On April 12, 2018, the Treasury Department and the Internal Revenue Service (IRS) issued Notice 2018-35 (Notice) that provides transitional guidance relating to advance payments under Rev. Proc. 2004-34. Despite the significant change made to section 451(b) of the Internal Revenue Code (Code) relating the timing of income recognition for tax purposes to a taxpayer’s treatment for financial accounting purposes, the Notice focuses only on section 451(c) and the ability of taxpayers to continue to rely on Rev. Proc. 2004-34 for the treatment of advance payments. Specifically, the Notice:
- Provides that the IRS intends to issue guidance for the treatment of advance payments under section 451(c);
- Allows taxpayers to continue to rely on Rev. Proc. 2004-34 for their treatment of advance payments until such guidance is released; and
- Requests comments regarding a host of issues concerning advance payments, with a focus on guidance regarding the definition and requirement of applicable financial statements.
Section 451 of the Code provides guidance regarding the timing of income recognition. For accrual method taxpayers, Treas. Reg. § 1.451-1(a) provides that income is includible in gross income when all the events have occurred that fix the right to receive the income, and the income can be determined with reasonable accuracy (the “All Events Test”). There are numerous exceptions to the All Events Test allowing taxpayers to defer income recognition beyond the year of receipt, including the Deferral Method under Rev. Proc. 2004-34. Under the Deferral Method, an advance payment is included in gross income for the taxable year of receipt to the extent recognized for financial accounting purposes for that taxable year, and the remaining amount of the advance payment is included in the next succeeding taxable year after the taxable year in which the payment is received, i.e., a one-year deferral.
Under the Tax Cuts and Jobs Act (enacted as “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018”) (the Act), these historic rules of income recognition were changed. Under the Act, section 451(b) provides that for accrual method taxpayers, the All Events Test for any item of income shall not be treated as satisfied any later than when such income is recognized for financial accounting purposes. Additionally, section 451(c) was added to the Code and allows a taxpayer to elect to defer the recognition of advance payments to the taxable year following the taxable year of receipt, except any portion of such payment which is required under section 451(b) to be included in gross income in the taxable year in which the payment is received, generally applying rules similar to Rev. Proc. 2004-34.
The Notice announces that the Treasury and IRS intend to issue guidance under section 451(c) of the Code setting forth the treatment of advance payments. Until that guidance is published, the Notice allows taxpayers to continue to rely on Rev. Proc. 2004-34 with respect to the treatment of advance payments. The Notice states that during this time the IRS will not challenge a taxpayer’s use of Rev. Proc. 2004-34 to satisfy the requirements of section 451, although the IRS will continue to require taxpayers, on examination, to verify that they are properly applying Rev. Proc. 2004-34. To further assist taxpayers, the Notice states that the IRS intends to modify Rev. Proc. 2017-30 to provide a waiver of the eligibility rule in Rev. Proc. 2015-13 to enable taxpayers to make a change in method of accounting under Rev. Proc. 2004-34.
Besides announcing that guidance is still pending and allowing taxpayers to continue to rely on Rev. Proc. 2004-34 notwithstanding the statutory change, the remaining sections of the Notice merely request comments containing suggestions for future guidance under section 451. Specifically, the Notice requests comments on:
- Whether taxpayers without an applicable financial statement may continue to use the Deferral Method under Rev. Proc. 2004-34;
- Whether clarity is needed for the definition of an applicable financial statement under section 451(b)(3);
- Whether the definition of applicable financial statement under section 451 should be the same as the definition in Rev. Proc. 2004-34;
- Whether other items in addition to those listed in section 4.01(3) of Rev. Proc. 2004-34 should be included in the definition of an advance payment;
- Whether certain payments other than those listed in section 4.02 of Rev. Proc. 2004-34 should be excluded from the definition of an advance payment;
- Whether any new procedural rules for changing a method of accounting for advance payments would be appropriate and helpful; and
- The extent, if any, to which the IRS may provide procedures expanding the rules of section 451(c) to apply to additional taxpayers and types of income.
Eversheds Sutherland Perspective: While taxpayers and practitioners likely appreciate the clarification the Notice provides allowing companies to continue to rely on Rev. Proc. 2004-34 until additional guidance is issued, some may find that this Notice offers limited insight. A guidance project aimed at addressing the treatment of advance payments has been an item on the IRS’s Priority Guidance Plan for several years. However, Notice 2018-35, beyond allowing taxpayers to continue to rely on Rev. Proc. 2004-34, merely states that the IRS continues to work on such guidance and would appreciate comments to assist in its analysis. Furthermore, while the Notice makes clear that the IRS is focused on issues regarding advance payments and section 451(c), an equally, if not more significant, issue for many taxpayers are the changes made to section 451(b) and the new rules regarding the timing of income recognition. In light of the Act’s revisions to section 451(b) and companies’ implementation of the new financial accounting standards under ASC 606, guidance on section 451(b) would certainly be appreciated as well.