Just in time to add to your holiday reading list, the Department of the Treasury (Treasury) and Internal Revenue Service (IRS) released final regulations under sections 451(b) and 451(c) of the Code addressing income recognition and the treatment of advance payments (Final Regulations).¹

Under the Tax Cuts and Jobs Act² (TCJA), Congress amended section 451(b) and added section 451(c) to the Internal Revenue Code, dramatically altering the historic standard of income recognition,³ and also codified a longstanding method of accounting allowing income deferral for advance payments.⁴ Nearly two years later, on September 9, 2019, the IRS issued proposed regulations under section 451(b) and section 451(c) (Proposed Regulations).⁵ Over a year after the Proposed Regulations were published, the Final Regulations have been released.

Sections 451(b) and (c) reflect a great change to income recognition provisions. Moreover, these provisions apply to accrual basis taxpayers, which means a wide array of companies are subject to these provisions. As such, the government faced a daunting task in setting forth guidance for these provisions. The guidance challenge was complicated by the interaction with new financial accounting provisions addressing revenue recognition. For these reasons, the Final Regulations reflect a significant effort by Treasury and the IRS. With the scope of these regulations, Treasury and the IRS have addressed a range of important questions.

Taxpayers and practitioners inundated the government with comment letters that raised questions and identified recommendations for the Final Regulations. While the Final Regulations are certainly helpful, in large part, the Final Regulations fail to adopt most recommendations regarding key regulatory provisions. Significantly, the Final Regulations fail to define realization or provide taxpayers with examples demonstrating the interaction between section 451(b) and realization. Treasury and the IRS also determined a blanket cost offset for all items implicated by the AFS Income Inclusion Rule as inappropriate, and further declined to refine the definitions implicated by the Specified Goods Exception. In light of these missed opportunities, taxpayers and practitioners may find the Final Regulations somewhat disappointing.

This alert provides an overview of the notable issues addressed in the Final Regulations.

Section 451(b) Final Regulations

Section 451(b) provides that for taxpayers using an accrual method of accounting, the All Events Test for an item of gross income, or portion thereof, is met no later than when the item, or portion thereof, is included in revenue for financial accounting purposes on an applicable financial statement (AFS). This TCJA change reflects a dramatic shift in the historic income recognition standard for accrual method taxpayers, essentially adding a third prong to the All Events Test, financial statement conformity. Compounding the significance of this shift, concurrent with the enactment of the TCJA, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) also revised the standards for revenue recognition for financial accounting purposes. The new revenue recognition standards took effect for public companies beginning in 2018, and 2019 for other entities. Thus, not only were taxpayers faced with a dramatic change in their traditional evaluation of income recognition for tax purposes, but revenue recognition for financial accounting purposes as well. Due to these changes, taxpayers have faced uncertainty and sought additional detail and clarification regarding the operation of the statute. While taxpayers appreciate the additional guidance, it is unfortunate that more of the identified issues were not addressed by Treasury and the IRS in the Final Regulations.

Missed opportunities: IRS decides to neither define nor provide examples regarding the interaction of realization and recognition

Commenters were concerned that the Proposed Regulations created a conflict between realization prior to recognition and the AFS Income Inclusion Rule. While the legislative history of section 451(b), i.e., footnote 872 of the Conference Report to the TCJA, indicated that section 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 in which the Federal income tax realization event has not occurred, practitioners were concerned that the Proposed Regulations did not effectuate such legislative history by failing to define realization or offer examples clarifying when realization occurs in certain circumstances. Despite significant commentary and concern, the government declined to define the term realization in the Final Regulations. As with the Proposed Regulations, the government indicated, among other reasons, that section 451 addresses the timing for income recognition, not whether an item of income has been realized, and, thus, the Final Regulations focus on the appropriate taxable year of AFS income inclusion, not realization concepts.

Congress acknowledged a threshold consideration for income recognition is a determination of whether income realization has occurred.⁶ Consistent with the legislative history accompanying section 451(b), many had hoped that the Final Regulations would clarify that the AFS Income Inclusion Rule does not apply to an item of income that has not yet been realized at the time it is recognized in the taxpayer’s AFS. Absent such guidance in the Final Regulations, determinations regarding when realization occurs will be on a case-by-case basis leading to inconsistent application of this rule.

Although choosing not to define realization or provide examples regarding the interplay of realization and the AFS Income Inclusion rule, Treasury and the IRS did heed advice to refine the AFS Income Inclusion rule provided in the Proposed Regulations. There was concern a taxpayer could incur a tax liability without having the money to pay the liability, an outcome clearly inconsistent with the legislative history of section 451(b). The Final Regulations clarify that under the AFS Income Inclusion Rule, the All Events Test under Treas. Reg. §1.451-1(a) 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,” which is a change from the Proposed Regulations that required income recognition no later than when “taken into account as revenue in an AFS.”

