The timing of income inclusion for taxpayers using the accrual method is explained in IRS final regulations, reflecting changes made by the Tax Cuts and Jobs Act. The regulations focus on taxpayers with an applicable financial statement and those that receive advance payments for goods, services and other items.
The TCJA revised the application of the “All Events Test.” This test for income recognition requires that taxpayers include items of income in gross income in the taxable year in which: 1) all the events occur that fix the right to receive the income, and 2) the amount of the income can be determined with reasonable accuracy.
The final regulations implement the TCJA’s book-tax conformity rule that says, for an accrual method taxpayer, the All Events Test for an item of gross income is met no later than when the item is included as revenue in an applicable financial statement (the “AFS Income Inclusion Rule”). This rule restricts deferral opportunities that previously existed, although taxpayers with an AFS can continue to use a deferral method for advanced payments. A taxpayer may elect to include any portion of an advance payment in gross income in the taxable year following the year of receipt to the extent income is not included in revenue in the AFS in the year of receipt.
AFS Revenue and Enforceable Rights
Under the TCJA, in determining when an item of gross income is taken into account as AFS revenue, revenue is reduced by amounts that the taxpayer does not have an enforceable right to recover if the customer were to terminate the contract on the last day of the taxable year. The determination of whether the taxpayer has an enforceable right is governed by the terms of the contract and applicable Federal, state or international law, and includes amounts recoverable in equity and liquidated damages.
The IRS offers the following example from the Joint Tax Committee explanation of the TCJA:
A taxpayer enters into a contract with a customer for a customized piece of machinery. Under the contract, the taxpayer will not invoice the customer until the item is delivered to the customer, the customer accepts the machinery and title to the machinery has transferred to the customer. The contract specifically provides that, if the customer withdraws from the agreement, the taxpayer has an enforceable right to payment as the work is performed, even if the contract is not completed. The taxpayer does not complete the machinery in year one but includes an amount in revenue in its AFS in year one. Under the AFS Income Inclusion Rule, the taxpayer is required to recognize the amount in year one.
Alternative Method
To reduce the compliance burden of having to evaluate contracts, the final rules allow an alternative method to determine when an item of gross income is treated as “taken into account as AFS revenue.” Under the “alternative AFS revenue method”, the taxpayer does not have to reduce AFS revenue by amounts that the taxpayer lacks an enforceable right to recover if the customer were to terminate the contract on the last day of the taxable year. While this method is simpler, it can result in earlier income inclusion.
Cost Offset Allowed
One commenter on the proposed rules observed that, because the final regulations use the AFS to measure the receipt of an economic benefit, the rules also should reflect the AFS standards that require some items of income be reported “net” of offsetting items. The IRS agreed with this basic concept stating, “…taxpayers should be afforded the flexibility of applying an offset for costs incurred against AFS income inclusions from the future sale of inventory…”
Thus, the IRS rules include the AFS cost offset method, which allows taxpayers to offset AFS income inclusions from the sale of future inventory with costs incurred as of the end of the taxable year—the cost of goods in progress offset.
Change of Accounting Method
The IRS also intends to release a revenue procedure that allows taxpayers to get automatic consent to change accounting methods to comply with the final rules.
Timing and Choices
The 191-page final rules are technical and include exceptions and alternative methods of determining income inclusions for accrual method taxpayers. The rules also can be applied to earlier tax years. For this reason, it is important to analyze the best options to minimize tax liability while maintaining the required book-tax conformity. Your Frazier & Deeter tax professional can help you with this analysis.