Taxable Year of Income Inclusion Under an Accrual Method of Accounting and Advance Payments for Goods, Services, and Other Items

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9941]

RIN 1545-BO68 and 1545-BO78

Taxable Year of Income Inclusion Under an Accrual Method of Accounting and Advance Payments for Goods, Services, and Other Items

AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Final regulations.

SUMMARY:

This document contains final regulations regarding the timing of income inclusion under an accrual method of accounting, including the treatment of advance payments for goods, services, and certain other items. The regulations reflect changes made by the Tax Cuts and Jobs Act and affect taxpayers that use an accrual method of accounting and have an applicable financial statement. These final regulations also affect taxpayers that use an accrual method of accounting and receive advance payments.

DATES:

Effective Date:

The regulations are effective on December 30, 2021.

Applicability Dates:

For dates of applicability, see §§ 1.451-3(m), 1.451-8(h), and 1.1275-2(l)(2).

FOR FURTHER INFORMATION CONTACT:

Concerning any provisions in § 1.451-3 within the jurisdiction of the Associate Chief Counsel (Income Tax & Accounting), Jo Lynn Ricks, (202) 317-4615, Sean Dwyer, (202) 317-4853, or Doug Kim, (202) 317-4794, and concerning any provisions in § 1.451-8 within the jurisdiction of the Associate Chief Counsel (Income Tax & Accounting), Jo Lynn Ricks, (202) 317-4615, or David Christensen, (202) 317-4861; concerning any provisions in § 1.451-3 or § 1.451-8 within the jurisdiction of the Associate Chief Counsel (Financial Institutions & Products), Deepan Patel, (202) 317-3423, or Charles Culmer, (202) 317-4528 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document contains amendments to the Income Tax Regulations (26 CFR part 1) under section 451(b) and (c) of the Internal Revenue Code (Code).

On December 22, 2017, section 451(b) and (c) were amended by section 13221 of Public Law 115-97 (131 Stat. 2054), commonly referred to as the Tax Cuts and Jobs Act (TCJA). Section 451(b) was amended to provide that, for a taxpayer using an accrual method of accounting (accrual method taxpayer), the all events test for an item of gross income, or portion thereof, is met no later than when the item, or portion thereof, is included in revenue for financial accounting purposes on an applicable financial statement (AFS). Section 451(c) was amended to provide that an accrual method taxpayer may use the deferral method of accounting provided in section 451(c) for advance payments. Unless otherwise indicated, all references to section 451(b) and section 451(c) hereinafter are references to section 451(b) and section 451(c), as amended by the TCJA.

I. Section 451(b)

In general, section 451(a) provides that the amount of any item of gross income is included in gross income for the taxable year in which it is received by the taxpayer, unless, under the method of accounting used in computing taxable income, the amount is to be properly accounted for as of a different period. Under § 1.451-1(a), accrual method taxpayers generally include items of income in gross income in the taxable year when all the events occur that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy (all events test). All the events that fix the right to receive income occur when (1) the required performance takes place, (2) payment is due, or (3) payment is made, whichever happens first. Revenue Ruling 2003-10, 2003-1 C.B. 288; Revenue Ruling 84-31, 1984-1 C.B. 127; Revenue Ruling 80-308, 1980-2 C.B. 162.

Section 451(b)(1)(A) provides that, for an accrual method taxpayer, the all events test for an item of gross income, or portion thereof, is met no later than when the item, or portion thereof, is included as revenue in an AFS (AFS Income Inclusion Rule).

Section 451(b)(1)(B) lists exceptions to the AFS Income Inclusion Rule. The AFS Income Inclusion Rule does not apply to taxpayers that do not have an AFS for a taxable year or to any item of gross income from a mortgage servicing contract.

Section 451(b)(1)(C) codifies the all events test, stating that the all events test is met for any item of gross income if all the events have occurred which fix the right to receive such income and the amount of such income can be determined with reasonable accuracy.

Section 451(b)(2) provides that the AFS Income Inclusion Rule does not apply for any item of gross income the recognition of which is determined using a special method of accounting, “other than any provision of part V of subchapter P (except as provided in clause (ii) of paragraph (1)(B)).”

Section 451(b)(3) defines an AFS, as referenced in section 451(b)(1)(A)(i), by providing a hierarchical list of financial statements.

