On August 12, 2021, the IRS released Rev. Proc. 2021-34,¹ setting forth procedural guidance to implement the final Section 451 regulations (Final Regulations).² The revenue procedure not only provides the terms and conditions to comply with the Final Regulations by its effective date, (tax years beginning on or after January 1, 2021), it also permits taxpayers to early adopt the Final Regulations for the 2020 tax year. In a lengthy, 70-page piece of guidance, the procedural guidance identifies accounting method changes to comply with the Final Regulations.

The guidance describes accounting method change procedures to comply with the Final Regulations by revising automatic accounting method changes provided in Rev. Procs. 2019-43³ and 2015-13.⁴ With the addition of six new automatic accounting method changes, as well as the myriad of modifications made to existing automatic accounting method changes, Rev. Proc. 2021-34 is definitive guidance for any taxpayer considering filing an accounting method change to implement the Final Regulations. A thorough review of this new guidance is essential to ensure that a taxpayer qualifies for certain favorable terms and conditions offered in the revenue procedure, (e.g., implementation of accounting method changes with either a Section 481(a) adjustment or on a cutoff basis; audit protection; allowing concurrent changes filed on the same Form 3115 with shortened forms; permitting streamlined filing procedures for certain accounting method changes). 

Background

On December 22, 2017, with the enactment of the Tax Cuts and Jobs Act (the TCJA), Section 451(b) of the Internal Revenue Code (Code) was amended to provide that for accrual method taxpayers the all events test for any item of gross income is met no later than when that item is taken into account as revenue in an applicable financial statement (AFS) (the AFS Income Inclusion Rule). In addition to amending Section 451(b), the TCJA also added Section 451(c) to the Code, essentially codifying the deferral method for advance payments historically provided in Rev. Proc. 2004-34,⁵ with slight modifications. Subsequent to these statutory changes, the IRS has released a number of pieces of administrative guidance to assist taxpayers in evaluating and implementing these new provisions.⁶

Following the interim administrative guidance, the IRS and Treasury Department (Treasury) issued proposed regulations under Treas. Reg. § 1.451-3⁷ and 1.451-8.⁸ Proposed Treas. Reg. § 1.451-3 provided rules relating to the new AFS Income Inclusion Rule under Section 451(b), while proposed Treas. Reg. § 1.451-8 provided rules relating to the use of the deferral method for advance payments under Section 451(c). Concurrent with the release of these proposed regulations, the IRS also issued Rev. Proc. 2019-37,⁹ which provided taxpayers with automatic accounting method changes, and their relevant terms and conditions, to make an accounting method change to comply with Section 451(b) and the proposed regulations.

After over fifteen months of public comment, interaction with taxpayers and practitioners, and internal deliberation, the IRS and Treasury issued final regulations under Treas. Reg. §§ 1.451-3 and 1.451-8 on December 30, 2020. The Final Regulations are generally applicable to tax years beginning on or after January 1, 2021. It is important to note, the Final Regulations also obsoleted Rev. Proc. 2004-34 and the deferral and full inclusion methods for advance payments provided by such guidance for tax years beginning on or after January 1, 2021.

Rev. Proc. 2021-34

With the arrival of Rev. Proc. 2021-34 comes anticipated procedural guidance to assist taxpayers in implementing the Final Regulations. While the Final Regulations are generally effective for tax years beginning after January 1, 2021, the revenue procedure does allow taxpayers to early adopt the Final Regulations for a tax year beginning prior to January 1, 2021, but, in doing so, a taxpayer must apply the change in method of accounting rules under Section 446 and is, thereby, prohibited from early compliance with the Final Regulations with an amended return. The prohibition of early adoption on an amended return is particularly interesting given that the Service recently allowed taxpayers to use amended returns to implement accounting method changes related to bonus depreciation and qualified improvement property. Had early adoption been made more broadly available, the IRS would have encouraged earlier compliance with the Final Regulations.  More importantly, because many of the accounting method changes that are necessary to comply with the Final Regulations require an increase to income as a result of a positive Section 481(a) adjustment that must be taken into account over four tax years beginning with the year of change, many taxpayers would have appreciated the opportunity to early adopt the Final Regulations prior to the 2020 tax year in advance of a likely increase to the corporate income tax rate.

