Income recognition changes for accrual-method taxpayers
By Colleen M. O’Connor, J.D., and Karen S. Messner, E.A.
The general tax rules for income recognition under an accrual method of accounting were changed in the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, which added new Secs. 451(b) and (c). Prior to the TCJA, Sec. 451 required accrual-method taxpayers to include amounts in gross income when all the events occurred that fix the right to receive the income and the amount of income can be determined with reasonable accuracy (the all-events test), unless an exception permitted deferral or exclusion, or a special method of accounting applied. An accrual-method taxpayer is now required to recognize income no later than the tax year in which the income is taken into account as revenue in an applicable financial statement (AFS). Sec. 451(b) does not treat the all-events test as being met any later than when an item of income is taken into account in the taxpayer's AFS (to be defined in regulations) for the first tax year beginning after 2017.
While proposed regulations have not yet been issued, the IRS issued Rev. Proc. 2018-60, which provides automatic consent for accrual-method taxpayers with an AFS to make certain accounting method changes to comply with Sec. 451(b), specifically, (1) to recognize income in accordance with the all-events test under Sec. 451(b)(1)(A); and (2) if not adopting the new revenue recognition standards in the year of change, to allocate the transaction price to performance obligations under Sec. 451(b)(4). These automatic changes may be made for tax years beginning after 2017. Until Sec. 451(b) guidance is issued, taxpayers with an AFS will need to do their best to determine whether income needs to be accelerated based on when it is recognized in the financial statements and make any necessary accounting method changes.
Sec. 451(c) requires a taxpayer to include an advance payment in gross income in the tax year of receipt, unless it elects to defer the recognition of all or a portion of the advance payment to the tax year succeeding the year it is received. Sec. 451(c) contains rules similar to Rev. Proc. 2004-34, permitting a limited deferral of an advance payment. The IRS has not issued regulations or other specific guidance on the treatment of advance payments but has issued Notice 2018-35, which permits taxpayers to continue to rely on Rev. Proc. 2004-34 for the treatment of advance payments under the deferral method or full inclusion method until further guidance is issued.
Note that the IRS plans to remove existing Regs. Sec. 1.451-5, relating to the treatment of advance payments for goods and long-term contracts, which would affect accrual-method taxpayers that receive advance payments for goods, including those for inventoriable goods. In general, Regs. Sec. 1.451-5 permitted taxpayers to defer the inclusion of income from advance payments for goods for federal tax purposes until the advance payments were recognized in gross receipts under the taxpayer's method of accounting for financial reporting purposes. New Secs. 451(b) and (c) override the Regs. Sec. 1.451-5 deferral method. Taxpayers that are currently using an accounting method permitted by Regs. Sec. 1.451-5 will need to make an accounting method change to a permitted method of accounting for advance payments, effective for tax years beginning after 2017. Changes that qualify under Rev. Proc. 2004-34 may be made automatically; any changes that do not qualify under Rev. Proc. 2004-34 are generally nonautomatic method changes.