On September 6, 2019, the Internal Revenue Service (Service) issued Rev. Proc. 2019-37, which grants advance consent to taxpayers seeking to change a method of accounting to comply with the new proposed regulations under sections 451(b) and (c). As both sets of proposed regulations indicated a change to comply with the new guidance may be considered a change in method of accounting, many accounting method changes are anticipated. It has been suggested that tens of thousands of accounting method changes will be filed. For this reason, taxpayers and practitioners appreciate that the Service has determined that these accounting method changes are generally available automatically.
To the extent that an accounting method change is required for the 2018 tax year, the revenue procedure has been issued so that these accounting method change can be filed with 2018 Federal income tax returns. Although taxpayers and practitioners appreciate that this guidance has been released prior to the due date for corporate calendar-year taxpayers, it is unfortunate that the proposed regulations and accompanying revenue procedure were issued so late in the filing season. Many companies have already filed returns and/or have finalized draft returns. For this reason, some companies will find it challenging to fully comply with the new rules on their 2018 federal income tax returns.
Section 451 of the Internal Revenue Code (Code) provides guidance regarding the timing of income recognition. Historically, for accrual method taxpayers, Treas. Reg. § 1.451-1(a) provided 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”). 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 TCJA), these historic rules of income recognition were changed significantly. Under the TCJA, section 451(b) provided 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; section 451(c) generally codified the Deferral Method under Rev. Proc. 2004-34.
Both sections are generally effective for tax years beginning after December 31, 2017. Section 451(b) requires accrual-method taxpayers that were recognizing income under the All Events Test in a tax year later than when it is recognized for financial accounting purposes to change its existing method of accounting for tax purposes. Similarly, section 451(c) allows accrual-method taxpayers with an AFS to use a deferral method of accounting provided for advance payments but also requires an accounting method change to the method required under the statute.
After the TCJA, the Service issued limited guidance with respect to the application of these new income recognition provisions. Notice 2018-35 was issued on April 12, 2018, and provided transitional guidance to taxpayers regarding the treatment of advance payments under the new section 451(c), namely allowing taxpayers to continue to rely on Rev. Proc. 2004-34 for their treatment of advance payments until subsequent guidance was released. Rev. Proc. 2018-60 was issued on November 29, 2018, and provided an automatic accounting method change for taxpayers seeking to comply with section 451(b).
On September 5, 2019, nearly concurrently with the release of Rev. Proc. 2019-37, the Service released proposed regulations for sections 451(b) and (c). Both sets of proposed regulations indicate that a taxpayer’s change to follow the new rules provided under proposed Treas. Reg. §§ 1.451-3(l)(1) and 1.451-8(e) would be considered a change in method of accounting. Additionally, both sets of regulations provide clarification for taxpayers seeking to implement and follow the new rules for income recognition and the treatment of advance payments. For additional detail and analysis regarding the proposed regulations for sections 451(b) and (c), please see Eversheds Sutherland’s alerts on such guidance.
Rev. Proc. 2019-37
Rev. Proc. 2019-37 modifies Rev. Proc. 2018-31, which lists accounting method changes that are available automatically. Thus, with Rev. Proc. 2019-37, any taxpayers seeking to change a method of accounting under section 451 to apply proposed Treas. Reg. §§ 1.451-3 and 1.451-8, have received advance consent for such a change. In light of the interaction between income recognition for tax purposes and revenue recognition for financial accounting purposes, Rev. Proc. 2019-37 also provides an additional automatic change in method of accounting for a taxpayer that changes the manner in which it recognizes amounts in revenue in its applicable financial statements (AFS) and that wants to change its method of accounting for federal income tax purposes as well. The guidance is generally effective for tax years beginning after December 31, 2017; for specified credit card fees, the guidance is effective for tax years beginning after December 31, 2018.