Nonetheless, certain taxpayers may seek to implement the Final Regulations on their 2020 federal income tax returns. Depending on the specific method change being made, early adoption may be helpful in securing audit protection for a potential item of exposure, recognizing an income adjustment in a tax year when the corporate rate is lower than its anticipated rise, or merely complying with the Final Regulations from the beginning, well knowing, due to the guidance’s waiver of the five-year limitation under Section 5.01(f) of Rev. Proc. 2015-13, a future, clarifying change in method of accounting is permitted.

Rather than issue a revenue procedure setting out separate accounting method change guidance, the IRS structured Rev. Proc. 2021-34 to reflect changes to the existing rules in Rev. Proc. 2019-43. The guidance walks though, at times in great length, the modifications it makes to Rev. Proc. 2019-43, to facilitate a taxpayer’s implementation of the Final Regulations. As such, filing an accounting method to implement the Final Regulations will require familiarity with the provisions in Rev. Proc. 2021-34 as well as Rev. Proc. 2019-43. Attached is a table that shows the numerous automatic accounting method changes made available by Rev. Proc. 2021-34. The table also shows how the new guidance modifies existing automatic accounting method changes available in Rev. Proc. 2019-43.

For example, five current automatic method changes related to certain inventory methods are modified to provide a temporary waiver of the aforementioned five-year limitation on subsequent method changes to the extent such inventory changes are being made in connection with changes to comply with the Final Regulations. This waiver is generally contingent on an accounting method change either by a taxpayer early adopting the Final Regulations in their 2020 tax year, or a taxpayer’s first tax year beginning on or after January 1, 2021. The temporary waiver applies to: UNICAP changes made by certain resellers and reseller-producers under Section 12.01 of Rev. Proc. 2019-43; UNICAP changes made by certain producers and producer-resellers under Section 12.02 of Rev. Proc. 2019-43; changes relating to impermissible methods of identification and valuation of inventories under Section 22.05 of Rev. Proc. 2019-43; changes relating to permissible methods of identification and valuation of inventories under Section 22.11 of Rev. Proc. 2019-43; and, changes from currently deducting inventories to permissible methods of identification and valuation of inventories under Section 22.18 of Rev. Proc. 2019-43.

It is unfortunate that the IRS did not provide a more comprehensive waiver of the five-year limitation for all accounting method changes filed to comply with the Final Regulations, as they did recently when final regulations were issued under Section 263A. However, this waiver is helpful as such changes are required for certain taxpayers with inventory that seek to otherwise file accounting method changes to comply with the Final Regulations that affect the taxpayer’s inventory methods. By providing the waiver, a taxpayer is not prohibited from complying with the Final Regulations merely because another similar accounting method change has been filed within the last five years. Also, the waiver allows a taxpayer to adopt the new rules and then make a subsequent change should future determinations suggest a more favorable method, or should modifications be required so that a method may be implemented properly. 

In addition, Rev. Proc. 2021-34 makes automatic method changes available to taxpayers both with and without an AFS. Previous guidance tended to offer greater availability of automatic accounting method changes to taxpayers with an AFS. Offering an automatic accounting method change for taxpayers that do not maintain an AFS, Rev. Proc. 2021-34 may simplify compliance with the Final Regulations. Further, as our table at the end of this alert highlights, the guidance provides automatic changes not only to comply with the new AFS Income Inclusion Rule, but also the Alternative AFS Revenue Method provided in Treas. Reg. § 1.451-3(b)(2)(ii), i.e., which does not require taxpayers to apply the new enforceable right standard in their income recognition calculation. In light of the waiver of the five-year limitation with respect to such a change, a taxpayer may consider filing an initial change under the Alternative AFS Revenue Method, and then after completing an enforceable right analysis of relevant contracts, a taxpayer may subsequently file a second accounting method change to use the general AFS Income Inclusion Rule.

In addition to providing automatic accounting method changes to comply with the AFS Income Inclusion Rule and the Alternative AFS Revenue Method under the Final Regulations, Rev. Proc. 2021-34 also provides a number of automatic accounting method changes implicated by one of the cost offset provisions in the Final Regulations. As shown in the attached table, the guidance provides not only an automatic change for taxpayers seeking to apply the AFS cost offset method in Treas. Reg. § 1.451-3(c), but also for taxpayers seeking to change from applying a cost offset method to not applying a cost offset method, as well as changes to comply with Treas. Reg. § 1.451-3(c)(5)(ii) as a result of a concurrent cost-offset related inventory method change or because the taxpayer determines its cost of goods in progress offset by reference to costs that have been impermissibly capitalized or allocated under its present method. Within the arena of changes implicating cost offsets and inventory methods, taxpayers will want to pay particular attention to the differing Section 481(a) provisions, as depending on the particular change being made, some changes have the optionality of being implemented on either a cutoff basis or with a Section 481(a) adjustment.

