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Where GAAP and Tax Meet: Understanding IRC §451(b)

by Edward Zollars

When the Tax Cuts and Jobs Act (TCJA) was enacted, one of the revenue raising provisions was found at IRC §451(b).

That provision was meant to require certain taxpayers to recognize revenue at least as quickly as they were reporting revenue in financial statements that were being given to various third parties. For those impacted by this provision, their expected tax cut from the new tax law may be greatly reduced or, potentially, may face an even higher tax bill than before the law was enacted.

The Internal Revenue Service recently released the proposed rules governing the one-sided revenue conformity rules added by Congress as part of the TCJA in late 2017 at IRC §451(b). The details of the IRS’s first draft of how these rules should be implemented had been anticipated by those in the tax and accounting community.

The rules create an intersection between accounting standards as promulgated by the Financial Accounting Standard’s Board and the International Accounting Standards Board for revenue recognition and the Internal Revenue Code rules for reporting income.

The Basic Rule
Briefly, IRC §451(b) requires a taxpayer with an applicable financial statement (AFS) who files federal income taxes using an overall accrual method of accounting, and is subject to the “all-events” test, to recognize revenue at least as quickly on the tax return as the entity does on the AFS.

The all events test is the rule used by most accrual method taxpayers to determine when income is to be reported on the organization’s tax return. Generally, the all events test is deemed met when:

  • All events have taken place to fix the organization’s legal right to the income; and
  • The amount of the income can be reasonably estimated. 

Congress added  §451(b), which provides that, for a covered taxpayer, even if the all events described earlier isn’t met, it will be deemed met if the revenue has been reported in the entity’s applicable financial statement. This means that if some revenue is recorded earlier in the AFS than for tax, while other revenue is recorded later on the AFS than under tax rules, the taxpayer will report the revenue at the earlier of the date it is recorded under US GAAP or the date it has traditionally been recorded under the tax law.

Applicable Financial Statements
A taxpayer must first determine if the entity has any AFSs and, if there are more than one, which one has priority. Generally, if any of the following statements exist that cover the entire taxable year, the statement is considered to be an AFS, in order of decreasing priority:

  • A statement filed with the U.S. Securities and Exchange Commission or a similar foreign regulatory agency;
  • An audited financial statement prepared for a substantial non-tax purpose; or
  • A financial statement filed with a non-taxing governmental agency.

Generally, under the regulations, financial statements prepared under US GAAP have the highest priority, followed by those prepared under IFRS and then any other AFS qualified statement.

Presumably the goal of these rules is to prevent Congress from being embarrassed by reports of companies showing a high level of income to investors, borrowers or other interested parties, while delaying the reporting of such income for tax purposes.

No Similar Treatment for Related Expenses
Unfortunately, while the law provided for revenue conformity, the law provided no equivalent conformity for expenses, including closely related expenses such as costs of sales. The IRS had received a number of comments regarding this problem, with suggestions that the final regulations include some relief in this area.

However, the final regulations contain no such relief provision. The IRS acknowledges the comments in the preamble to the regulations, but declined to provide such relief, believing it went beyond what the law provided and that Congress had not provided such rules for concern that it might be abused.

Several commentators worried that some organizations had been pushed to GAAP revenue recognition methods that are similar to the construction contracting percentage of completion (PCM) method by ASC 606, Revenue From Contracts with Customers. Under the IRC, the use of such methods is limited to contracts that meet the definition of long-term contracts under IRC §460(f), which generally are construction contracts, or manufacturing of products not normally included in the finished goods inventory of the taxpayer or which take more than 12 calendar months to complete.

While the IRS did not provide for relief for those using GAAP PCM who don’t meet the tests under §460(f) to use tax PCM, in the preamble the agency did ask for comments regarding whether the IRS should consider expanding tax PCM methods to taxpayers who currently are barred from using the method and, if so, under what conditions such a method should be allowed. But in the interim, taxpayers are out of luck if they are required to accelerate revenue under a PCM-like method on their AFS, but do not meet the tax requirements to use the method.

Taxpayers Part of a Larger Group or with Different Tax/Book Year Ends
What if the taxpayer reports as part of a larger group’s financial statement? In that case, if the group’s financial statements meet the requirements of an AFS, that will become the AFS of the taxpayer. The taxpayer will need to look at separately stated items on the AFS or, if those do not exist, by creating the information from source documents used to create the group’s AFS.