Rev. Proc. 2019-37 provides advance consent for the following accounting method changes:
- Change in the treatment of an item of gross income as meeting the All Events Test no later than when such item is taken into account as revenue in its AFS under §451(b)(1)(A);
- Change to allocate the transaction price to performance obligations under §451(b)(4), but is not adopting the new revenue recognition standards for financial accounting purposes;
- Change its method of accounting to comply with proposed Treas. Reg. §1.451-3; or
- Change its method of accounting to comply with proposed Treas. Reg. §1.451-8 (c).
In addition to these accounting method changes, which all apply to taxpayers with an AFS, an additional automatic change in method of accounting was added for taxpayers without an AFS, and which seek to change an accounting method to comply with proposed Treas. Reg. §1.451-8(d).
It is important to note that Rev. Proc. 2019-37 allows certain changes to be made on a cut-off basis, rather than requiring the calculation of a section 481(a) adjustment.1 Generally, when an accounting method change is filed, a taxpayer is required to compute its taxable income for the year of change and thereafter using the new method of accounting as if the new method of accounting had always been used; the difference between the old method and the new method is taken into account as a section 481(a) adjustment. If the adjustment is positive, it is generally taken into account as income over four years. When an accounting method change is made on a cut-off basis, there is no section 481(a) adjustment; items arising on or after the beginning of the year of change are accounted for under the new method of accounting.
Specifically, taxpayers making an accounting method change to comply with new section 451(b) or proposed Treas. Reg. §§ 1.451-3 or 1.451-8(c) are allowed to file the change with a section 481(a) adjustment or on a cut-off basis, at the taxpayer’s choice. By offering taxpayers a choice about whether to include a section 481(a) adjustment, compliance with the new statute and the proposed regulations may be encouraged. Because certain taxpayers are finding that moving to section 451(b) and (c) results in a positive section 481(a) adjustment, if these accounting method changes are available on a cut-off basis, the change will be less expensive. It is important to note that under the revenue procedure, if a taxpayer is filing concurrent accounting method changes and effects any change on a cut-off basis, the cut-off basis must be used for all concurrent changes. Further, for taxpayers using the streamlined procedures provided in the guidance, a taxpayer may not file on a cut-off basis.
As noted, generally, when an accounting method change requires a positive section 481(a) adjustment (an increase in income), that income is spread ratably over a four-year period. Here, the general rule is followed for most accounting method changes. However, for accounting method changes involving the treatment of credit card fee income, the section 481(a) adjustment is taken into account over six tax years, as outlined in section 3.01(5)(b)(i) of Rev. Proc. 2019-37. This approach is consistent with the statute and reflects a change in the treatment of certain credit card fees, which no longer create or increase OID accrued in gross income over the term of the debt instrument.
Aside from more favorable section 481(a) adjustments and periods, Rev. Proc. 2019-37 also provides that a taxpayer under examination that seeks to file an accounting method change to comply with either proposed Treas. Reg. § 1.451-3 or 1.451-8, will receive audit protection for their first, second or third tax year beginning after December 31, 2017, when the accounting method is changed. In other words, the audit protection exception in section 8.02(1) of Rev. Proc. 2015-13, which limits such accounting method changes, is inapplicable.
Finally, and reflecting the taxpayer-favorable elements of this guidance, Rev. Proc. 2019-37 allows taxpayers, which seek one or more concurrent changes under the revenue procedure to file a single Form 3115, merely requiring the section 481(a) adjustment to be allocated among the various method changes.
Eversheds Sutherland observation: Following a thorough review of the proposed section 451(b) and (c) regulations, i.e., proposed Treas. Reg. §§ 1.451-3 and 1.451-8, many taxpayers will identify the need to file a change in method of accounting to comply with the proposed regulations. Not only does Rev. Proc. 2019-37 allow an automatic change in method of accounting, but the guidance also generally provides audit protection to taxpayers under examination seeking to file such changes, allows taxpayers to file such change with a section 481(a) adjustment or on a cut-off basis, and allows taxpayers to file multiple changes concurrently on the same Form 3115. Due to the complexity of the proposed regulations, taxpayers will generally find that multiple method changes may be necessary to comply with the new rules.