Tax accounting rules issued for advance payments

By Alistair M. Nevius, J.D.

Two sets of proposed Treasury regulations issued on Thursday provide new rules on how taxpayers treat income from advance payments under new book-tax conformity rules. One set of proposed regulations (REG-104554-18) governs the timing of inclusion under Sec. 451(c) of advance payments for goods, services, and other items. The other set (REG-104870-18) covers Sec. 451(b), which requires taxpayers that use the accrual method and have an applicable financial statement (AFS) to recognize income when the all-events test is met or when the item of income is included in revenue in its AFS (the AFS income inclusion rule).

The IRS also issued a revenue procedure (Rev. Proc. 2019-37) that provides procedures for obtaining automatic consent to change an accounting method to comply with Sec. 451 and the proposed regulations. Certain qualifying taxpayers can make a method change to comply with the proposed regulations without filing Form 3115, Application for Change in Accounting Method.

Sec. 451(b) was amended by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, and was effective for tax years beginning after Dec. 31, 2017. It requires accrual-method taxpayers that were deferring income to a tax year later than when it is recognized on the taxpayer’s books to change their existing tax method of accounting. Sec. 451(c), also amended by the TCJA, allows accrual-method taxpayers with an AFS to use a deferral method of accounting provided in Sec. 451(c) for advance payments.

Sec. 451(b) regulations

REG-104870-18 creates a new Prop. Regs. Sec. 1.451-3, which clarifies how the Sec. 451(b) AFS income inclusion rule applies to accrual-method taxpayers with an AFS. Under the proposed regulations, 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.” The regulations clarify that the AFS income inclusion rule applies only to taxpayers that have one or more AFSs covering the entire tax year.

The proposed regulations also clarify that the AFS income inclusion rule does not change the treatment of a transaction for federal income tax purposes, which may be different than its treatment for AFS purposes.

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 the Code, the regulations, or other IRS guidance. The IRS says this is “consistent with Congressional intent that the provision does not revise the rules associated with the time at which an item is realized for Federal income tax purposes.”

The proposed regulations also (1) address the application of the AFS income inclusion rule to multiyear contracts; (2) define “AFS” under Sec. 451(b)(3); (3) define the term “revenue” to broadly include all items of income under Sec. 61; (4) describe the allocation of the transaction price under Sec. 451(b)(4); (5) establish that taxpayers that include items of income as revenue in an AFS over a period of time are not allowed to follow that AFS over-time method for federal income tax purposes; and (6) provide rules for debt instruments.

The IRS is asking for comments on whether special rules are needed to address the applicability of the AFS income inclusion rule to foreign persons.

Sec. 451(c) regulations

REG-104554-18 creates a new Prop. Regs. Sec. 1.451-8, which provides 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 Sec. 451(c)(1)(B) and Prop. Regs. Sec. 1.451-8(c) (the AFS deferral method).

Under the proposed regulations’ AFS deferral method, a taxpayer with an AFS that receives an advance payment must: (1) include 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) include the remaining amount of the advance payment in income in the next tax year.

The proposed regulations’ AFS deferral method closely follows the deferral method that the IRS provided in Rev. Proc. 2004-34.

The proposed regulations also provide a deferral method for taxpayers that do not have an AFS (similar to the method for non-AFS taxpayers in Rev. Proc. 2004-34).

The proposed regulations also (1) define “advance payment”; (2) provide rules for acceleration of an advance payment in certain circumstances; (3) address the treatment of advance payments when financial statement adjustments cause an item to not be included in income; (4) incorporate the short-year rules of Rev. Proc. 2004-34; (5) address the treatment of performance obligations; and (6) clarify that Sec. 451(c) is a method of accounting.

Alistair M. Nevius, J.D., (Alistair.Nevius@aicpa-cima.com) is the JofA’s editor-in-chief, tax.

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