The Final Regulations further clarify that AFS revenue does not include amounts the taxpayer does not have an enforceable right to recover if the customer were to terminate the contract on the last day of the taxable 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 and state law. This change addresses a concern that the AFS Income Inclusion rule may require income recognition for tax purposes merely because it had been included on an AFS even though the taxpayer lacks an enforceable right to the income. In fact, the preamble notes “the revised rule is designed to reconcile the intended preservation of the realization concept… with the intended scope of section 451(b).”

To minimize compliance burdens, the Final Regulations provide an alternative method to determine when an item of gross income is treated as “taken into account as AFS revenue” whereby revenue is not reduced by amounts for which a taxpayer lacks an enforceable right to recover if the customer were to terminate the contract on the last day of the taxable year. The Final Regulations apply two adjustments to AFS revenue. First, if the transaction price, defined in Treas. Reg. §1.451-3(b)(14), was increased because a significant financing component is deemed to exist under the standards the taxpayer uses to prepare its AFS, then, the taxpayer disregards AFS revenue attributable to such increase. Second, to the extent that AFS revenue reflects a reduction for (1) amounts that are cost of goods sold or liabilities that are required to be accounted for under other provisions of the Code, such as section 461, including liabilities for allowances, rebates, chargebacks, rewards issued in credit card and other transactions and other reward programs, and refunds, regardless of when any such amount is incurred (Liability Amounts); or (2) amounts anticipated to be in dispute or anticipated to be uncollectable, the taxpayer must increase AFS revenue by such amount. This provision aims to prevent a double tax benefit, which could result from taxpayers taking such amounts into account under 451(b) prior to the tax year in which they are included under other Code sections.

Treasury and the IRS are still evaluating whether the rules in Treas. Reg. §1.451-4 should be modified or clarified in light of certain financial reporting changes under ASC 606, however, the aforementioned AFS adjustments do not preclude a taxpayer from accounting for trading stamps and premium coupons under Treas. Reg. §1.451-4.

Six of one, half dozen of the other: IRS declines to provide cost offset based on estimates of future costs, but allows offset for the future sale of inventory

Proposed Treas. Reg. § 1.451-3(b) failed to provide for a cost offset when an amount is included under the AFS Income Inclusion Rule. Commenters had suggested that income recognition should be limited to the total net income recognized in a taxpayer’s AFS under the AFS Income Inclusion Rule reflecting cost offsets and contra revenue adjustments. Commenters also proposed an offset for costs of goods sold (COGS) due to concerns that income may be distorted by income inclusions in the earlier years of a multi-year contract, with the costs being allowed in later years without income to offset. While Treasury and the IRS determined that a general cost offset is inappropriate and inconsistent with sections 461, 263A, and 471, an offset for costs incurred against AFS income inclusions from the future sale of inventory, the “AFS cost offset method,” was allowed.

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 taxable year by the cost of goods related to the item of inventory for the taxable year (the cost of goods in progress offset). The deferred revenue is then taken into account in the taxable year in which ownership of the item of inventory is transferred to the customer. As noted in the preamble, the AFS cost offset method provides inventory taxpayers with a certain level of optionality in accounting for such costs. While all taxpayers that are required to account for income from the sale of inventory under the AFS Income Inclusion rule and that report AFS revenue in a taxable year prior to the taxable year in which ownership of the item of inventory is transferred to the customer will generally be required to accelerate income inclusions under such rule, the AFS cost offset method provides taxpayers with the option to reduce the amount of income they are required to accelerate under such rule. The AFS cost offset method allows taxpayers to reasonably match income inclusions and incurred cost of goods, and more clearly reflects income.

The AFS cost offset method is a method of accounting that applies to all items of income eligible for the method in the trade or business. The method applies to items at the trade or business level, allowing taxpayers to apply the method to trades or businesses where the burden of determining costs incurred relative to the related reduction in AFS income inclusion amount warrants the adoption of the method. If a taxpayer uses the AFS cost offset method, it must also use the advance payment cost offset method in Treas. Reg. §1.451-8(e), discussed below.

While commenters also urged Treasury and the IRS to consider an offset for interchange fees, credit card late fees, and similar items of revenue, the IRS declined to include an offset in the final rules. Treasury and the IRS reasoned that the fee offset recommended by commenters is based on rewards costs and uncollectable late fees, rather than the costs of goods.

