One of the key developments keeping those CPAs who specialize on the “accounting and auditing” (or A&A as we tend to refer to it) side of the profession jumping has been the soon to be implemented standard titled “Revenue from Contracts with Customers” FASB Accounting Standards Update 2014-09, which makes significant changes to revenue recognition, particularly the timing of such recognition of revenue.
Of course, for those of us working in the tax arena, when you start talking about timing of recognition you realize that if any of this either does flow onto a tax return or a taxpayer reasonably would like to have it do so to keep tax and book the same in this area you realize you are dealing with an “accounting method” which would require IRS permission to change under IRC §446. And we also realize the timing of the inclusion of an item of income is governed under the IRC by IRC §451.
The IRS has been aware of this potential problem as well, and now has released a proposed Revenue Procedure to allow for certain automatic changes in accounting methods. This proposed procedure, on which the IRS is seeking comments, is found in IRS Notice 2017-17.
The IRS has previously asked for some guidance in this area in Notice 2015-40. In that notice, the IRS asked for guidance on the following issues:
- To what extent would using the new standards for federal income tax purposes result in acceleration or deferral of income under § 451 or other income provisions of the Code?
- What industry and/or transaction-specific issues might arise as a result of the new standards that may need to be addressed in future guidance?
- To what extent do the new standards deviate from the requirements of § 451? In what situations should the IRS allow taxpayers who adopt the new standards to follow their book method of accounting for tax purposes (for example, where income is always accelerated)?
- To what extent do the rules regarding allocation of standalone sales price and transaction price in the new standards affect taxpayers’ ability to satisfy their tax obligations?
In a very broad sense, IRC §451 and Reg. §1.451-1(a) provide the following recognition rule as discussed in Section 2.03 of the proposed procedure:
.03 Accounting for income generally. Section 451(a) of the Code and § 1.451-1(a) of the Regulations provide that any item of gross income must be included in gross income in the year in which it was received by the taxpayer unless it is includible for a different year pursuant to the taxpayer’s method of accounting.
As the proposed procedure explains, the new revenue recognition standard has the following effective dates that aren’t that far into the future:
The new standards are effective for publicly-traded entities, certain not-for- profit entities, and certain employee benefit plans for annual reporting periods beginning after December 15, 2017. For all other entities, the new standards are effective for annual reporting periods beginning after December 15, 2018. Early adoption is allowed for reporting periods beginning after December 15, 2016. See FASB Update No. 2015-14, “Revenue from Contracts with Customers (Topic 606), Deferral of the Effective Date.”
The IRS explains its view of the likely effect of the new accounting standard on tax matters in Section 2.05:
(1) The Internal Revenue Service (Service) anticipates that many taxpayers will request consent to change a method of accounting for one or more items of income as a result of, or directly related, to the adoption of the new revenue standards for the same taxable year that the new standards are adopted for financial accounting purposes.
(2) The Service must balance taxpayers’ need to comply with the new standards with the Service’s need to approve appropriate method changes.
The proposed ruling would provide for some automatic change approvals for a “qualifying same-year method change.” The IRS defines that term as follows:
A qualifying same-year method change is a change of method of accounting for recognizing income that is made for the same year as the year the taxpayer adopts the new standards and made as a result of, or directly related to, the adoption of those standards.
The procedure notes that any change under this procedure must comply with the general rules for automatic accounting method changes which will include filing a Form 3115, Application for Change in Accounting Method, in duplicate, one copy filed with the taxpayer’s return for the year of change and one copy mailed to the specified IRS office (right now that office is in Covington, Kentucky but the IRS has varied the location over time).
Section 5.01 of the proposed procedure would apply if the method being sought is one for which there is an already existing automatic method change available under Revenue Procedure 2016-29 (or any successor). Not surprisingly, in that case the taxpayer is directed to simply follow the standard procedures for an automatic change found in Revenue Procedure 2015-13 (or any successor). But the problem arises for those changes which, while not contrary to the provisions of the Code or Regulations, do not currently have “automatic change” status.
Section 5.02 deals with those areas, outlining a temporary automatic change option for a “qualifying same-year method change” that complies with the income recognition provisions of the Code or Regulations. A taxpayer who has this change that isn’t covered under the standard automatic change options will need to:
- File a Form 3115;
- Check the box for line 1(b), and write “Rev. Proc. 2017-XX” followed by the applicable income provision of the Code or Income Tax Regulations or the applicable relevant guidance; and
- Attach a brief description of the change and why it satisfies the applicable income provision or guidance referenced in line 1(b) of the Form 3115.
Normally when a taxpayer makes a change in accounting method, the taxpayer is required to account for the cumulative effect of the change on taxable income under the rules of IRC §481(a), which requires the taxpayer to recognize the cumulative change:
- Entirely in the year of change if
- The cumulative effect is negative or
- The cumulative effect is positive, less than $50,000 and the taxpayer elects to recognize the adjustment all in one year; or
- Recognized evenly over four years, including the year of change.
However, the proposed procedure will allow that a taxpayer may make the change on a “cut-off” basis for certain small trades or business. To qualify for cut-off treatment the taxpayer must have one or more distinct trade(s) or business(es) (within the meaning of Reg. §1.446-1(d)) that individually have:
- Total assets of less than $10 million as of the first day of the taxable year for which a change in method of accounting is requested, or
- Average annual gross receipts of $10 million or less for the three preceding taxable years, as determined under § 1.263(a)-3(h)(3) (substituting “separate and distinct trade or business” for “taxpayer”)
Somewhat confusingly, though, the ruling goes on to say “a § 481(a) adjustment is neither permitted nor required for each such separate and distinct trade or business.” The statement that a §481(a) seems to imply there is no election, but the term “may” suggests just the opposite. Presumably the IRS means that if you elect this method you don’t do a §481(a) adjustment.
From a practical standpoint, for most taxpayers this option would have the same effect as a §481(a) adjustment taking effect entirely in the year of change—only those with contracts that began before the start of the tax year and are still in process at the end of the tax year would see a different result.
While the above guidance uses the same tests for a “small business” as was found for the capitalization/repair regulation relief granted in Revenue Procedure 2015-20 and, as with that relief, allows for a “cut-off” recognition of the change, this relief does not remove the need to file the Form 3115 itself.
For those changes that do not meet the “small business” exception above, a separate §481(a) adjustment will need to be computed for each separate and distinct trade or business the taxpayer conducts.
The proposed revenue procedure concludes by noting that multiple requests to make qualifying same-year method changes may be made in a single request. That is, a single Form 3115 would suffice, rather than needing a separate Form 3115 for each distinct method change.
One key take-away from this proposed procedure is that the IRS is not providing that all changes required by the new FASB standard will be rendered acceptable for tax purposes merely by filing a Form 3115. Rather, the burden is on the taxpayer to establish that the method being requested is not itself at odds with the law or regulations under IRC §451. Rather, to the extent the new standard results in a method that is acceptable under the already existing law, the IRS will smooth the path to allow the taxpayer to bring its revenue for tax purposes more into line with what the entity will now be reporting for financial statement purposes.