Proposed Regs Implement TCJA Changes to Code Sec. 451 for Accrual Method Taxpayers

(Parker Tax Publishing September 2019)

The IRS issued proposed regulations reflecting amendments to Code Sec. 451, which provide rules relating to the tax year for including amounts in gross income under Code Sec. 451(b) by taxpayers with an applicable financial statement (AFS), as well as rules relating to the use of the deferral method for advance payments for taxpayers with or without an AFS. Concurrently, the IRS issued procedures for obtaining automatic IRS consent to change accounting methods to comply with Code Sec. 451 and the proposed regulations. REG-104870-18; REG-104554-18; Rev. Proc. 2019-37.

Background

Under Code Sec. 451, an item of income must generally be included in gross income for the tax year in which the income is received, unless the item is properly accounted for in a different period. Reg. Sec. 1.451-1 provides that an accrual method taxpayer must include items of income in gross income in the tax year when all the events occur that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy (the all events test).

The Tax Cuts and Jobs Act (TCJA) made several changes to Code Sec. 451, effective for tax years beginning after December 31, 2017, relating to the timing of income for accrual method taxpayers. Code Sec. 451(b) provides that, for an accrual method taxpayer, the all events test with respect to any item of gross income is not treated as met any later than when the item is taken into account as revenue in an applicable financial statement (AFS) of the taxpayer (the AFS income inclusion rule). In addition, Code Sec. 451(c) provides an elective deferral method for an accrual method taxpayer that receives an advance payment during the tax year.

In September 2019, the IRS issued REG-104870-18, which contains Prop. Reg. Sec. 1.451-3 and which describes and clarifies the requirements of Code Sec. 451(b). The IRS also issued REG-104554-18, which contains Prop. Reg. Sec. 1.451-8 and which describes and clarifies the requirements of Code Sec. 451(c). Concurrently, the IRS issued Rev. Proc. 2019-37, which modifies Rev. Proc. 2018-31 and provides procedures to obtain automatic consent of the IRS to change methods of accounting in order to comply with Code Sec. 451, Prop. Reg. Sec. 1.451-3 and/or Prop. Reg. Sec. 1.451-8.

Proposed Reg. 1.451-3

Prop. Reg. Sec. 1.451-3 describes and clarifies the requirements of the AFS income inclusion rule in Code Sec. 451(b) and clarifies how the AFS income inclusion rule applies to accrual method taxpayers with an AFS. Under Prop. Reg. Sec. 1.451-3(b), the AFS income inclusion rule generally applies to accrual method taxpayers with an AFS when the timing of income inclusion for one or more items of income is determined using the all events test. Prop. Reg. Sec. 1.451-3(d)(1) clarifies that the AFS income inclusion rule applies only to taxpayers that have one or more AFS covering the entire tax year.

Under Prop. Reg. Sec. 1.451-3(e), the AFS income inclusion rule generally does not change the treatment of a transaction for federal income tax purposes. The IRS explained that the AFS income inclusion rule was not intended to require taxpayers to recharacterize a transaction for tax purposes to conform to the characterization of the transaction in the taxpayer's AFS. The proposed regulations also clarify that the AFS income inclusion rule does not change the applicability of any exclusion provision or the treatment of nonrecognition transactions. In addition, Prop. Reg. Sec. 1.451-3(b) generally provides that the AFS income inclusion rule does not apply when the timing of income inclusion is determined under a special method of accounting used for federal income tax purposes.

The proposed regulations address how to apply the AFS income inclusion rule and all events test to a multiyear contract. Prop. Reg. Sec. 1.451-3(k) provides that for multiyear contracts, a taxpayer applies the all events test using a cumulative approach reflecting amounts previously included under Code Sec. 451 rather than an annualized approach. According to the IRS, a cumulative approach better reflects the economic reality of a multiyear transaction.

The proposed regulations describe and clarify the definition of an AFS under Code Sec. 451(b)(3). Prop. Reg. Sec. 1.451-3(c)(1) provides a list of financial statements qualifying as an AFS that is generally consistent with the list of AFS in Rev. Proc. 2004-34. In addition, Prop. Reg. Sec. 1.451-3(c)(4) defines revenue broadly to include all items of income under Code Sec. 61. Code Sec. 451(b) and Code Sec. 451(c)(4)(D) require that taxpayers with contracts that contain multiple performance obligations must allocate the transaction price, and therefore defer (or accelerate) income inclusion, consistent with the transaction price allocation used for AFS purposes. The proposed regulations also describe and clarify the allocation of transaction price under Code Sec. 451(b)(4) and provide a definition of performance obligation in Prop. Reg. Sec. 1.451-3(c)(3).