Clarity provided in connection with contingent consideration rules

Commenters expressed concern with the Proposed Regulations reference to “increases in consideration” in the Proposed Regulation’s definition of transaction price, “the gross amount of consideration to which a taxpayer expects to be entitled for AFS purposes in exchange for transferring goods, services, or other property, but not including, among other things, ‘increases in consideration’ to which a taxpayer’s entitlement is contingent on the occurrence or nonoccurrence of a future event for the period in which the amount is contingent.” Notably, taxpayers commented that any portion of the contract price subject to contingency should be excluded from the transaction price. The IRS agreed with commenters and removed the “increases in consideration” language from the final regulation, noting that their intent to exclude items subject to a condition precedent is now subsumed by the revised AFS Income Inclusion rule that to determine when an item of gross income is “taken into account as AFS revenue,” AFS revenue is reduced by any amount which the taxpayer does not have an enforceable right to recover if the customer were to terminate the contract at the end of the year.

Proposed Treas. Reg. §1.451-3(c)(6)(ii) provided a rebuttable presumption that amounts in AFS revenue are presumed not to be contingent unless the taxpayer establishes to the satisfaction of the Commissioner that the amount is contingent on the occurrence or nonoccurrence of a future event. Commenters urged the IRS to remove the presumption as it not only conflicted with ASC 606 and IFRS 15, which focus on the likely outcome of a contingency not the occurrence or nonoccurrence of such, but also imposed a higher standard of proof on taxpayers than is ordinarily required to establish that consideration is contingent. As noted above, Treasury and the IRS agreed with the comments provided and removed the reference to contingent consideration, effectively removing the rebuttable presumption, by reducing AFS revenue by amounts which a taxpayer does not have an enforceable right to recover if the customer terminates the contract at the end of the year.

Final Regulations modify impact of a contractual enforceable right to payment

Proposed Treas. Reg. §1.451-3(c)(6)(ii) treats amounts for which a taxpayer has an “enforceable right to payment” for performance completed to date as not contingent on the occurrence or nonoccurrence of a future event. Commenters noted that the proposed rule was ambiguous and did not align with the realization requirement of requiring a fixed, unconditional right to payment. Treasury and the IRS agreed with commenters and the Final Regulations provide that the AFS Income Inclusion Rule is reduced by AFS revenue for which a taxpayer does not have an enforceable right to recover if the customer terminates the contract by the end of the year. The final rules further define enforceable right by reference to contractual rights or rights under Federal, state, or international law.

IRS agreement with commenter concerns regarding reductions for amounts subject to section 461 and disputed income

The IRS modified Treas. Reg. § 1.451-3(c)(2)(i)(A)(1) to include rewards issued in a credit card transaction as items subject to section 461 in response to comments that doing so would create uniformity among issuers, ease the compliance burden on taxpayers by eliminating the need for a facts and circumstances analysis of each credit card program, and reduce controversy between taxpayers and the IRS.

Treasury and the IRS also clarified that the AFS Income Inclusion Rule does not modify the treatment of disputed income amounts as set forth in Rev. Rul. 2003-10, 2003-1 C.B. 288. The final rules provide that to the extent that AFS revenue was reduced for amounts anticipated to be in dispute or uncollectable, AFS revenue is increased by such amounts. Accordingly, although ASC 606 reduces the transaction price for anticipated disputes to determine the amount of revenue to include on an AFS, AFS revenue is increased for amounts anticipated to be in dispute or anticipated to be uncollectable, because those amounts are included in gross income until they are actually disputed.

Contracts with multiple performance obligations

Many comments noted the issues that arise with contracts containing multiple performance obligations where part of income is accounted for under Treas. Reg. §1.451-3, and part under a special method of accounting. Treasury and the IRS recognized this conflict, and amended the Final Regulations to provide that the transaction price allocation rule in Treas. Reg. §1.451-3(e)(1) does not apply to determine the amount of each item of gross income that is subject to a special method of accounting. Under the Final Regulations, the transaction price is first allocated to items of gross income subject to a special method of accounting, as determined under the special method of accounting. Adjustments must be made to the AFS transaction price in accordance with the general rules, as detailed above, prior to such allocation.

Section 451(c) Final Regulations

Under the TCJA, section 451(c) was added to the Code, essentially codifying that an accrual method taxpayer may use the deferral method of accounting for advance payments, historically provided by Rev. Proc. 2004-34. Following the release of the Proposed Regulations, taxpayers and practitioners sought guidance with respect to certain cost offsets that impacted the new deferral income recognition method, as well as clarification with respect to the Specified Goods Exception, which excludes a taxpayer with certain advance payments from section 451(c). Unfortunately, similar to many of the concerns that were left unaddressed with respect to Treas. Reg. §1.451-3, the guidance provided related to section 451(c) is minimal at best.