Section 451(b)(4) provides that for purposes of section 451(b), in the case of a contract which contains multiple performance obligations, the allocation of the transaction price to each performance obligation is equal to the amount allocated to each performance obligation for purposes of including such item in revenue in the taxpayer's AFS.

Section 451(b)(5) provides that, if the financial results of a taxpayer are reported on the AFS for a group of entities, the group's financial statement shall be treated as the AFS of the taxpayer.

II. Section 451(c)

Section 451(c) provides special rules for the treatment of advance payments. Section 451(c)(1)(A) provides the general rule requiring an accrual method taxpayer to include an advance payment in gross income in the taxable year of receipt. However, section 451(c)(1)(B) permits a taxpayer to elect to include any portion of the advance payment in gross income in the taxable year following the year of receipt to the extent income is not included in revenue in the AFS in the year of receipt. Section 451(c)(1)(B) generally codifies Revenue Procedure 2004-34, 2004-22 I.R.B. 991, which provided for a similar deferral period.

Section 451(c)(2)(A) provides the Secretary of the Treasury or his delegate (Secretary) with the authority to provide the time, form and manner for making the election under section 451(c)(1)(B), and the categories of advance payments for which an election can be made. Under section 451(c)(2)(B), the election is effective for the taxable year that it is first made and for all subsequent taxable years, unless the taxpayer receives the consent of the Secretary to revoke the election. Section 451(c)(3) provides that the deferral election does not apply to advance payments received in the taxable year that the taxpayer ceases to exist.

Section 451(c)(4)(A) defines advance payment for purposes of section 451(c). Under section 451(c)(4)(A), the term advance payment means any payment that meets the following three requirements: (1) The full inclusion of the payment in gross income in the year of receipt is a permissible method of accounting; (2) any portion of the

advance payment is included in revenue in an AFS for a subsequent tax year; and (3) the advance payment is for goods, services, or such other items that the Secretary has identified. Section 451(c)(4)(B) lists certain payments that are excluded from the definition of advance payment and gives the Secretary the authority to identify other payments to be excluded from the definition. Section 451(c)(4)(C) provides a special definition of the term “receipt” for purposes of the definition of advance payment, and section 451(c)(4)(D) states that rules similar to those for allocating the transaction price among performance obligations in section 451(b)(4) also apply for purposes of section 451(c).

III. Prior Guidance

On April 12, 2018, the Department of the Treasury (Treasury Department) and the IRS issued Notice 2018-35, 2018-18 I.R.B. 520, providing interim guidance on the treatment of advance payments and requesting suggestions for future guidance under section 451(b) and section 451(c). On September 27, 2018, the Treasury Department and the IRS issued Notice 2018-80, 2018-42 I.R.B. 609, announcing that the Treasury Department and the IRS intend to issue proposed regulations providing that accrued market discount is not includible in income under section 451(b).

On September 9, 2019, the Treasury Department and the IRS published proposed regulations under section 451(b) (REG-104870-18, 84 FR 47191) (proposed section 451(b) regulations) and proposed regulations under section 451(c) (REG-104554-18, 84 FR 47175) (proposed section 451(c) regulations), referred to collectively hereinafter as the “proposed regulations.” The notices of proposed rulemaking for section 451(b) and (c) reflect consideration of the comments received in response to Notice 2018-35.

A public hearing on the proposed regulations was held on December 10, 2019, at which two speakers provided testimony. The Treasury Department and the IRS received approximately ten written comments responding to the proposed regulations.

After the comment period for the proposed regulations closed, the Treasury Department and the IRS received a comment letter regarding the allocation of transaction price for contracts that include both income subject to section 451 and income subject to a special method of accounting provision, specifically, section 460. In response to these comments, in the Explanation of Provisions of a notice of proposed rulemaking (REG-132766-18) that was published on August 5, 2020 (85 FR 47508), the Treasury Department and the IRS suggested allocation rules and requested comments regarding the application of section 451(b)(2) and (4) to contracts with income that is accounted for in part under proposed § 1.451-3 and in part under a special method of accounting. No formal comments were received regarding these suggested rules.

Comments received before these regulations were substantially developed, including all comments received on or before the deadline for comments on November 8, 2019, were carefully considered in developing these regulations. Copies of the comments received are available for public inspection at

http://www.regulations.gov

or upon request. After consideration of the comments received and the testimony at the public hearing, this Treasury decision adopts the proposed regulations as revised in response to such comments and testimony. The comments and the revisions are discussed in the Summary of Comments and Explanation of Revisions section of this preamble.

