With the implementation of the revenue recognition standards under generally accepted accounting principles (GAAP) quickly approaching, it is also necessary to determine the impact of these standards on an entity’s taxable income. Once an entity establishes a method of recognizing revenue for tax purposes, it cannot unilaterally change such method without requesting permission from the IRS. Given the sweeping changes of how revenue will now be recorded on an entity’s books, the IRS issued Notice 2017-17 on March 28, 2017. If finalized, the procedures, as outlined, may be used in certain circumstances to request consent to change a method of accounting for recognizing income for tax purposes related to the adoption of the new financial accounting revenue recognition standards.
New accounting standard
New financial accounting standards for recognizing revenue from contracts with customers are effective for annual reporting periods beginning after Dec. 15, 2017, for publicly traded entities, certain not-for-profit entities and certain employee benefit plans. Other taxpayers have an additional year to implement the standards (i.e., for annual reporting periods beginning after Dec. 15, 2018). GAAP will apply a five-step analysis to all contracts with customers to transfer goods and services (other than leases, insurance, financial instruments, guarantees and certain nonmonetary exchanges between entities in the same line of business). See [BT web page link] for further information regarding the five-step process used to recognize revenue under the new standard.
Tax revenue recognition principles and accounting method change procedures
Under federal tax principles, which have not changed as a result of the new financial standards, revenue is generally recognized under the “all-events” test when the taxpayer has (1) a fixed right to receive the revenue (usually the earlier of when the revenue is due, received or earned) and (2) the amount can be determined with reasonable accuracy. Certain advance payments received from the provision of goods, services and other eligible sources may be deferred for one to two tax years.
Changing the timing of recognizing revenue for tax purposes typically requires IRS consent to implement (i.e., by filing Form 3115, “Application for Change in Accounting Method”). Generally, Form 3115 is filed pursuant to advance consent procedures, which require the form(s) to be filed with the IRS National Office by the last day of the year of change, along with payment of a user fee. However, certain changes designated as “automatic” by the IRS, such as changes in the method of accounting for certain advance payments, are filed under “automatic” consent procedures, which do not require a user fee and are filed in duplicate with the timely filed (including extensions) federal income tax return for the year of change. Taxpayers filing Form 3115 must typically compute an adjustment, known as a section 481(a) adjustment, to recognize the effect of the change in accounting method. If the adjustment gives rise to additional taxable income, it is recognized into taxable income ratably over four tax years, beginning with the year of change. If a negative adjustment, taxpayers can reduce taxable income in the year of change.
IRS proposed automatic accounting method change procedures
The proposed guidance under Notice 2017-17 would temporarily allow taxpayers to file revenue recognition method changes using the automatic change procedures if the change in method of recognizing revenue is the result of or directly related to the taxpayer’s adoption of the new financial revenue recognition standard. Certain eligibility requirements must be met and the Form 3115 must be filed in the year the GAAP standard is adopted in order to qualify to use the automatic change provisions. This means taxpayers should be evaluating their tax accounting methods as they implement the new GAAP standard so they can take advantage of this process.
Other key provisions include:
- Cutoff method for small taxpayers: To reduce the administrative burden of implementing these accounting method changes, certain small taxpayers are permitted to make the change on a cutoff basis (i.e., without a section 481(a) adjustment). An eligible small taxpayer is a taxpayer with one or more separate trade(s) or business(es) that individually have (a) total assets of less than $10 million as of the first day of the tax year of change, or (b) average annual gross receipts of $10 million or less for the three tax years preceding the change year. For purposes of applying this exception, separate and distinct trades or businesses and average annual gross receipts are determined on a separate entity basis.
- A section 481(a) adjustment must be computed for the year of change for all separate and distinct trades or businesses other than those meeting the small taxpayer thresholds described above.
- Multiple requests to make qualifying same-year method changes may be made in one Form 3115.
Potential tax effects
Software, entertainment, manufacturing and construction taxpayers may be particularly affected by the new revenue recognition standards due to the prevalence in those industries of certain business practices and accounting methods. If it is not permissible or desirable to adopt the new standard for tax reporting purposes, the taxpayer will need to have procedures in place to track and report revenue for tax purposes. This could result in having to keep dual sets of records to track revenue. This can become burdensome and add to an entity’s internal accounting responsibilities. Some examples are included in the following chart.
|Revenue stream||Tax||New GAAP standard|
|Percentage of completion (PCM)||Generally, taxpayers on PCM recognize revenue for tax purposes using a ratio of costs incurred to date to total estimated costs incurred to complete the contract.||The business may be required to recognize revenue at a point in time or as items are produced.|
|Income from services||With respect to advance payments, taxpayers can defer revenue recognition under certain circumstances for one to two years, but no longer than the period it is deferred for financial reporting purposes.||The new GAAP standard may require revenue to be recognized upfront rather than over the life of the agreement; therefore, adoption of the standard may accelerate the recognition of revenue for book and tax purposes.|
|Revenue from bill-and-hold sale transactions||Taxpayers typically recognize revenue for tax purposes when the amounts become fixed and determinable.||The new GAAP standard requires contingent revenue to be recognized upfront or when receipt is probable.|
|Sales and returns of goods||Taxpayers commonly recognize revenue when the benefits and burdens of ownership are transferred.||Under the new GAAP standard, this revenue may be recognized as items are produced; potentially resulting in an accelerated recognition period on the books than would be for tax purposes.|
|Income from sale of licenses and warranties|
As a rule, taxpayers recognize such revenue ratably over the term of the license.
|Revenue may be recognized for financial reporting purposes upfront or at a specific point in time. The contract price for bundled software licenses and maintenance contracts may have to be allocated between the two items, with revenue from the software license recognized upfront while the maintenance revenue is be recognized ratably over the agreement term.|
Although the proposed procedures described in Notice 2017-17 may not be used until finalized, it indicates the approach the IRS will likely apply in granting tax accounting method changes related to the new revenue recognition standards. Significantly, if finalized in their current form, these favorable procedures will be available only for a limited period (i.e., only for tax method change(s) implemented in the year the new standards are adopted).
Consequently, taxpayers that fail to file method change applications within the prescribed time frame may be required to apply for consent under the more onerous and costly advance consent procedures, and “small” taxpayers may no longer be eligible to apply the simplified cutoff approach to implement revenue recognition accounting method changes related to the new standard.
Accordingly, taxpayers and their tax advisors should act now to evaluate and plan for the tax implications of the new financial revenue recognition standards, starting with identifying affected revenue streams, and then assessing whether tax accounting method changes are necessary or desired to change to compliant methods or to follow the new book accounting method(s). Alternatively, taxpayers that will continue using their current tax revenue recognition methods will need to determine whether their systems and books and records adequately track the necessary data to maintain those methods going forward.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.