Final regulations issued on TCJA revenue recognition provisions

| 3/4/2021
Final regulations issued on TCJA revenue recognition provisions

Final regulations covering the Tax Cuts and Jobs Act of 2017 (TCJA) revenue recognition rules under IRC Sections 451(b) and 451(c) were published on Jan. 6. These regulations include several significant revisions to the proposed regulations issued in 2019.

Final regulations under IRC Section 451(b): Treasury regulation Section 1.451-3

The rules under Section 451(b) generally require accrual method taxpayers with an applicable financial statement (AFS) to recognize an item of gross income, or portion thereof, no later than when the item, or portion thereof, is included in revenue in the taxpayer’s AFS (the AFS income inclusion rule). Adopting the definition from the proposed regulations, the final regulations define an AFS as a financial statement that is certified as prepared in conformity with U.S. GAAP or International Financial Reporting Standards (generally an audited financial statement). Financial statements provided to federal or state regulatory agencies also are treated as AFSs.

Under the proposed regulations, revenue for purposes of Section 451(b) (AFS revenue) does not include gross income subject to a contingency based on the occurrence or nonoccurrence of a future event. In response to comments requesting clarification of this exclusion, the final regulations allow – but do not require – taxpayers to exclude from AFS revenue amounts that the taxpayer does not have an enforceable right to recover if the customer terminates the contract to which the income relates on the last day of the taxable year. Certain other adjustments to AFS revenue also are provided in the final regulations, such as a reduction for amounts anticipated to be in dispute or uncollectible.

In response to multiple comments, the final regulations also provide an optional offset against AFS revenue for costs related to the future sale of inventory. Under the “AFS cost offset method,” taxpayers may reduce income from the sale of an item of inventory that is required to be accelerated under the AFS income inclusion rule by the incurred cost of goods related to the item (although such offset cannot result in a negative income inclusion). To be eligible for the offset, at the end of the year the cost of goods incurred must do all of the following:

  • Be related to the item of inventory produced or acquired for resale
  • Have been incurred under Section 461 and capitalized
  • Be included in inventory under Sections 471 and 263A or any other applicable provision of the IRC

These costs reduce AFS income for the year in which they are incurred but are deducted in the taxable year in which ownership of the item of inventory is transferred to the customer. The use of the AFS cost offset method might require taxpayers to identify additional Section 263A costs to be deducted at year-end for tax reporting purposes.

The final regulations also provide that the AFS inclusion rules apply to specified fees generally accelerating the recognition of that income. Specified fees are those fees that are not spread over a period of time as a discount or an adjustment to the yield of a debt instrument (such as credit card late fees).

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Final regulations under IRC Section 451(c): Treasury regulation Section 1.451-8

The rules under Section 451(c) generally apply to accrual method taxpayers that receive advance payments and allow income recognition under either the deferral method or the full inclusion method. Generally, taxpayers that adopt the deferral method must include in income advance payments that are included in the AFS or are determined to be earned by the taxpayer if it does not have an AFS. Under the deferral method, income can be deferred only until the tax year following the year of receipt. For taxpayers that opt for the full inclusion method, income is recognized upon receipt.

The proposed regulations under Section 451(c) generally followed the guidance in Revenue Procedure 2004-34 regarding when advance payments are included in income, which did not provide for a cost offset when determining the amount of the advance payment. However, the final regulations allow an optional cost offset to better match income from advance payments, with incurred cost of goods related to the payment to more clearly reflect income. The final regulations obsoleted the revenue procedure for taxable years beginning on or after Jan. 1, 2021, and taxpayers are cautioned that a change in method of accounting might be necessary if taxpayers relied on this obsolete guidance.

The final regulations’ rule for advance payment cost offset is mechanically similar to the “AFS cost offset method” described earlier and applies to advance payments included in income under either the full inclusion or the deferral method.

The final regulations also give taxpayers the option to treat specified goods as advance payments eligible for the deferral method. Specified goods generally are goods for which payment is received in a year the taxpayer doesn’t have the goods on hand to satisfy the contract with the customer and all the revenue from the sale of goods is recognized in the AFS in the year of delivery.

Applicability date

The final regulations generally apply for taxable years beginning on or after Jan. 1, 2021. Taxpayers generally may apply the rules in the final regulations to a taxable year beginning after Dec. 31, 2017, and before Jan. 1, 2021, if the rules are applied in their entirety and in a consistent manner. Alternatively, taxpayers generally may rely on the proposed regulations for taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2021. For specified fees that are not credit card fees, the final regulations generally apply to tax years beginning on or after Jan. 6, 2022.

Looking forward

Most of the rules under the final regulations apply beginning with 2021 tax years. However, the final regulations can be applied to earlier years in certain cases. In addition, several pieces of prior IRS guidance relating to revenue recognition have been obsoleted by the final regulations. Accordingly, accrual basis taxpayers, particularly those with an AFS, should evaluate how the final regulations affect their present revenue recognition methodology and assess how these rules affect them, whether to apply the final regulations to prior years, and whether a method change would be beneficial or required.

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