Taxable Year of Income Inclusion under an Accrual Method of Accounting
IRS has issued proposed reliance regs under Code Sec. 451(b) on when accrual-method taxpayers with an applicable financial statement (AFS) must include items in income under the all events test. The proposed regs reflect the amendments to Code Sec. 451(b) made by the Tax Cuts and Jobs Act. For procedures for adopting income inclusion accounting methods, see Procedures for adopting TCJA inclusion-in-income methods.
Background. Generally, Code Sec. 451 provides that the amount of any item of income is included in gross income for the tax year in which it is received by the taxpayer unless, under the accounting method used in computing taxable income, the amount is properly accounted for in a different period.
Under Reg. §1.451-1, accrual method taxpayers generally include items of income in gross income in the tax year when all the events occur that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy (the all events test).
Generally, the “all events test” is satisfied when
1. The required performance takes place,
2. Payment is due, or
3. Payment is made, whichever happens first.
In 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) jointly announced new financial accounting standards for revenue recognition (New Standards). Under the New Standards, items of income may be included as revenue in an AFS earlier than they would have been included in income under the all events test.
In 2017, Code Sec. 451(b) was amended by the TCJA to provide that, for an accrual-method taxpayer with an AFS, the all events test for any item of gross income (or portion thereof) is not met any later than when the item is included in revenue for financial accounting purposes on an AFS or other financial statement specified by the IRS (AFS income inclusion rule).
The amendments made to Code Sec. 451(b) did not change the time at which income subject to the all events test is taken into income for accrual method taxpayers without an AFS or other specified financial statement.
Proposed regs. The proposed regs provide guidance on the tax year for income inclusion under Code Sec. 451(b) for accrual-method taxpayers with an AFS.
Prop Reg §1.451-3(b) provides that if a taxpayer has an AFS, the all events test under Reg §1.451-1(a) with respect to any item of gross income, or portion thereof, is met no later than when that item, or portion thereof, is taken into account as revenue in the taxpayer’s AFS. (the AFS income inclusion rule).
Prop Reg §1.451-3(b) also provides that when a taxpayer uses a special method of accounting, the special method of accounting determines the timing of the income inclusion, not the AFS income inclusion rule.
Generally, under Prop Reg §1.451-3(c)(1) an AFS is defined as a taxpayer’s financial statement that is prepared under generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS) and is used
1. To report to certain regulatory bodies or federal agencies (except the IRS),
2. To report to shareholders, partners, proprietors or beneficiaries, or
3. For credit purposes.
Under Prop Reg §1.451-3(c)(4) the term “revenue” includes all items of income under Code Sec. 61.
Prop Reg §1.451-3(c)(6)(ii) provides that an amount included in the transaction price for AFS purposes may not be treated as contingent on the occurrence or non-occurrence of a future event if the taxpayer has been paid or has an equitable, contractual, or other right to partial payment for performance completed to date.
Prop Reg §1.451-3(c)(6)(iii) provides that the transaction price may not be reduced for amounts subject to Code Sec. 461, including, in the case of credit card transactions, reward amounts.
Prop Reg §1.451-3(d) provides that the AFS income inclusion rule applies only to taxpayers that have an AFS covering the entire tax year. Therefore, the AFS income inclusion rule doesn’t apply to a tax year for which the taxpayer doesn’t have an AFS or has an AFS covering only part of the tax year.
Prop Reg §1.451-3(e) clarifies that the AFS income inclusion rule does not change the treatment of a transaction for federal income tax purposes. For example, a transaction that is not required to be marked-to-market for federal income tax purposes, but that is marked-to-market for AFS purposes, will not be marked-to-market for federal tax purposes under these proposed regs.
Prop Reg §1.451-3(f) provides that the AFS income inclusion rule does not change the applicability of any exclusion provision, or the treatment of non-recognition transactions, in the Code, the Income Tax Regulations, or other guidance published in the Internal Revenue Bulletin.
Generally, under Prop Reg §1.451-3(h) if a taxpayer’s financial results are reported on an AFS for a group of entities, then the taxpayer’s AFS is the group’s AFS. However, if the taxpayer’s financial results are also reported on a separate AFS that is of equal or higher priority to the group’s AFS under Prop Reg §1.451-3(c)(1), then the taxpayer’s AFS is its separate AFS.
Under Prop Reg §1.451-3(h)(4) if a taxpayer’s AFS is prepared based on a financial accounting year that differs from the taxpayer’s tax year, the taxpayer must use one of the three permissible methods to determine revenue for purposes of the AFS income inclusion rule. The permissible methods are listed in Prop Reg §1.451-3(h)(4)(ii).
Under Prop Reg §1.451-3(h)(5) if a taxpayer restates revenue on an AFS and such restatement changes the timing of when an item of income, or a portion thereof, is taken into account as revenue on the AFS, the change constitutes a change in method of accounting under Code Sec. 446. A taxpayer may change its method of accounting only with the consent of the IRS.
Prop Reg §1.451-3(i)(1), generally provides that if an item is described in Prop Reg §1.451-3(i)(2), it may not be taken into income later than when that item, or portion thereof, is taken into account as revenue in the taxpayer’s AFS, regardless of whether the timing of income inclusion for that item is normally determined using a special method of accounting.
Prop Reg §1.451-3(j) generally provides that if a taxpayer treats an item of income as deferred revenue in its AFS and writes down or adjusts that item, or portion thereof, to an equity account (for example, retained earnings) or otherwise writes down or adjusts that item of deferred revenue in a subsequent tax year, revenue for that subsequent tax year includes that item, or portion thereof, that is written down or adjusted.
Prop Reg §1.451-3(k) provides that a taxpayer with a multi-year contract applies the all events test by applying a cumulative approach reflecting amounts previously included under Code Sec. 451 rather than an annualized approach.
Generally, Prop Reg §1.451-3(l) provides that a change in the method of recognizing revenue in an AFS that changes or could change the timing of the recognition of income for federal income tax purposes is a change in method of accounting under Code Sec. 446. Accordingly, a taxpayer that changes the method of accounting used to recognize revenue in its AFS is required to secure IRS’s consent before computing income using this new method for federal income tax purposes.
Prop Reg §1.451-3(m) provides examples that illustrate various concepts discussed in the proposed regs.
Effective date. Under Prop Reg §1.451-3(n)(1) these regs are proposed generally to apply to tax years beginning on or after the date the final regs are published in the Federal Register. Until the final regs are published a taxpayer generally may rely on these proposed regs for tax years beginning after December 31, 2017, provided that the taxpayer:
1. Applies all the applicable rules contained in these proposed regs, and
2. Consistently applies these proposed regs to all items of income during the tax year.
Source: Thompson Reuters 9/9/19