IRS issues procedures for complying with Section 451(b) revenue recognition

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Successful business deal The IRS has released automatic procedures (Rev. Proc. 2018-60) for accrual method taxpayers with applicable financial statements (AFS) to change methods of accounting to comply with Section 451(b), as revised by the Tax Cuts and Jobs Act (TCJA).

With the issuance of these procedures, most changes in revenue recognition due to new accounting standards and the TCJA are at least temporarily automatic. However, certain special accounting method changes remain non-automatic.

Background The TCJA amended Section 451 relating to the timing of the recognition of income for accrual method taxpayers. The new Section 451(b) generally provides that for an accrual method taxpayer, the all-events test with respect to any item of gross income (or portion thereof) shall not be treated as met any later than when such item (or portion thereof) is taken into account as revenue in the taxpayer’s applicable financial statement (AFS), or such other financial statement as the Treasury Secretary may specify. Section 451(b), as revised by the TCJA, is generally effective for tax years beginning after Dec. 31, 2017. However, in the case of income from a debt instrument having original issue discount (OID), the rules of Section 451(b) apply to taxable years beginning after Dec. 31, 2018, and the Section 481(a) adjustment period for a qualified change in method of accounting is six taxable years.

On May 28, 2014, the Financial Accounting Standards Board and International Accounting Standards Board announced new accounting standards for revenue recognition (ASC 606). Publicly-traded entities, some not-for-profit entities and employee benefit plans are required to adopt these new standards for years beginning after Dec. 15, 2017. All other entities are required to adopt ASC 606 for years beginning after Dec. 15, 2018. The IRS previously issued an automatic method change procedure (Section 16.11 of Rev. Proc. 2018-31 as added by Rev. Proc. 2018-29, as modified by Rev. Proc. 2018-49) for taxpayers that are implementing changes related to the new financial accounting standards for revenue recognition, ASC 606.

This revenue procedure modifies Rev. Proc. 2018-31 to provide new procedures for obtaining automatic consent to change methods of accounting to comply with Section 451(b)(1)(A) and (b)(4), as amended by the TCJA.

Automatic procedures The procedures add new Section 16.12, which applies to a taxpayer who either:
  • Wants to change to a method of accounting that treats an item of gross income, or portion thereof, as meeting the all-events test no later than when such item, or portion thereof, is taken into account as revenue in its AFS under Section 451(b)(1)(A)
  • Is not adopting the ASC 606 for the year of change, and wants to allocate the transaction price to performance obligations under Section 451(b)(4)

This change does not apply to a taxpayer who does not have an AFS, as defined in Sections 451(b)(1)(A)(i) or (ii). Taxpayers cannot use this automatic procedure to change to a special method of accounting that is not subject to Section 451(b)(1)(A).

Additionally, the change does not apply to taxpayers who want to make a change for federal income tax purposes to a method that conforms to the financial statement method in ASC 606 in the year such standards are adopted, as those changes generally must be made under Section 16.11 of Rev. Proc. 2018-31. There is a special ordering rule that states that taxpayers who concurrently make a change to use a method that conforms to ASC 606 under Section 16.11 and this new change section 16.12 to conform to revised Section 451(b) must apply the change under Section 16.11 first, although they may be combined on one Form 3115. Similarly, taxpayers must apply the change in method to allocate transaction price under Section 451(b)(4) first and then apply the change in method to accelerate income under Section 451(b)(1)(A).

Because section 16.12 was added to Rev. Proc. 2018-31, the normal terms and conditions in Rev. Proc. 2015-13 apply unless otherwise noted, including audit protection and four-year spread of positive Section 481(a) adjustments. Taxpayers are required to separately state the Section 481(a) adjustment for each revenue item being changed, but may combine them on one Form 3115. Rev. Proc. 2018-60 provides a temporary waiver of the eligibility rule for taxpayers that have changed the method for the same item within the last five taxable years. In addition, the requirement to file the duplicate copy with the IRS in Covington, Ky., is waived.

Grant Thornton Insight: Audit protection generally applies at the time the duplicate copy is filed. Therefore, audit protection presumably would not apply until the Form 3115 is filed with the tax return.

Rev. Proc. 2018-60 provides simplified method change procedures for taxpayers (who are not making a change under Section 16.11) with no Section 481(a) adjustment and for small taxpayers with average aggregate annual gross receipts for the three prior taxable years of $25 millioin or less. Such taxpayers may choose to not file a Form 3115 at the cost of not receiving audit protection.

Additionally, Rev. Proc. 2018-60 makes conforming changes to the change from an overall cash method to an overall accrual method under Section 15.01 of Rev. Proc. 2018-31.

Any Form 3115 filed under the non-automatic procedures of Rev. Proc. 2015-13 for a taxable year beginning after Dec. 31, 2017, that is pending with the IRS National Office will be returned and user fees will be refunded to the taxpayer. The timely resubmitted Form 3115 will be considered filed as of the date the taxpayer originally filed the non-automatic method change.

The procedures generally apply to taxable years beginning after Dec. 31, 2017, or Dec. 31, 2018, in the case of income from a debt instrument having original issue discount.

Next steps With the issuance of this procedure, most changes in revenue recognition due to ASC 606 and the revisions made by the TCJA are at least temporarily automatic:
  • Section 16.12 applies to changes to conform to revised Section 451(b).
  • Section 16.11 applies temporarily to changes to conform to ASC 606 (if the book method is allowable).
  • Sections 16.07 and 16.10 apply to changes to advance payments under Rev. Proc. 2004-34. Note that the IRS previously issued Notice 2018-35 informing taxpayers that changes to conform to Section 451(c) should rely on Rev. Proc. 2004-34 until final regulations are issued.

However, because special methods of accounting are not subject to the revised Section 451(b), such changes generally remain non-automatic. Additionally, Section 16.11 specifically excludes changes under the percentage of completion method in Section 460, from the automatic procedures, as well as certain changes in determining the transaction price or identifying contracts. Therefore, taxpayers such as contract manufacturers and construction businesses that are not using a correct tax percentage of completion method under Section 460, would have to file nonautomatic changes in method to change to a permissible method.

Knowing which procedure to file under, whether the change is eligible for the automatic procedures, the ordering rules, whether audit protection applies, and whether a change can be made with a Section 481(a) adjustment and/or on a cut-off basis, and whether a Form 3115 must be filed, and if so, which changes may be combined on one Form 3115, can get complex when dealing with so many procedures. Taxpayers should perform an assessment to determine whether a nonautomatic method change is required to be filed before year end.

For more information contact: Sharon Kay
Partner, Accounting Methods
Washington National Tax Office
Grant Thornton LLP
+1 202 861 4140

John Suttora
Managing Director
Washington National Tax Office
Grant Thornton LLP
+1 202 521 1523

Caleb Cordonnier
Manager, Accounting Methods
Washington National Tax Office
Grant Thornton LLP
+1 202 521 1555

Debbie Shi
Manager, Accounting Methods
Washington National Tax Office
Grant Thornton LLP
+1 202 521 1501

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