Summary of Comments and Explanation of Revisions

I. Overview

This Summary of Comments and Explanation of Revisions section summarizes the formal written comments and some of the informal commentary, both in writing and at public events, addressing the proposed regulations. Comments merely summarizing or interpreting the proposed regulations or recommending statutory revisions generally are not discussed in this preamble. Similarly, comments outside the scope of this rulemaking generally are not addressed in this Summary of Comments and Explanation of Revisions section.

II. Comments and Explanation of Revisions Regarding the Proposed Section 451(b) Regulations

A. Realization and Recognition

As noted in the preamble to the proposed section 451(b) regulations, footnote 872 of the Conference Report to the TCJA states that section 451(b) was not intended to revise the rules associated with when an item is realized for Federal income tax purposes and does not require the recognition of income in situations where the Federal income tax realization event has not taken place. See H.R. Rep. No. 115-466, at 428 fn. 872 (2017) (Conf. Rep.). As also noted in the preamble to the proposed section 451(b) regulations, footnote 874 of the Conference Report provides, by way of example, that the timing rules of section 451(b) apply to unbilled receivables for partially performed services.

Id.

at 428 fn. 874.

Commenters provided little commentary on footnote 874, except to state that it is contrary to footnote 872. Instead, the commenters presented two views. First, some commenters highlighted footnote 872 and cited case law to support the claim that a realization event is, and has always been, a prerequisite for income recognition. These commenters acknowledged, however, that the case law frames the issue not in terms of “realization” but rather in terms of whether a seller has a fixed right to income under the all events test.

Second, some commenters suggested definitions of realization. However, these recommended definitions differ, particularly as to whether realization applies to the provision of services. For example, some commenters described realization as applying to both contracts for the provision of services and contracts for the sale of goods, and stated that realization occurs when the taxpayer has a “fixed and unconditional right to payment” under the contract. One commenter reasoned that existing judicial precedents require realization without distinguishing between whether the income is for the performance of services or the sale of property. Another commenter asserted that realization means there has been a sale or disposition under section 1001(a), suggesting that realization applies only to the sale of property. In sum, these commenters suggested that the proposed section 451(b) regulations do not give effect to footnote 872 in the Conference Report and ask that the final regulations either explicitly define realization or clarify when realization occurs in certain circumstances, such as where a taxpayer produces goods for customers or where a taxpayer provides non-severable services to customers.

The Treasury Department and the IRS have considered these comments and decline to define the term realization in the final regulations. Congress did not explicitly define realization in the Conference Report. Some of the suggested definitions of realization, particularly the ones equating realization with the all events test, would nullify the AFS Income Inclusion Rule entirely, which is clearly contrary to Congress' intent. Accordingly, it is reasonable to conclude that Congress intended a different concept of realization that would give full effect to

the statute. Further, the final regulations do not clarify when realization occurs in specific circumstances. Realization is a factual determination that, while closely aligned with the all events test, has different meanings in different contexts.

Section 451 is a timing provision and the amendments to section 451(b)(1)(A) by TCJA were intended to modify the timing of income to require an accrual method taxpayer with an AFS to treat the right to income as fixed, under the all events test, no later than the time at which the item (or portion thereof) is taken into account in its AFS. The statute thus reflects Congress' intent to incorporate timing concepts from the financial reporting rules in the tax timing rules for including items in gross income. It does not seek to answer whether the AFS income inclusion has been realized. Accordingly, the focus of the final regulations is on the appropriate taxable year of AFS income inclusion.

B. Scope of AFS Income Inclusion Rule

1. Proposed § 1.451-3(b): General Rule

The general AFS Income Inclusion Rule in the proposed section 451(b) regulations provides that, if a taxpayer includes an item of gross income, or portion thereof, in revenue in the taxpayer's AFS, the taxpayer must include the item in gross income under section 451(b). In addition to commenting that the general rule in the proposed section 451(b) regulations potentially overrides the realization requirement, contrary to footnote 872 of the Conference Report, commenters suggested that the rule is overbroad and could cause taxpayers to incur a tax liability without having the money to pay the liability.

