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Revenue recognition: New proposed regulations issued

September 30, 2019 / 12 min read

On Sept. 5, 2019, the Treasury Department released proposed regulations related to the revenue recognition changes under the Tax Cuts and Jobs Act (TCJA).

On Sept. 5, 2019, the Treasury Department released proposed regulations related to the revenue recognition changes under the Tax Cuts and Jobs Act (TCJA). Since these regulations are merely proposed, taxpayers are not yet required to follow them. However, the revenue recognition changes made by the TCJA do apply to 2018 and subsequent tax years. Thus, taxpayers still must apply the new law even if choosing not to adopt the proposed regulations.

In conjunction with these tax law changes, businesses are in the process of adopting ASC 606, a recent change in U.S. Generally Accepted Accounting Principles (GAAP) requiring a wholesale change to how businesses measure and recognize revenue. Most nonpublicly traded businesses are required to adopt the new GAAP revenue recognition standard, ASC 606, for their 2019 calendar year. While ASC 606 doesn’t necessarily have a direct impact on tax law, it may impact the timing of revenue recognition for tax purposes. The impact the TCJA law changes and the adoption of the new GAAP revenue recognition standard will vary by industry and taxpayer facts, but many taxpayers will experience significant revenue acceleration resulting in a significant increase in tax.

Revenue recognition after TCJA

Historically, accrual method taxpayers recognized revenue in the taxable year in which (1) all the events have occurred which fix the right to receive the income and (2) the income can be determined with reasonable accuracy (the all-events test). The all-events test is generally treated as being met upon the earliest date when an amount is either earned, due, or collected. The TCJA made two major changes to these principles:

  1. Tax revenue recognition is generally required to occur no later than when revenue is considered for financial statement purposes under Section 451(b) (the “revenue acceleration” provision). This provision may have a significant impact on many taxpayers, but especially impacts taxpayers adopting the new GAAP revenue recognition standard.
  2. Advance payments, or deferred revenue, received by taxpayers are now only eligible for a one-year deferral under Section 451(c) in most cases. This provision was intended to codify the one-year deferral method previously available to taxpayers, but also eliminated the more extended deferral methods previously utilized by certain taxpayers. Taxpayers that previously deferred revenue for more than one tax year will likely need to recognize such revenue sooner under this provision.

Revenue acceleration provision proposed regulations

The proposed regulations provide specific guidance for taxpayers who restate their AFS by generally providing that only restatements occurring before a tax return is filed will be taken into account for that tax year. Restatements occurring after the tax return is filed may have to be considered in subsequent tax years. However, the proposed regulations don’t explain whether a taxpayer who files a tax return before an AFS is completed is subject to the revenue acceleration provision.

Example: In 2019, ManufacturerCo contracts to build a widget for its customer for $2 million. The widget will cost $1.8 million to manufacture. Under its prior book and tax method of accounting, ManufacturerCo inventoried the $1.8 million of costs while the widget was being manufactured and recognized all of the revenue and cost of goods sold only at the time the widget was delivered in 2020. ManufacturerCo adopted ASC 606 in its audited financial statements in 2019 and changed its book revenue recognition to an “over-time” recognition. Therefore, it recognized revenue and related costs as the widget was being manufactured. At the end of 2019, the widget was almost complete and 80% of the revenue and cost of goods sold was recognized. For book purposes, this resulted in a gross profit of $160,000 in 2019 based on $1.6 million of revenue and $1.4 million of cost of goods sold.

For income tax purposes, ManufacturerCo is required to recognize the $1.6 million of revenue in taxable income in 2019 under the revenue acceleration provision. However, it cannot recognize any of the $1.4 million of cost of goods sold because the widget hasn’t yet been delivered. Therefore, ManufacturerCo will have taxable income on this transaction of $1.6 million in 2019 and a loss of $1.4 million in 2020 when the widget is delivered. If the loss in 2020 generates a net operating loss, that loss cannot be carried back under another change made by the TCJA.

ManufacturerCo from the previous example may want to evaluate whether its contract to manufacture the widget should be subject to the percentage of completion method for tax purposes. In which case, the tax recognition of income on the contract would more closely approximate recognition for financial statement purposes. Taxpayers are typically required to apply percentage of completion to contracts that extend across more than one tax year related to either (1) the construction or installation of real property or (2) the manufacture of personal property for an item that is unique or normally requires more than 12 months to complete.

Advance payments proposed regulations

Procedures

Generally, any changes to tax accounting methods require the taxpayer to file a Form 3115, Application for Change in Accounting Method, with the IRS. Changes to a method of accounting under both provisions are generally automatic consent filings and are due by the extended due date of the tax return, but no later than the date of filing the tax return. These changes are not typically reviewed by the IRS, and don’t require a user fee. However, some taxpayers may be required to file an accounting method change under the advance consent procedures. An advance consent method change must be filed by Dec. 31, 2019, to be effective for 2019 calendar-year taxpayers (i.e., by the end of the tax year), and would require payment of a $10,800 user fee to the IRS.

What’s next?

A comment period on the proposed regulations is now underway as the Treasury Department and IRS are actively seeking input on these rules. Accordingly, the final regulations will likely change in some respects based on comments that are submitted. Until that time, taxpayers are permitted to rely on the proposed regulations, if they so choose, in implementing the TCJA revenue recognition provisions. However, taxpayers aren’t required to rely on the proposed regulations until they are finalized. With respect to advance payments, taxpayers are also permitted to continue to rely on the rules that existed prior to the TCJA until the proposed regulations are finalized. The regulations are proposed to apply only to tax years beginning after they are finalized. It’s highly unlikely they will be finalized during 2019, which means that they will likely not be effective for calendar year taxpayers until the 2021 tax year.

Taxpayers should consider the impact of these regulations and file accounting method changes as needed. In addition, since revenue recognition on a taxpayer’s AFS impacts both the revenue acceleration and advance payment tax provisions, taxpayers implementing ASC 606 should take steps now to analyze how those changes will impact their tax obligations. As illustrated in the example above, the shift in taxable income under these new rules can be substantial and significant penalties and interest may be accruing for taxpayers who haven’t yet factored these changes into estimated tax payments. In addition, taxpayers that should have applied some of these concepts to their 2018 tax years but didn’t will also want to file a Form 3115 as soon as possible because the IRS is generally prevented from challenging an incorrect position in a previous year once a Form 3115 is filed.

If you have any questions, please contact us.

The information provided in this alert is only a general summary and is being distributed with the understanding that Plante & Moran, PLLC, is not rendering legal, tax, accounting, or other professional advice, position, or opinions on specific facts or matters and, accordingly, assumes no liability whatsoever in connection with its use.

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