Revenue Recognition and the New Section 451(b)
The Tax Cuts and Jobs Act (TCJA), may have decreased the corporate tax rate, but it also created a new rule by which many taxpayers will actually recognize taxable income sooner. No longer may a company defer revenue recognition for a number of previously acceptable reasons. Instead, revenue will be taxable in the period no later than the year it is recognized on the company’s financial statements. If this change is not something you are already aware of, read on to learn more.
In addition to the change in revenue recognition for tax purposes, the Financial Accounting Standards Board (FASB) introduced a new model for recognizing revenues, Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers. ASC 606 is the culmination of Accounting Standards Update (ASU) 2014-09 and several other amendments. These new guidelines will require extra scrutiny over accounting for customer contracts for book and tax purposes.
Revenue from Contracts with Customers (ASC Topic 606)
ASU 2014-09 sets out a new framework for revenue recognition that supersedes virtually all previous revenue recognition guidance, with the exception of certain industry-specific guidance. Insurance contracts are specifically out of the scope of ASC 606 and continue to be accounted for separately under ASC 944, Financial Services – Insurance. However, insurance entities and their affiliates may enter into other contracts for services that fall within the scope of ASC 606. Examples of some of these activities include:
- Managing general agent services
- Managing general underwriter services
- Producer services
- Claims administration services
- Accounting services
- Risk management services
- Administrative services only plans or arrangements
- Membership fees
The new ASC 606 guidance requires entities to re-evaluate their revenue recognition rules for customer contracts. Revenue should now be recognized at a point in time, or over time as the entity satisfies a performance obligation. These changes may potentially result in changes to the timing of revenue recognition when compared to the old standards. ASC 606 became effective January 1, 2018, for public companies and January 1, 2019, for nonpublic companies.
Revenue Recognition for Tax Purposes
In the past, it was common for the timing of revenue recognition to differ for financial and tax accounting purposes. Therefore, a change in the financial accounting treatment of a revenue item would not have necessarily required a change for tax purposes. However, the TCJA made significant changes to the Internal Revenue Code (IRC), with the notable inclusion of new Code Section 451(b). Sec. 451(b) fundamentally changes the concept that revenue could be recognized differentially for financial and tax accounting because it alters the definition of the all-events test. Prior to the TCJA, for an item of revenue to be recognized for tax purposes, all events must have occurred that determined the right of the taxpayer to receive the income, the amount of such income must have been determined with reasonable accuracy, and economic performance must have occurred with respect to that revenue. If any of these three factors occurred in years subsequent to that in which the item was recognized for financial statement purposes, the tax recognition of revenue was deferred. Now, Sec. 451(b) states that “the all-events test, with respect to any item of gross income, shall not be met later than when” the income is included in an applicable financial statement of the taxpayer. It is possible, then, that revenue may be recognized for tax purposes even though economic performance has not yet occurred. Effectively, as soon as revenue is recognized in the financial statements, it must also be recognized for tax purposes. There may be some situations where facts and circumstances should be a consideration as to whether the revenue is considered recognized for tax before automatically forcing inclusion due to the income being included in financial statements.
Additionally, if a taxpayer has financial reporting changes due to the adoption of ASC 606, they should consider the tax implications for any restatement portion of revenue.
Many taxpayers were worried that this change would also impact allowable revenue deferral as it relates to certain advance payments set forth in Revenue Procedure 2004-34. The TCJA incorporated some of the specific wording from that Rev. Proc. into the new Code Sec. 451(c), Treatment of Advance Payments, and outlines a limited one-year deferral for those items. Based on this rule, taxpayers who are in receipt of advance payments for services may elect to include in taxable income the portion related to the current taxable year only, and defer the remaining portion to the subsequent taxable year as long as the remainder is also recognized in the subsequent year for financial statement purposes.
The initial release of the TCJA also raised questions pertaining to the impact of Sec. 451(b) on the deferral of market discount income as defined in Sec. 1278(a)(2). Taxpayers are still allowed to defer the recognition of market discount income on a bond until the bond matures or is sold. When the TCJA was signed, it was unclear if the new all-events test of 451(b) would impact this deferral. The IRS has since released Notice 2018-80 which clarifies that the accrual of market discount is not includible in income under Sec. 451(b).
Procedures for Adopting these Standards
If taxpayers’ taxable recognition of revenue is impacted by ASC 606 and/or Sec. 451(b), they will be required to follow procedures outlined in Rev. Proc. 2018-60 which provides for an automatic consent to change methods to comply with Sec. 451(b) and ASC 606 upon the filing of Form 3115, Accounting for Change in Accounting Method. The Rev. Proc. offers a short form version of Form 3115 and eliminates the requirements for duplicate copies to be filed, as well as payment of user fees. Some taxpayers may even qualify to adopt the method changes under a streamlined procedure that will not require the filing of Form 3115 at all. Additional information on the adoption of the new method can be found here.
Given that ASC 606 is only just now effective for nonpublic companies and Sec. 451(b) is effective for tax years after December 31, 2017, there is still time to plan for the corresponding tax consequences of that change. Interim reporting, estimated tax payments, and annual filings will be impacted. Understanding these changes, and planning for their implementation and effect should be a priority topic for all taxpayers.
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