The Treasury Department and the IRS note that the potential to incur a tax liability without having the money to pay the liability is inherent in the accrual method. However, the Treasury Department and the IRS acknowledge that the proposed AFS Income Inclusion Rule could exacerbate this situation and that the proposed rule could result in inclusions that would be inconsistent with footnote 872 of the Conference Report. Accordingly, the final regulations provide that, under the AFS Income Inclusion Rule, the all events test under § 1.451-1(a) for any item of gross income, or portion thereof, is met no later than when that item, or portion thereof, is “taken into account as AFS revenue.” In determining when an item of gross income is “taken into account as AFS revenue,” AFS revenue is reduced by amounts that the taxpayer does not have an enforceable right to recover if the customer were to terminate the contract on the last day of the taxable year. The determination of whether the taxpayer has an enforceable right to recover amounts of AFS revenue is governed by the terms of the contract and applicable Federal, state, or international law, and includes amounts recoverable in equity and liquidated damages.

The revised rule is designed to reconcile the intended preservation of the realization concept, consistent with footnote 872 of the Conference Report, with the intended scope of section 451(b), as illustrated in footnote 874 of the Conference Report. The revised rule is also consistent with concepts illustrated in Example 4 in the Joint Committee on Taxation, General Explanation of Public Law 115-97 (JCS-1-18) at 163 (Dec. 20, 2018) (Blue Book). In the example, the taxpayer enters into a contract with a customer for a customized piece of machinery. Under the contract, the taxpayer will not invoice the customer until the item is delivered to the customer, the customer accepts the machinery, and title to the machinery has transferred to the customer. The contract specifically provides that, if the customer withdraws from the agreement, the taxpayer has an enforceable right to payment as the work is performed, even if the contract is not completed. The taxpayer does not complete the machinery in year one but includes an amount in revenue in its AFS in year one. Example 4 concludes that, under the AFS Income Inclusion Rule, the taxpayer is required to recognize the amount in year one. The revised AFS Income Inclusion Rule in the final regulations incorporates the key elements reflected in Example 4.

To reduce any additional compliance burdens, the final regulations provide an alternative method to determine when an item of gross income is treated as “taken into account as AFS revenue” under the AFS Income Inclusion Rule. Under the “alternative AFS revenue method”, the taxpayer does not reduce AFS revenue by amounts that the taxpayer lacks an enforceable right to recover if the customer were to terminate the contract on the last day of the taxable year. The alternative AFS revenue method is a method of accounting that applies to all items of gross income in the trade or business that are subject to the AFS income inclusion rule. Taxpayers using the alternative AFS revenue method may also use the AFS cost offset method provided in the final regulations.

Under the final regulations two additional adjustments to AFS revenue are made in determining whether an item of gross income is treated as “taken into account as AFS revenue.” These adjustments apply both under the AFS Income Inclusion Rule and under the alternative AFS revenue method. First, if the transaction price, as defined in § 1.451-3(a)(14), was increased because a significant financing component is deemed to exist under the standards the taxpayer uses to prepare its AFS, then any AFS revenue attributable to such increase is disregarded. In such situations, total AFS revenue taken into account over the term of the contract exceeds the stated consideration in the contract and such excess is, for AFS purposes, offset by a corresponding interest expense. Because such excess is generally not imputed income for Federal income tax purposes and a deduction for the AFS interest expense is generally not imputed for Federal income tax purposes, it is necessary to adjust AFS revenue to prevent the improper acceleration, or overreporting, of gross income. If situations arise in which imputed income and imputed deductions are also required for Federal income tax purposes, an adjustment to AFS revenue is still appropriate as the amount and timing of the imputed income would be outside the scope of section 451 and the regulations thereunder. Second, to the extent that AFS revenue reflects a reduction for (1) amounts that are cost of goods sold or liabilities that are required to be accounted for under other provisions of the Code, such as section 461, including liabilities for allowances, rebates, chargebacks, rewards issued in credit card and other transactions and other reward programs, and refunds (for example, estimated returns based on historic practice), regardless of when any such amount is incurred (Liability Amounts); or (2) amounts anticipated to be in dispute or anticipated to be uncollectable, the taxpayer must increase AFS revenue by such amounts. The Treasury Department and the IRS have determined that adjustments for such amounts are necessary to prevent the taxpayer from effectively taking such amounts into account for Federal income tax purposes in a taxable year prior to the taxable year in which they are otherwise permitted to be taken into account under other provisions of the Code. Additionally, if AFS revenue is not adjusted for Liability Amounts in the taxable year that such amounts are otherwise permitted to be taken into account, then a taxpayer may obtain an improper double benefit by taking such amounts into account to reduce taxable income under another provision of the Code while also deferring an equal

amount of gross income to a later year under § 1.451-3. The AFS revenue adjustments in the final regulations do not preclude a taxpayer from accounting for trading stamps and premium coupons under § 1.451-4. However, the Treasury Department and the IRS are still evaluating whether the rules in § 1.451-4 should be modified or clarified in light of certain financial reporting changes under ASC 606.