Similar to the host of changes provided for taxpayers seeking to comply with Treas. Reg. § 1.451-3, an equal number of automatic accounting method changes are provided for a taxpayer seeking to change its method of accounting for advance payments to comply with the advance payment provisions in Treas. Reg. § 1.451-8. Rev. Proc. 2021-34 allows automatic accounting method changes for taxpayers seeking to move to the full inclusion method, the deferral method, as well as the method under Treas. Reg. § 1.451-8(f) that treats payments that would otherwise qualify for the specified goods exception as advance payments. To the extent a taxpayer cannot fully evaluate whether a certain item of income qualifies for the specified goods exception on its 2020 returns, one approach may be to file an accounting method change to the method provided under Treas. Reg. § 1.451-8(f), which would offer audit protection and other benefits. Then should a more thorough analysis of the taxpayer’s advance payments indicate eligibility for the specified goods exception, a subsequent method change may be filed taking advantage of the waiver of the five-year limitation.  Rev. Proc. 2021-34 also provides similar automatic accounting method changes for an inventory taxpayer with certain offsets that seek to change to the advance payment cost offset method, change from applying that method to not applying that method, as well as changes to comply with Treas. Reg. § 1.451-8(e)(8)(ii) as a result of a concurrent cost-offset related inventory method change or because the taxpayer determines its cost of goods in progress offset by reference to costs that it impermissibly capitalized or allocated under its present method.

In addition to the general provision of a number of new automatic accounting method changes to implement the Final Regulations, taxpayers will also appreciate the generally favorable terms and conditions provided to file such accounting method changes. For example, changes made under Section 16.12 of Rev. Proc. 2019-43 require only a short Form 3115 with the requirement to file a duplicate copy waived. Additionally, depending on the particular accounting method change being made, a taxpayer may have the flexibility to implement the change either with a Section 481(a) adjustment or on a cutoff basis (i.e., no Section 481(a) adjustment required).

As a result, once a taxpayer has confirmed which accounting method changes are to be filed, it will be important to carefully review the provisions regarding Section 481(a) adjustments to determine available options. For most of the changes implicating a taxpayer’s inventory methods or certain cost offsets, the guidance also allows a taxpayer to net its Section 481(a) adjustment for all such changes. With that in mind, if filing a method change implicating a cost offset method, or otherwise governed by the relevant section in Rev. Proc. 2021-34, the guidance offers some administrative convenience.

Lastly, although there are exceptions, a taxpayer filing an accounting method change to comply with the Final Regulations will generally receive audit protection, whether the regulations are implemented through early adoption in 2020, or timely adoption for the 2021 tax year. Audit protection coupled with other favorable terms and conditions sprinkled throughout Rev. Proc. 2021-34, will encourage a taxpayer to file required accounting method changes to comply with the Final Regulations.

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¹ 2021-35 I.R.B. 1.

² T.D. 9941.

³ 2019-48 I.R.B. 1107.

⁴ 2015-5 I.R.B. 419.

⁵ 2004-1 C.B. 991.

⁶ See Notice 2018-35, 2018-18 I.R.B. 520, which provided transitional guidance relating to advance payments under Rev. Proc. 2004-34; Rev. Proc. 2018-29, 2018-22 I.R.B. 634, which provided automatic accounting method changes to taxpayers seeking to change their methods of accounting for income recognition to a method described in the new financial accounting standards under ASC 606; and, Rev. Proc. 2018-60, 2018-51 I.R.B. 1045, which provided taxpayers an automatic accounting method change to change a method of accounting for income recognition to comply with Section 451(b) for tax years beginning after December 31, 2017.

⁷ REG-104870-18; 84 FR 47205 (09/09/2019).

⁸ REG-104554-18; 84 FR 47191 (09/09/2019).

⁹ 2019-39 I.R.B. 731 (09/19/2019).

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