Similarly, some taxpayers have a tax year end that is not the same as the year end used for financial reporting. If there is a mismatch of year ends, the regulations give the taxpayer the following three options to come up with the revenue numbers for applying the conformity rules:

  • The taxpayer computes revenue by using the accounting principles used to create its AFS to determine whether an item would be included in revenue in an AFS for the taxable year as if its financial reporting period was the same as its taxable year, for example, by conducting an interim closing of its books;
  • The taxpayer computes revenue by including a pro rata portion of the revenue for each financial accounting year that includes any part of the taxpayer’s taxable year. If the taxpayer’s AFS for part of the taxable year is not available by the due date of the return (with extension), the taxpayer must make a reasonable estimate of revenue for the pro rata portion of the taxable year for which an AFS is not yet available; or
  • If a taxpayer’s financial accounting year ends five or more months after the end of its taxable year, the taxpayer computes revenue for Federal income tax purposes based on the revenue reported on the AFS prepared for the financial accounting year ending within the taxpayer’s taxable year. If a taxpayer uses a 52-53 week year for financial accounting or Federal income tax purposes, the last day of such year shall be deemed to occur on the last day of the calendar month ending closest to the end of such year.

Exempt Tax Methods of Accounting
While most accrual method taxpayers with an AFS are subject to this, some methods of accounting for revenue under tax are not subject to these rules. Some of those excluded include those using:

  • The crop method of accounting;
  • Long-term contracting methods; and
  • Installment method of accounting.

As well, the rule does not change the tax treatment of an item—so, for instance, an item properly treated as a lease under federal tax law would not have its treatment changed due to being treated differently under GAAP.

Different rules apply to OID debt instruments, and the rules do not apply to any item of gross income from a mortgage servicing contract.

The Mechanics of Complying—Filing a Form 3115
Complying with these rules is considered a method of accounting and, as such, the permission of the IRS must be obtained to make these changes. That is true even though the law requires taxpayers to comply with these rules (one of the quirks of the tax laws), but the IRS has published procedures (Revenue Procedure 2019-37) for taxpayers to obtain this consent automatically.

Organizations that will be most highly impacted by these rules are those that have had significant tax timing differences in revenue, information the organization has been compiling in the past to prepare calculations needed under ASC 740, Income Taxes. As well, since ASC 606, Revenue from Contracts with Customers, has come into effect in the same time frame, organizations will also look at analyses prepared to deal with the impact of those changes on recording revenue.

Impact on Taxpayers And Potential Mitigations
Many taxpayers report revenue at the same time for tax and book purposes—for those taxpayers, these rules will have little or no impact. But what about taxpayers who are facing issues with these rules?

The obvious option is to stop creating the applicable financial statement—but that’s not going to be possible for many taxpayers since the audited statement or filing with an agency is a requirement being imposed by a third party. While a lender might be able to be persuaded to accept a reviewed financial statement in some cases, for most taxpayers with an AFR there will be no way to escape creating that statement each year.

For very small taxpayers (those with average revenue of less than $25 million over a three-year period), one option is to make use of the break added by TJCA at IRC §448(c). Such taxpayer may elect to use the overall cash method of reporting income and expenses. In most cases where receivables are in excess of payables, moving to the cash basis will result in income being reported less rapidly than on their accrual basis GAAP statements.

Because the revenue conformity rules only apply to taxpayers using the overall accrual basis of accounting, automatically moving to the overall cash basis of accounting may result in a similar or greater deferral of reporting income as the taxpayer had previously enjoyed before this law change. Taxpayers who may want to go down this path will consult IRS Revenue Procedure 2018-40 for the requirements and procedures to make this change on their return.

If a taxpayer is finding that the adoption of ASC 606 is accelerating the recognition of income, the organization may be able to at least claim deductions at the same time as they are claimed under ASC 606 by seeing if they can justify the ASC methods overall for tax purposes and then changing their tax accounting methods to comply with ASC 606 timing for both revenue and expense. The IRS released Revenue Procedure 2018-29 to allow for such a change, but subject to the taxpayer showing that their specific ASC 606 methods are allowable for tax purposes.

Ultimately, this was designed to raise revenue—so that means for some taxpayers there is going to be no escaping a higher tax bill triggered by recognizing revenue earlier on tax returns than is generally required the other provisions of the tax law.

Edward Zollars, CPA, is an instructor at Kaplan Professional Education