On a separate issue relating to the scope of the AFS Income Inclusion Rule, taxpayers questioned, in light of the realization discussion in footnote 872, whether the AFS Income Inclusion Rule applies to the sale of goods. Since Example 4 of the Blue Book involves the sale of goods, it is reasonable to conclude that Congress intended for the AFS Income Inclusion Rule, as revised, to extend to contracts for the sale of goods. Accordingly, as with the proposed section 451(b) regulations, the final regulations provide that the AFS Income Inclusion Rule applies to contracts for the sale of goods.

2. Proposed § 1.451-3(b): Cost Offset for AFS Income Inclusions

Proposed § 1.451-3(b) does not provide for a cost offset when an amount is included under the AFS Income Inclusion Rule. The preamble to the proposed section 451(b) regulations discusses reasons for not providing a cost offset, including the potential for income distortions and Congressional intent that a cost offset not be provided. The preamble to the proposed section 451(b) regulations requests comments on this issue.

Multiple commenters proposed allowing an offset for the cost of goods sold (COGS) when income is included under the AFS Income Inclusion Rule. Commenters pointed out that the term “item of gross income” generally means total sales net of COGS. See, for example, § 1.61-3(a). Commenters also described situations where income might be distorted by inclusions in early years of a multi-year contract with the costs being allowed in later years without income to offset. Commenters expressed concern that, in these situations, or more generally, the AFS Income Inclusion Rule might operate as a tax on gross receipts.

One commenter suggested that the statute uses the AFS as a backstop to timing recognition of revenue because the AFS provides a good standard by which to determine when a taxpayer receives an economic benefit. The commenter acknowledged that there has been a policy interest in achieving greater book-tax conformity in a variety of areas. The commenter recommended that, if the final regulations use the AFS to measure the receipt of an economic benefit, then the final regulations also should reflect the AFS standards that require certain items of income be reported “net” of offsetting items.

Commenters also noted that, for AFS purposes, credit card issuers generally report interchange fees net of estimated reward costs and report credit card late fees net of estimated uncollectable amounts. Commenters explained that reward costs and uncollectable credit card late fees “are so closely aligned with the realization of income that AFS standards require those items to be presented separately in the revenue section of the income statement but concurrently as to timing.” One commenter expressed concern that not reducing interchange fees by estimated reward costs and credit card late fees by estimated uncollectable amounts in determining the amount of income recognized under the AFS Income Inclusion Rule would result in the inclusion of more income for Federal income tax purposes than was reported on the AFS.

Accordingly, commenters recommended that the final regulations provide that the all events test and the economic performance requirement under section 461 should be deemed to be met for items that are “closely aligned” with income amounts recognized under the AFS Income Inclusion Rule. Commenters explained that section 461 should be deemed to be met for items such as estimated reward costs and estimated uncollectable late fees to the extent these items are reported on the revenue section of the AFS as a reduction to amounts subject to the AFS Income Inclusion Rule. One commenter further explained that this treatment would be consistent with the clear reflection of income doctrine of section 446. Alternatively, one commenter recommended modifying the definition of transaction price under proposed § 1.451-3(c)(6) to reduce interchange fees by the amount of reward costs that satisfy section 461 and credit card late fees by amounts that are considered uncollectable for AFS purposes.

The Treasury Department and the IRS have considered these comments and have determined that a cost offset based on estimates of future costs would be inappropriate. As discussed in the preamble to the proposed section 451(b) regulations, allowing a cost offset based on estimated costs would be inconsistent with sections 461, 263A, and 471, and the regulations under those sections of the Code. In addition, a cost offset based on estimated costs would increase the possibility of income distortions as the costs of goods would effectively be recovered, through income deferral, prior to the taxable year in which the cost was actually incurred.

