Jessica L. Jeane, J.D., Director of Public Policy & Strategic Communications
December 22, 2020
The IRS has issued final regulations, (T.D. 9941) on certain accounting changes to sections 451(b) and (c) made under the Tax Cuts and Jobs Act (TCJA) (P.L. 115-97). The final rules provide guidance 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 follow last year’s proposed rules, (REG-104870-18,) on revised section 451(b), and (REG-104554-18,) on added section 451(c), which codifies Rev. Proc. 2004-34.
Note: Rev. Proc. 2004-34 and Rev. Proc. 79-38 remain effective after the enactment of section 451(c) and may be relied upon after these regulations are finalized, according to the IRS.
The final regulations reflect changes made by the TCJA, which affect taxpayers who use an accrual method of accounting and have an applicable financial statement. Additionally, these final regulations also apply to taxpayers who use an accrual method of accounting and receive advance payments.
As amended, section 451(b) provides that for taxpayers using the 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, is included in revenue for financial accounting purposes on an applicable financial statement (AFS). Section 451 (b)(1)(C) codifies the all events test, stating that the test is met for any item of gross income if all the events have occurred, which fix the right to receive such income and the amount of such income can be determined with reasonable accuracy. Section 451(c) was amended to provide that an accrual method taxpayer may use the deferral method of accounting provided in section 451(c) for advance payments.
AFS Income Inclusion Rule
The final regulations provide that, under the AFS Income Inclusion Rule, the all events test under section 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.” When determining whether an item of gross income is “taken into account as AFS revenue,” AFS revenue is reduced by the amounts that the taxpayer does not have an enforceable right to recover if the customer terminated the contract on the last day of the taxable year. Aiming to reduce 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” under the AFS Income Inclusion Rule. Thus, under the “alternative AFS revenue method”, the taxpayer does not reduce AFS revenue by amounts that the taxpayer lacks an enforceable right to recover if the customer were to terminate the contract on the last day of the taxable year. Taxpayers using the alternative AFS revenue method may also use the AFS cost offset method provided in the final rules.
Notably, Treasury and the IRS declined to define the term realization in the final regulations, because Congress did not explicitly define realization in the Conference Report. “Accordingly, it is reasonable to conclude that Congress intended a different concept of realization that would give full effect to the statute,” the rules state. Further, the final rules intentionally do not clarify when realization occurs in specific circumstances, because, according to Treasury and the IRS, realization is a factual determination that, though aligned with the all events test, has different meanings in different contexts.
Specified Goods Exception
The final regulations make a “minor” change to the specified goods exception, which gives taxpayers the option to treat upfront payments that satisfy the criteria for the specified good exception as a typical advance payment under section 451(c). Essentially, taxpayers have the option of including the advance payment in gross income under the full inclusion method or the deferral method. “This flexibility in the section 451(c) regime reduces uncertainty for taxpayers who may be unsure if a contract meets the specified good exception relative to the proposed regulations," the rules sate. "It also allows taxpayers using the 1-year deferral under Revenue Procedure 2004-34 prior to the passage of the TCJA the option to continue to do so."
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