable right may be burdensome, a taxpayer may wish to forgo adjusting the AFS income inclusion for these amounts. Either approach is a method of accounting that a taxpayer must apply to all income items that are subject to Sec. 451(b) for each trade or business (see Regs. Secs. 1.451-3(b)(2)(ii) and 1.451-3(l)(1)).
Observation: Taxpayers may want to review contracts for which income is accelerated under Sec. 451(b) to evaluate whether the contract terms provide for an enforceable right to payment under applicable law. Taxpayers may be able to defer income if, for example, unbilled revenue is recognized as AFS revenue but the taxpayer's right to payment is not enforceable under applicable law.
Cost-offset method: The optional cost-offset method in the final regulations allows taxpayers to reduce income by offsetting incurred inventory costs against AFS revenue that is otherwise required to be recognized under Sec. 451(b) and/or Sec. 451(c) before the related inventory is transferred.
Under the AFS cost-offset method, a taxpayer determines the amount of gross income includible under Sec. 451(b) for tax years before the year in which ownership of inventory transfers to a customer (year of sale), by reducing the amount of income the taxpayer otherwise would be required to take into account under the AFS inclusion rule by a cost-of-goods-in-progress offset (offset). The regulations require taxpayers to calculate the offset separately for each item of inventory.
A taxpayer calculates the offset for each item of inventory as (1) the cost of goods incurred through the last day of the tax year, (2) reduced by the cumulative "cost of goods in progress offset amounts" attributable to the items of inventory that were taken into account in earlier tax years. The costs taken into account under the offset rule must have been incurred under Sec. 461 and included in inventory costs at the end of the tax year.
Under the regulations, costs are determined by applying a taxpayer's inventory accounting methods and must be properly capitalized to inventory under those methods. A taxpayer using a simplified method under Sec. 263A must determine the portion of additional Sec. 263A costs allocable to an item of inventory in computing the offset by multiplying total additional Sec. 263A costs by a ratio based on the tax basis of the item.
In the tax year of sale, a taxpayer generally includes in gross income the income reduced as a result of the offset. The taxpayer is not permitted a cost offset for an item in the year of sale and instead recovers costs capitalized to the item as cost of goods sold.
A taxpayer must include in gross income all payments received for an item of inventory that the taxpayer did not previously include in gross income under the cost-offset rules if, in a tax year before the tax year of sale, either (1) the taxpayer dies or ceases to exist in a transaction other than a Sec. 381(a) transaction or (2) the taxpayer's obligation to the customer regarding the item of inventory ends other than in a Sec. 381(a) transaction or certain Sec. 351(a) transactions.
The cost-offset method is a method of accounting. A taxpayer that uses the cost-offset method must use it consistently for all relevant items of gross income in a trade or business and also must use the advance payment cost-offset method under the Sec. 451(c) final regulations to account for advance payment of inventory, which operates substantially similarly to the cost-offset rules described above (see Regs. Secs. 1.451-3(l)(1) and 1.451-8(e)(1)).
Observation: The cost-offset method applicable to Sec. 451(b) accelerated revenue may be especially helpful when goods are accounted for under a percentage-of-completion method for book purposes but not for tax purposes (which may result in a significant mismatch between revenue and costs under Sec. 451 for tax purposes) or when book recognizes revenue and cost of goods sold in advance of transfer of ownership of the inventory. Similarly, the advance payment cost-offset method applicable to Sec. 451(c) accelerated revenue may be beneficial to taxpayers required to recognize advance payments under either the deferral method or full-inclusion method. However, while these cost-offset methods may be favorable options, they may be difficult to apply in practice, given that the regulations require taxpayers to identify and track costs incurred related to specific items of inventory.
In August 2021, the IRS released Rev. Proc. 2021-34, providing procedures for taxpayers to change their methods of accounting to comply with the Sec. 451 amendments and the final regulations. Rev. Proc. 2021-34 amended Rev. Proc. 2019-43, the description of automatic method changes and their terms and conditions (later superseded by Rev. Proc. 2022-14), and Rev. Proc. 2015-13, the general method change procedures. A change to a method of accounting to defer income for which there is no enforceable right to payment under a contract or to use the cost-offset method generally may be made under the automatic procedures with audit protection.
Rev. Proc. 2021-34 modified Rev. Proc. 2015-13 to require that a taxpayer make a change to its cost-offset method to conform to a permissible inventory method and a cost-offset-related inventory method change concurrently. A cost-offset-related inventory method change is a change in accounting method for inventory or a liability that could affect a taxpayer's cost-of-goods-in-progress offset under the cost-offset method.
Taxpayers should consider using the enforceable-right provision and optional cost-offset method to reduce their revenue accelerated under Sec. 451(b) or Sec. 451(c), but they also should take into account the complexities regarding implementation from a practical standpoint.
Christine M. Turgeon, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in New York City.
For additional information about these items, contact Ms. Turgeon at 973-202-6615 or email@example.com.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.