Final Sec. 451 Regs Introduce New Methods for Income Inclusion and Cost Offsets

(Parker Tax Publishing January 2021)

The IRS issued final regulations on the timing of income inclusion under an accrual method of accounting, including the treatment of advance payments for goods, services, and certain other items. The final regulations introduce a new applicable financial statement (AFS) Income Inclusion Rule, as well as a cost offset rule which applies when an amount is included under the AFS Income Inclusion Rule. T.D. 9941.

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 of 2017 (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 Prop. Reg. Sec. 1.451-3, which described the requirements of Code Sec. 451(b). The IRS also issued Prop. Reg. Sec. 1.451-8, which described the requirements of Code Sec. 451(c). Concurrently, the IRS issued Rev. Proc. 2019-37, which 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.

The IRS has now finalized these regulations in T.D. 9941. Among other changes, the final regulations provide for a cost offset when an amount is included under the AFS Income Inclusion Rule and a revised AFS Income Inclusion Rule.

The final regulations set forth the following methods of accounting:

(1) Application of AFS income inclusion rule by making all AFS revenue adjustments (Reg. Sec. 1.451-3(c)(2)(i));

(2) Application of AFS income inclusion rule by making certain AFS revenue adjustments (i.e., Alternative AFS Revenue method) (Reg. Sec. 1.451-3(c)(2)(ii));

(3) AFS cost offset method (Reg. Sec. 1.451-3(d));

(4) Computing revenue when the AFS and tax years are mismatched (Reg. Sec. 1.451-3(j)(4));

(5) Change in the method of recognizing revenue in an AFS (Reg. Sec. 1.451-3(m));

(6) Deferral method for taxpayers with an AFS (Reg. Sec. 1.451-8(c));

(7) Deferral method for taxpayer without an AFS (reg. Sec. 1.451-8(d));

(8) Advance payment cost offset method (Reg. Sec. 1.451-8(e));

(9) Election for the specified goods exception to not apply (Reg. Sec. 1.451-8(f)); and

(10) Change in the method for recognizing advance payments on an AFS (Reg. Sec. 1.451-8(g)).

Compliance Tip: Because Code Sec. 451(b) and Code Sec. 451(c) and these final regulations provide various methods of accounting affecting the timing of income inclusion, taxpayers without an existing method of accounting for these items may initially adopt such method without the consent of the IRS. However, IRS consent under Code Sec. 446(e) and the regulations thereunder is required before implementing method changes from one method to another method.

Income Realization and Income Recognition

Footnote 872 of the TCJA Conference Report states that Code Sec. 451(b) was not intended to revise the rules associated with when an item is realized for federal income tax purposes and does not require the recognition of income in situations where the federal income tax realization event has not taken place. Footnote 874 of the Conference Report provides, by way of example, that the timing rules of Code Sec. 451(b) apply to unbilled receivables for partially performed services. Practitioners had asked that the final regulations either explicitly define realization or clarify when realization occurs in certain circumstances, such as where a taxpayer produces goods for customers or where a taxpayer provides non-severable services to customers.

In the final regulations, the IRS declined to clarify when realization occurs in specific circumstances because, it said, realization is a factual determination that, while closely aligned with the all events test, has different meanings in different contexts. The IRS noted that Code Sec. 451 is a timing provision and the amendments to Code Sec. 451(b)(1)(A) by TCJA were intended to modify the timing of income to require an accrual method taxpayer with an AFS to treat the right to income as fixed, under the all events test, no later than the time at which the item (or portion thereof) is taken into account in its AFS. The statute thus reflects Congress' intent to incorporate timing concepts from the financial reporting rules in the tax timing rules for including items in gross income. It does not seek to answer whether the AFS income inclusion has been realized. Accordingly, the focus of the final regulations is on the appropriate tax year of AFS income inclusion.

