Final 451(b) and 451(c) regulations address offsets, exceptions, and more
On Dec. 21, 2020, the IRS and Treasury released Final Regulations under Internal Revenue Code (IRC) Sections 451(b) and 451(c) regarding the timing of income inclusion under Section 451(b) and the treatment of advance payments under Section 451(c) for U.S. federal income tax purposes. The IRS and Treasury had published a 2018 Notice and 2019 Proposed Regulations with proposed rules and guidance.
The Final Regulations address numerous issues raised by commenters. The regulations adopt some suggestions, reject others, clarify numerous issues, and provide examples. The following is a summary of significant issues addressed by the regulations, which are almost 170 pages, including the Preamble.
1. Treas. Reg. Section 1.451-3, addressing rules related to Section 451(b): Section 451(b) says, generally, that a taxpayer may treat the “all events test” as being satisfied not later than when the item is included as revenue in a company’s applicable financial statement (AFS) (“AFS revenue”). The worry was that the rule contained in Section 451(b) might cause accelerated revenue recognition for tax purposes in certain situations. The regulations address numerous issues:
a. Realization: The legislative history to Section 451(a) stated that – by enacting Section 451(b) – Congress did not intend to change the rules related to when an amount of revenue is “realized.” The IRS rejected commenters’ requests for a definition of realization and for any other clarification.
b. Adjustments to AFS revenue: Even though the AFS revenue is the starting point in Section 451(b), the regulations allow several adjustments. For example, if AFS revenue includes amounts that would be uncollectible if the contract was canceled, taxpayers are permitted to exclude those uncollectible amounts from revenue for tax purposes. The Final Regulations removed a rebuttable presumption that would have assumed amounts to be non-contingent and/or enforceable if they were included in AFS revenue.
c. Alternative AFS revenue method: This method allows a taxpayer to follow the company’s AFS revenue method and ignore adjustments related to uncollectable amounts (above), but would allow the taxpayer to include certain cost offsets (“AFS cost offset method”).
d. Cost offsets: The Proposed Regulations addressed cost offsets of any kind. In the Final Regulations, the IRS rejected requests for cost offsets based on estimated costs, but they do allow for cost offsets based on actual costs if the transaction is for the future sale of inventory.
e. Other areas: The Proposed Regulations contain other rules relating to allocation of transaction price among multiple performance obligations and across multiple years; rules for special methods of accounting; and exclusions from the AFS revenue rule.
f. Book Percentage of Completion (PCM): Commenters asked for a “book PCM method” as a special method of accounting for certain contracts that would have allowed taxpayers to follow the company’s financial statement method of accounting where the company recognized revenue over time. The IRS did not implement this request, but they are considering the issue.
2. Treas. Reg. Section 1.451-8 (advance payments), addressing rules related to Section 451(c): Section 451(c)(1)(A) requires taxpayers to include the full amount of an advance payment in income in the year of receipt. However, Section 451(c)(1)(B) allows a taxpayer to defer income inclusion until the following year under certain circumstances. The rule in Section 451(c) generally follows the rule that was contained in Rev. Proc. 2004-34.
a. Specified goods exception: One of the most important parts of 451(c) and 1.451-8 is the “specified goods exception,” which is an exception to 451(c). It is important because if it applied, amounts received would not be subject to the limited one-year deferral under Section 451(c), but would be subject to the general rule in Section 451(b), which merely requires that revenue be deferred no longer than deferred in the taxpayer’s AFS. The IRS is aware of the potential for a longer deferral, but pointed out that taxpayers are required to properly apply the “all events” test. In other words, taxpayers should only get a longer deferral in appropriate circumstances. The Final Regulations did not change the criteria to fall into the specified goods exception, but clarified several points:
i. Specified good defined: A taxpayer fits into the specified goods exception if it receives a payment in the year preceding the year in which the goods are set to be delivered (per the terms of the contract) and provided that (1) the taxpayer does not have similar inventory on hand with which it could fulfill the order, and (2) the taxpayer recognizes all of the income from the transaction in the year in which the goods are delivered).
ii. Broadening of the specified goods exception: Commenters asked that the specified goods exception be broadened. Specifically, they asked that the rule apply even if the taxpayer recognizes some revenue in a year before the year of delivery; that there be flexibility in connection with the delivery date requirement; and that the rule be expanded to include “integral services” (not just inventory). The IRS and Treasury rejected these requests.
iii. Option to apply 451(c) to “specified goods” situations: The regulations provide an option for taxpayers that would otherwise meet the specified goods exception to apply the limited deferral rules in Section 451(c) (“specified goods Section 451(c) method”). Taxpayers electing this method of accounting would be permitted to a limited cost of goods sold offset for costs actually incurred as of the date revenue is accelerated.
iv. Cost offset for advance payments: The IRS rejected commenters’ requests to offset revenue with estimated costs (i.e., costs not yet incurred). However, the Final Regulations now allow a cost offset for actual costs incurred to date. This “cost of goods in progress offset” cannot reduce income below zero. The IRS also specifically said that the COGS offset cannot be used for gift cards or point programs (because you can never point to incurred COGS related to items produced).
b. Applicability date: The Final Regulations generally apply for tax years beginning on or after Jan 1., 2021, with some exceptions. Taxpayers are permitted to apply the regulations to earlier taxable years.
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