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:
- 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.
- 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
- Applicable financial statements required: The revenue acceleration provision only impacts taxpayers with an “applicable financial statement” (AFS). The proposed regulations define an AFS and include a hierarchy, which requires a taxpayer to use the financial statement with the highest priority. Such financial statements include a Form 10-K filed with the SEC, a GAAP-audited financial statement, an IFRS-audited financial statement, or other statements filed with a federal or state government/agency. Taxpayers with reviewed or compiled financial statements don’t have an AFS, unless such statements are filed with a federal or state government or agency. This means that taxpayers with reviewed or compiled financial statements will not typically be subject to the revenue acceleration provision. The revenue acceleration provision doesn’t apply unless a taxpayer’s entire taxable year is covered by an AFS. Taxpayers should consider whether their financial statements rise to the level of AFS for this provision. Further, taxpayers that may have an AFS in one year but not in another should consider how that will impact taxable income as they move in and out of the revenue acceleration provision.
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.
- No reduction for cost of goods sold: The proposed regulations do not include an offsetting acceleration of costs (such as cost of goods sold, rebates, allowances, etc.); therefore, expenses will continue to be deducted only when incurred under general tax principles. GAAP has a matching concept whereby costs are generally recognized when the related revenue is recognized. However, that concept doesn’t apply for tax purposes even though tax revenue might be accelerated to match book revenue under this provision. Even taxpayers with inventoriable goods may be required to recognize revenue in an earlier tax year and continue to defer cost of goods sold to the year of delivery. This is true even for taxpayers who may have been permitted to accelerate costs under prior law. This remains a contentious issue, and taxpayers are seeking relief due to the unfavorable distortion of taxable income that can be caused by this provision. The Treasury Department and IRS are currently considering whether any exceptions to this rule may be appropriate.
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.
- Sale versus lease: The revenue acceleration provision cannot change the character of a transaction for income tax purposes. For example, if a transaction is treated as a sale for financial statement purposes but a lease for tax purposes, this provision will not require the acceleration of all lease revenue into the year that the sale of property is recorded in the financial statements.
- Contingent revenue: The proposed regulations also provide that contingent revenue based on a future event will not be accelerated until the contingency is resolved. Under ASC 606, taxpayers with variable or contingent consideration may recognize portions of that revenue for GAAP purposes before the contingency lapses depending on the likelihood of the future conditions being met. However, taxpayers who recognize contingent revenue for financial statement purposes before the contingency is met may be able to continue to defer such revenue for tax purposes.
- Special methods of accounting: Taxpayers using a special method of accounting aren’t subject to the revenue acceleration provision. This includes taxpayers using the percentage of completion method, cash method, and mark-to-market method, among others. Mortgage servicing rights are also not subject to the revenue acceleration provision.
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
- Taxpayers with AFS can defer only up to one-year: The proposed regulations provide a one-year deferral for advance payments but only where a portion of the payment is included in revenue in the taxpayer’s AFS in a subsequent tax year. The proposed regulations provide that an AFS has the same meaning as provided under the revenue acceleration provision discussed above.
- Taxpayers without an AFS can also elect one-year deferral: While the TCJA didn’t explicitly provide access to the one-year deferral to taxpayers without an AFS, the proposed regulations broaden the rules to allow for such a deferral. These taxpayers may defer advance payments to the extent the payment is not earned in the year of receipt. As a result, the timing isn’t necessarily tied to the treatment on the taxpayer’s financial statements. If a taxpayer is unable to determine when a payment is earned, the proposed regulations provide that a taxpayer may determine the amount earned on a statistical basis, straight-line ratable basis, or any other basis that provides for a clear reflection of income. This is a welcome rule as these taxpayers were permitted to follow a similar rule prior to the TCJA.
- No reduction for cost of goods sold: Similar to the revenue acceleration provisions, the proposed advance payment regulations do not include an offsetting acceleration of costs, even when revenue is accelerated. This is consistent with the historical treatment of advance payments for many taxpayers, including service providers. However, under historical advance payment guidance, a taxpayer selling goods may have been able to limit the income accelerated to amounts received in excess of estimated costs. This is no longer permitted so sellers of inventoriable goods who receive long-term deferred revenue will now incur a tax burden based on the revenue received in advance (rather than based on profit) and should consider how this will impact their cash flow (but see below for one exception that may apply to some of these taxpayers).
- Limited provision for greater than one-year deferral: The regulations may also provide relief for certain taxpayers who receive advance payments at least two tax years before a contracted delivery date. Under this exception, a taxpayer who has (1) a contracted delivery date, (2) for goods that aren’t on hand at the end of the year in which the advance payment is received, and (3) recognizes all of the revenue for financial statement purposes in the delivery year, is not considered to have an advance payment. The goal of this provision is to permit a more extended deferral for these taxpayers. However, the rules may be of limited benefit both because of a lack of clarity in the rules as written but also because they are limited only to taxpayers with definite delivery dates at the outset of a contract. Taxpayers in most industries rarely have such a definite date for the delivery of goods that would otherwise meet these requirements.
- Other provisions: The proposed regulations provide for various other rules related to revenue being accelerated in short tax years of greater than 92 days such as revenue being accelerated when it ceases to exist or is no longer obligated on the contract and other similar rules. Additionally, taxpayers who are subject to the percentage of completion method aren’t subject to the advance payment rules, so while they will recognize income over the course of the contract, they’ll also deduct costs as incurred. These rules are all similar to the rules that were in place under the advance payment rules that existed prior to the TCJA.
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.
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.
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