However, the Treasury Department and the IRS agree with comments suggesting that taxpayers should be afforded the flexibility of applying an offset for costs incurred against AFS income inclusions from the future sale of inventory, the “AFS cost offset method.” Accordingly, a taxpayer that uses the AFS cost offset method determines the amount of gross income includible for a year prior to the year in which ownership of inventory transfers to the customer by reducing the amount of revenue it would otherwise be required to include under the AFS Income Inclusion Rule for the taxable year (AFS inventory inclusion amount) by the cost of goods related to the item of inventory for the taxable year, the “cost of goods in progress offset.” The net result is the amount that is required to be included in gross income for that year under the AFS Income Inclusion Rule. The deferred revenue, that is, the revenue that was reduced by the cost of goods in progress offset for a taxable year prior to the taxable year that ownership of the item of inventory is transferred to the customer, is generally taken into account in the taxable year in which ownership of the item of inventory is transferred to the customer.

The final regulations provide that the cost of goods in progress offset for each item of inventory for the taxable year is calculated as (1) the cost of goods incurred through the last day of the taxable year, (2) reduced by the cumulative cost of goods in progress offset amounts attributable to the items of inventory that were taken into account in prior taxable years, if any. However, the cost of goods in progress offset cannot reduce the AFS inventory inclusion amount for the item of inventory below zero. Further, the cost of goods in progress offset attributable to one item of inventory cannot reduce the AFS inventory inclusion amount attributable to a separate item of inventory. Any cost of goods that were not used to offset AFS inventory inclusion amounts because they were subject to limitation are considered when the taxpayer determines the cost of goods in progress offset for that item of inventory in a subsequent taxable year.

The cost of goods in progress offset is determined by reference to the costs and expenditures related to each item of inventory produced or acquired for resale, which costs have been incurred

under section 461 and have been capitalized and included in inventory under sections 471 and 263A or any other applicable provision of the Code at the end of the year. However, the cost of goods in progress offset does not reduce the costs that are capitalized to the item of inventory produced or acquired for resale by the taxpayer under the contract. That is, while the cost of goods in progress offset reduces the AFS inventory inclusion amount, it does not affect how and when costs are capitalized to inventory under sections 471 and 263A or any other applicable provision of the Code or when those capitalized costs will be recovered. Instead, the cost of goods in progress offset serves only to reduce or “offset” any AFS income inclusion amounts for the item of inventory and defer such amounts to the taxable year in which ownership of the item of inventory is transferred to the customer.

The costs of goods comprising the cost of goods in progress offset must be determined by applying the inventory accounting methods used by the taxpayer for Federal income tax purposes. A taxpayer must calculate its cost of goods in progress offset by reference to all costs that the taxpayer has permissibly capitalized and allocated to items of inventory under its inventory method, but may not consider costs that are not properly capitalized under such method.

In the taxable year in which ownership of the item of inventory is transferred to the customer, any revenue deferred by way of a prior year cost offset is included in gross income in the year of the transfer along with any additional revenue that is otherwise required to be included in gross income under the AFS Income Inclusion Rule for such year. Although no cost offset is permitted in such year, the taxpayer would recover costs capitalized and allocated to the item of inventory transferred as cost of goods sold in such year in accordance with sections 471 and 263A or any other applicable provision of the Code. However, if in a taxable year prior to the taxable year in which ownership of the item of inventory is transferred to the customer, either (A) the taxpayer dies or ceases to exist in a transaction other than a transaction to which section 381(a) applies, or (B) the taxpayer's obligation to the customer with respect to the item of inventory ends other than in a transaction to which 381(a) applies or certain section 351(a) transactions between members of the same consolidated group, then all payments received for the item of inventory that were not previously included in gross income as a result of the application of the cost offset rules are required to be included in gross income in such year.

The Treasury Department and the IRS adopted this approach in the final regulations because the AFS cost offset method provides options for taxpayers. All taxpayers that are required to account for income from the sale of inventory under the AFS income inclusion rule and that report AFS revenue in a taxable year prior to the taxable year in which ownership of the item of inventory is transferred to the customer will generally be required to accelerate income inclusions under such rule. However, taxpayers have the option of using the AFS cost offset method to reduce the amount of income they are required to accelerate under such rule. The AFS cost offset allows taxpayers to reasonably match income inclusions and incurred cost of goods, and more clearly reflects income.