Cost Offset for AFS Income Inclusions - AFS Cost Offset Method

While the proposed regulations did not provide for a cost offset when an amount is included under the AFS Income Inclusion Rule, the IRS did request comments on this issue. In response, practitioners proposed allowing an offset for cost of goods sold (COGS) when income is included under the AFS Income Inclusion Rule. They also described situations where income might be distorted by inclusions in early years of a multi-year contract with the costs being allowed in later years without income to offset. Practitioners recommended that the final regulations provide that the all events test and the economic performance requirement under Code Sec. 461 should be deemed to be met for items that are "closely aligned" with income amounts recognized under the AFS Income Inclusion Rule. The IRS rejected these proposals, saying that a cost offset based on estimates of future costs would be inappropriate. However, the IRS did agree with comments suggesting that taxpayers should be afforded the flexibility of applying an offset for costs incurred against AFS income inclusions from the future sale of inventory, the "AFS cost offset method." Accordingly, a taxpayer that uses the AFS cost offset method determines the amount of gross income includible for a year prior to the year in which ownership of inventory transfers to the customer by reducing the amount of revenue it would otherwise be required to include under the AFS Income Inclusion Rule for the tax year (AFS inventory inclusion amount) by the cost of goods related to the item of inventory for the tax year, the "cost of goods in progress offset." The net result is the amount that is required to be included in gross income for that year under the AFS Income Inclusion Rule. The deferred revenue (i.e., the revenue that was reduced by the cost of goods in progress offset for a tax year prior to the tax year that ownership of the item of inventory is transferred to the customer) is generally taken into account in the tax year in which ownership of the item of inventory is transferred to the customer.

The final regulations provide that the cost of goods in progress offset for each item of inventory for the tax year is calculated 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 prior tax years, if any. However, the cost of goods in progress offset cannot reduce the AFS inventory inclusion amount for the item of inventory below zero. Further, the cost of goods in progress offset attributable to one item of inventory cannot reduce the AFS inventory inclusion amount attributable to a separate item of inventory. Any cost of goods that were not used to offset AFS inventory inclusion amounts because they were subject to limitation are considered when the taxpayer determines the cost of goods in progress offset for that item of inventory in a subsequent tax year.

The cost of goods in progress offset is determined by reference to the costs and expenditures related to each item of inventory produced or acquired for resale, which costs have been incurred under Code Sec. 461 and have been capitalized and included in inventory under Code Sec. 471 and Code Sec. 263A or any other applicable provision of the Code at the end of the year. However, the cost of goods in progress offset does not reduce the costs that are capitalized to the item of inventory produced or acquired for resale by the taxpayer under the contract. That is, while the cost of goods in progress offset reduces the AFS inventory inclusion amount, it does not affect how and when costs are capitalized to inventory under Code Sec. 471 and Code Sec. 263A or any other applicable provision of the Code or when those capitalized costs will be recovered. Instead, the cost of goods in progress offset serves only to reduce or "offset" any AFS income inclusion amounts for the item of inventory and defer such amounts to the tax year in which ownership of the item of inventory is transferred to the customer.

AFS Income Inclusion Rule

The general AFS Income Inclusion Rule in the proposed regulations provided that, if a taxpayer includes an item of gross income, or portion thereof, in revenue in the taxpayer's AFS, the taxpayer must include the item in gross income under Code Sec. 451(b). In the preamble to the final regulations, the IRS acknowledged that the proposed AFS Income Inclusion Rule could exacerbate a situation where a taxpayer incurs a tax liability without having the money to pay the liability. Accordingly, the final regulations provide that, under the AFS Income Inclusion Rule, the all events test for any item of gross income, or portion thereof, is met no later than when that item, or portion thereof, is "taken into account as AFS revenue." In determining when an item of gross income is "taken into account as AFS revenue," AFS revenue is reduced by amounts that the taxpayer does not have an enforceable right to recover if the customer were to terminate the contract on the last day of the tax year. The determination of whether the taxpayer has an enforceable right to recover amounts of AFS revenue is governed by the terms of the contract and applicable federal, state, or international law, and includes amounts recoverable in equity and liquidated damages.

Observation: According to the IRS, the revised rule is designed to reconcile the intended preservation of the realization concept, consistent with footnote 872 of the Conference Report, with the intended scope of Code Sec. 451(b), as illustrated in footnote 874 of the Conference Report.

Effective Date

Generally, under Reg. Sec. 1.451-3(n)(3)(i), early application of these regulations is available. Under the early application rule, taxpayers may apply the provisions of the final regulations to a tax year beginning after December 31, 2017, and before the later of either January 1, 2021, or the date the regulations are published in the Federal Register, provided that, once applied to a tax year, the rules are applied in their entirety and in a consistent manner to all subsequent tax years. Otherwise, the regulations are effective for tax years beginning on or after the later of January 1, 2021, or the date the regulations are published in the Federal Register.

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.

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