A refusal to refine the Specified Good Exception

The section 451(c) Proposed Regulations generally codify the deferral method for advance payments provided by Rev. Proc. 2004-34. The section 451(c) Proposed Regulations include a significant exception to this general rule (the Specified Goods Exception), which provides that prepayments received for certain goods (generally, goods that are not scheduled to be delivered for two or more years) are not treated as advance payments subject to section 451(c).

The Specified Goods Exception represents a significant exception to the limited one-year deferral of advance payments, as it could imply either no deferral at all or full deferral until payments are recognized on financial statements. Commenters took issue with the “contractual delivery date” requirement because many taxpayers enter into long-term production or delivery contracts, which may not have a specific delivery date, even though the taxpayer reasonably expects delivery of the goods in a year subsequent to the taxable year after receipt. Treasury and the IRS kept the exception limited to situations in which written contracts provide a delivery date, asserting that modifying the rule would decrease administrability and increase uncertainty for taxpayers and the potential for litigation. Essentially, Treasury and the IRS chose to stick with an arbitrarily-limiting definition rather than provide a realistic solution to address business practicalities.

Commenters also questioned why the Specified Good Exception applied only when all revenue from the sale of the good is recognized in the taxpayer’s AFS in the year of delivery. Specifically, one comment requested that the exception include situations in which the taxpayer recognizes revenue no later than the time when revenue is recognized for financial accounting purposes. This inclusion would allow taxpayers using the over-time method of revenue reporting under ASC 606 to use the exception. Treasury and the IRS declined to adopt a broader exception. The Final Regulations require the taxpayer to recognize all revenue in its AFS from the sale of the good in the year of delivery.

Although the Specified Goods Exception is modeled on former Treas. Reg. §1.451-5, a major difference between the provisions is the treatment of services performed as an integral part of the sale of goods. Because there should be no distinction in the treatment of such services in this context, commenters recommended that deferral of income attributable to services integral to the sale of a specified good should be allowed. However, the preamble to the Final Regulations suggested that IRS controversies would be increased with this addition and so the change was not made.

Surprisingly, the one change made in the Final Regulations to the Specified Goods Exception involves providing a method of accounting for taxpayers that satisfy the exception. Many commenters sought guidance regarding the consequence of satisfying the exception, i.e., the timing and method of accounting for such income. Generally, Treasury and the IRS noted in the preamble to the Final Regulations that payments qualifying for the exception remain subject to the general rules under sections 451(a) and (b), including the All Events Test previously discussed. Notably though, the Final Regulations provide a “specified goods section 451(c) method,” which enables taxpayers with prepayments that otherwise meet the exception to follow section 451(c) and use the one-year deferral method. While this new method may not allow a taxpayer to fully match the book timing of the prepayment, it does provide the single-year of deferral.

Double take: another denial of a cost offset for advance payments

Similar to comments made on section 451(b), commenters requested a cost offset under section 451(c), such as a cost of goods sold (COGS) offset. Commenters stated that a COGS offset is supported by the definition of “receipt” in section 451(c)(4)(C), which refers to an “item of gross income.” Commenters further cited to Hagen Advertising Displays, Inc. v. Comm’r,⁷ in which the Sixth Circuit noted that to determine the proper amount of gross income for advance payments for the sale of goods to be delivered in the future, it is appropriate for a taxpayer to reduce the advance payment by the estimated cost of goods to be delivered. The court stated that denying an offset for related COGS would tax the return of capital. Commenters also noted that for over thirty years, section 461(h) coexisted with the allowance of a cost offset for expected future COGS against substantial advance payments under former §1.451- 5(c), based on Hagen Advertising.

Treasury and the IRS determined that an offset based on estimates of future costs is inappropriate, as it is inconsistent with sections 461, 263A, and 471. Nonetheless, Treasury and the IRS do agree with the need for flexibility with an offset for costs incurred against advance payments for the future sale of inventory. Under the offset, a taxpayer determines the amount of the advance payment to be included in gross income for the taxable year by reducing the amount that would otherwise be included in gross income for such taxable year under the taxpayer’s full inclusion method or deferral method, as applicable by the cost of goods related to the item of inventory, known as the “cost of goods in progress offset.” The portion of any advance payment that is offset by a cost of goods in progress offset for a taxable year is deferred and included in gross income in the taxable year in which ownership of the item of inventory is transferred to the customer. The advance payment cost offset operates similarly to the AFS cost offset in Treas. Reg. §1.451-3(d).

As noted above, if a taxpayer elects to use the advance payment cost offset method for a trade or business, it must also use the AFS cost offset method in Treas. Reg. §1.451-3(d) for that trade or business.

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