Prop. Reg. Sec. 1.451-3 provides rules for the tax treatment of certain debt instruments. According to the IRS, Congress enacted Code Sec. 451(b) to overturn the treatment of certain credit card fees as original issue discount (OID). Under Prop. Reg. Sec. 1.451-3(i), if a fee is not treated by a taxpayer as a discount or as an adjustment to the yield of a debt instrument over the life of the instrument (such as points) in its AFS and the fee otherwise would be treated as creating or increasing OID, then the rules in Prop. Reg. Sec. 1.451-3 apply before the rules in Code Sec. 1271 through Code Sec. 1275 and the regulations under those sections. The proposed regulations include the market discount rules in Code Sec. 1276 on the list of special methods of accounting to which Code Sec. 451(b) does not apply.

Proposed Reg. 1.451-8

Prop. Reg. Sec. 1.451-8 addresses the timing of income inclusion under Code Sec. 451 of advance payments for goods, services, and certain other items and provides a deferral method of accounting for taxpayers that do not have an AFS.

Consistent with Code Sec. 451(c)(1)(A), the proposed regulations provide that an accrual method taxpayer with an AFS includes an advance payment in gross income in the tax year of receipt unless the taxpayer uses the deferral method in Code Sec. 451(c)(1)(B) and Prop. Reg. Sec. 1.451-8(c) (the AFS deferral method). Under the AFS deferral method, a taxpayer with an AFS that receives an advance payment must include (1) the advance payment in income in the tax year of receipt, to the extent that it is included in revenue in its AFS, and (2) the remaining amount of the advance payment in income in the next tax year. A similar deferral method for non-AFS taxpayers is provided in Prop. Reg. Sec. 1.451-8(d) (non-AFS deferral method). Under the non-AFS deferral method, an accrual method taxpayer without an AFS that receives an advance payment must include (1) the advance payment in income in the tax year of receipt, to the extent that it is earned, and (2) the remaining amount of the advance payment in income in the next tax year.

Prop. Reg. Sec. 1.451-8(b)(1)(i) clarifies that the definition of advance payment under the AFS and non-AFS deferral methods is consistent with the definition of advance payment in Rev. Proc. 2004-34. A list of items excluded from the definition of advance payment that is similar to Rev. Proc. 2004-34 is provided in Prop. Reg. Sec. 1.451-8(b)(1)(ii).

Under Code Sec. 451(c)(3), the AFS deferral method does not apply to an advance payment received by the taxpayer during a tax year if the taxpayer ceases to exist during that year. Prop. Reg. Sec. 1.451-8(c)(2) and Prop. Reg. Sec. 1.451-8(d)(6) provide rules to ensure the acceleration of an advance payment when a taxpayer either dies or ceases to exist, or when a taxpayer's obligation regarding an advance payment is satisfied or otherwise ends, except in certain circumstances. Prop. Reg. Sec. 1.451-8(c)(3) and Prop. Reg. Sec. 1.451-8(d)(7) provide that a taxpayer that defers inclusion of all or a portion of an advance payment must include the remainder of the advance payment in gross income in the subsequent year, notwithstanding any write-down or adjustment for financial accounting purposes.

Observation: The IRS indicated that it will issue future guidance on the procedures by which a taxpayer may change its method of accounting to use one of the deferral methods described Prop. Reg. Sec. 1.451-8. Until further guidance for the treatment of advance payments is applicable, taxpayers may continue to rely on Rev. Proc. 2004-34, as described in Notice 2018-35.

Rev. Proc. 2019-37

Code Sec. 446(e) and Reg. Sec. 1.446-1(e)(2) generally require a taxpayer to secure the consent of the IRS before changing a method of accounting for federal income tax purposes. Rev. Proc. 2015-13, as clarified and modified by Rev. Proc. 2015-33, and as modified by Rev. Proc. 2016-1 and Rev. Proc. 2017-59, provides the general procedures by which a taxpayer may obtain automatic consent to a change in method of accounting. Rev. Proc. 2018-31 contains the current list of automatic changes.

Rev. Proc. 2019-37 modifies Rev. Proc. 2018-31 to provide additional automatic changes for method changes under Code Sec. 451 so that taxpayers can automatically apply the rules in Prop. Reg. Sec. 1.451-3 and/or Prop. Reg. Sec. 1.451-8. Rev. Proc. 2019-37 also modifies Rev. Proc. 2018-31 to provide an additional automatic method change for a taxpayer changing the manner in which it recognizes amounts in revenue in an AFS and that wants to change its method of accounting for federal income tax purposes.

For a discussion of the inclusion of tax income no later than its inclusion in an applicable financial statement, see Parker Tax ¶241,715. For a discussion of the tax treatment of advance payments, see Parker Tax ¶241,720.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker Tax Pro Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker Tax Pro Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com