2019 year-end tax letter: revenue recognition rules finally arrive

Authored by Kathleen Meade

In September, the IRS released eagerly awaited proposed regulations on revenue recognition for tax purposes. It also issued procedures for implementing accounting method changes to comply with these new provisions. Although the regulations are not effective until finalized, taxpayers may rely on the proposed regulations for taxable years beginning after Dec. 31, 2017, provided they consistently apply all the appropriate rules. Proposed rules related to specified credit card fees (late fees, cash advance fees and interchange fees) may be relied on for tax years beginning after Dec. 31, 2018.

Background: The Tax Cuts and Jobs Act (TCJA) revises the revenue-recognition timing rules for accrual-basis taxpayers with an applicable financial statement (AFS). Under tax reform, revenue is generally recognized upon the earlier of when the “all-events” test is met or when the taxpayer includes such income in its AFS.

The TCJA also codified the one-year deferral method of accounting for advance payments. Under this method, accrual-basis taxpayers are generally permitted to defer recognizing certain advance payments until the tax year following the tax year of receipt provided the amount is also deferred for financial statement purposes. The TCJA repealed the so-called “two-year deferral method” used for certain inventory and long-term contract payments.

The imposition of the AFS conformity requirement and repeal of the two-year deferral method may accelerate revenue significantly, particularly following the adoption of the new financial revenue recognition standards. Between the tax and AFS conformity rules, revenue will typically be accelerated for many common items such as long-term contracts, licenses, contingent amounts and advance payments.

The proposed regulations: Issued in two parts, the proposed regulations clarify and expand on the changes made by the TCJA.

One set of rules addresses revenue recognition timing, which, in addition to the new AFS conformity provision, requires the transaction price for multiple element contracts to be allocated to the respective performance obligations using the AFS allocation method.

The other set of rules primarily relates to the timing of advance payments.

Highlighted below are some of the key provisions and implications of the proposed regulations: 

Application of the “realization” rule: The proposed regulations under section 451(b) provide that the AFS conformity rule will not apply to accelerate income that is “contingent on the occurrence or nonoccurrence of a future event.” However, the proposed regulations include an unfavorable “presumption” that amounts are not contingent if they are included in the AFS. The taxpayer may “rebut” the presumption if it can establish “to the satisfaction of the Commissioner” that the amount is in fact contingent on the occurrence or non-occurrence of a future event (e.g., pursuant to a written agreement). The proposed regulations provide two helpful examples similar to those contained in the Blue Book to assist taxpayers in determining whether they have met the burden of proof to rebut the presumption and establish that the amount is “contingent.” The IRS requests comments regarding the presumption and various other aspects related to contingent consideration, indicating that further guidance in this area may be forthcoming. Comments are due by Nov. 8, 2019.

Key takeaway: Taxpayers with applicable financial statements should review their current accounting methods for compliance and look to proactively change methods, if possible, in order to help manage their tax position.

Definition of “special” methods exempt from the AFS conformity rule: Items accounted for using a “special method of accounting” are not subject to section 451(b). A special method of accounting is a method permitted or required under current tax law pursuant to which income is recognized in a taxable year other than the taxable year in which the all-events test is met. The proposed regulations provide an expanded and non-exclusive list of such special methods, including the following:

  • Methods provided in sections 453 through 460 (which include the installment method and long-term contracts)
  • Methods of accounting for hedging transactions under section 1.446-4
  • Methods of accounting for certain rental payments under section 467
  • Mark-to-market method under section 475 
  • Original issue discount (OID) methods of accounting (except for specified fees, including certain credit card fees, not treated as OID in the AFS)

The broad definition and non-exclusive list of special methods are welcome developments, particularly with respect to the limitation on the scope of OID income subject to the new section 451 provisions.

PCM book conformity not permitted: Comment letter requests for a book conformity “safe harbor” to reduce the complexity and book/tax disparities resulting from implementing the new revenue recognition book and tax standards for percentage-of-completion (PCM) contracts were not adopted in the section 451(b) proposed regulations. However, the preamble requests comments on this topic indicating the IRS may reconsider its position on this issue.

Cost offsets and reductions not permitted: As anticipated, neither set of proposed regulations adopts comment letter suggestions to allow accelerated revenue amounts be offset by related expenses, cost of goods sold and reductions such as allowances, adjustments, rebates, chargebacks, refunds and rewards. Conversely, such offsets are permitted for financial reporting purposes under the new financial revenue recognition standards. The inability to make similar adjustments for tax purposes is expected to affect significantly and adversely many taxpayers required to accelerate substantial amounts of gross revenue under the new revenue recognition timing rules. Consequently, the requests for comments contained in the preamble to the proposed regulations are likely to generate a substantial response from affected taxpayers and their advisors, and signify that the IRS may be open to suggestions on this matter.

Expanded list of advance payments eligible for the deferral method: As expected, the proposed regulations favorably increased the list of eligible advance payments from the two enumerated under section 451(c) (goods and services) to include nine additional items, consistent with Rev. Proc. 2004-34 and subsequently issued guidance. Notably, the proposed regulations authorize the IRS to designate additional qualifying items, signifying that the list of eligible payments may be amplified in the future.

Taxpayers without an AFS eligible to use the deferral method: While section 451(c) limited eligibility for the deferral method to taxpayers with an AFS, the proposed regulations follow Rev. Proc. 2004-34 and extend this favorable method to taxpayers without an AFS. Consistent with the treatment under Rev. Proc. 2004-34, an advance payment received by a non-AFS taxpayer is recognized in the year of receipt to the extent earned, and the balance is recognized in the following tax year.

Longer deferral period for “specified goods”: The proposed regulations under section 451(c) adopt comment letter proposals from the aerospace industry to exclude certain payments for “specified goods” from the definition of advance payments subject to the maximum one-year deferral period. This exclusion applies to upfront payments received at least two years prior to the contracted delivery date for goods that the taxpayer does not have on hand to fulfill the contract in the year payment is received, and all revenue from the sale of the goods is recognized in the taxpayer’s AFS in the year of delivery. The numerous comment requests raised in the preamble indicate the IRS may consider further guidance and/or additional exclusions benefitting other industries or types of payments.

Rev. Proc. 2019-37 automatic accounting method change procedures: The new section 451 provisions are methods of accounting which typically require IRS consent (Form 3115) to implement. Rev. Proc. 2019-37 provides procedures to obtain automatic consent to comply with new sections 451(b) and (c) and the proposed regulations. The procedures are generally effective for tax years beginning after Dec. 31, 2017, modify existing automatic change procedures, and are subject to certain scope limitations. Notably, the new procedures: (1) add a new change to implement the proposed regulations; (2) permit certain changes to be made on a cutoff basis or with a section 481(a) adjustment; (3) temporarily provide audit protection for taxpayers with an AFS that are under exam; and (4) allow certain small taxpayers to use streamlined procedures for a limited period to implement the new rules.

Bottom line is taxpayers with AFS should review their current accounting methods for compliance and look to proactively change methods, if possible, in order to help manage their tax position.

View more insights in the 2019 year-end tax planning letter >

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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.

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