The final regulations adopt a cost of goods sold offset based on incurred costs because the approach is consistent with § 1.61-3 and more objective than a cost of goods sold offset based on projected future costs. In addition, the AFS cost offset method provides a degree of parity for sellers of goods with service providers who deduct costs as incurred without capitalizing the costs to inventory. A cost offset based on projected future cost of goods sold was rejected because it is inconsistent with sections 461(h), 263A and 471, and the regulations under those sections of the Code. Further, Congress rejected the deferral method for advance payments in former § 1.451-5(c), which contained a cost of goods sold offset for estimated future costs. See Conf. Rep. at 429 fn. 880.

The AFS cost offset method is a method of accounting that applies to all items of income eligible for the AFS cost offset method in the trade or business. The method applies to items at the trade or business level so that taxpayers can choose to apply the method only to trades or businesses where the burden of determining costs incurred relative to the related reduction in AFS income inclusion amount warrants the adoption of the method. If a taxpayer uses the AFS cost offset method for a trade or business it must use the method for all eligible items in that trade or business. Further, if a taxpayer uses the AFS cost offset method, it must also use the advance payment cost offset method in § 1.451-8(e). The advance payment cost offset method is discussed later in this preamble. Special coordination rules exist for taxpayers that use the AFS cost offset method and the advance payment cost offset method and that have income from the sale of an item of inventory that is required to be accounted for under both §§ 1.451-3 and 1.451-8 because certain payments received for such item meet the definition of an advance payment under § 1.451-8(a)(1). See § 1.451-3(c)(1) for such coordination rules.

The AFS cost offset method reduces the amount of income from the sale of an item of inventory that is required to be accelerated under the AFS Income Inclusion Rule by an amount of incurred cost of goods related to the item. However, the offsets to interchange fees and credit card late fees recommended by the commenters are based on estimated reward costs and uncollectable late fees rather than incurred costs of goods. Accordingly, the final regulations do not allow a cost offset for interchange fees, credit card late fees, and similar items of revenue that are subject to the AFS Income Inclusion Rule and reported net of estimated future amounts for AFS purposes.

3. Proposed § 1.451-3(c)(4) and (c)(6)(ii): Revenue, Transaction Price and Increases in Consideration

Proposed § 1.451-3(c)(4) provides that, for the AFS Income Inclusion Rule, revenue means all transaction price amounts includible in gross income under section 61 of the Code. Proposed § 1.451-3(c)(6) provides that the transaction price is the gross amount of consideration to which a taxpayer expects to be entitled for AFS purposes in exchange for transferring goods, services, or other property, but not including, among other things, “increases in consideration” to which a taxpayer's entitlement is contingent on the occurrence or nonoccurrence of a future event for the period in which the amount is contingent.

Commenters expressed confusion about the phrase “increases in consideration” because the definition of transaction price otherwise refers to “amounts” and does not distinguish between increases and decreases. Commenters asserted that there is no reason to treat “increases” in consideration different from other consideration because all consideration is not realized until the taxpayer has a fixed right to payment. Commenters concluded that any portion of the contract price subject to a contractual contingency, for example, a future performance, is excluded from the transaction price until the contingency is satisfied. In addition, one commenter noted that it is unclear when there is a contingent “increase” in consideration,

and taxpayers could revise the contract terms to meet this requirement.

The Treasury Department and the IRS agree with these comments. The term “increases in consideration” was meant to signal income items that are subject to a condition precedent, such as bonus payments that require complete performance before the taxpayer is entitled to the bonus payment. The final regulations have been revised to remove the reference to “increases in consideration” entirely. The concept is now subsumed by the general rule that, to determine when an item of gross income is “taken into account as AFS revenue” under the AFS Income Inclusion Rule, AFS revenue is reduced by amounts that the taxpayer does not have an enforceable right to recover if the customer were to terminate the contract at the end of the taxable year. If an amount is contingent due to a condition precedent, such as with some bonus payments, and the taxpayer would not have an enforceable right to recover such amount if the customer were to terminate the contract at the end of the taxable year, the AFS Income Inclusion Rule does not require the taxpayer to include such amount in gross income in the current year.

4. Proposed § 1.451-3(c)(6)(ii): Rebuttable Presumption

Proposed § 1.451-3(c)(6)(ii) provides a rebuttable presumption that amounts included in revenue in an AFS are presumed to not be contingent on the occurrence or nonoccurrence of a future event unless, upon examination of all the facts and circumstances existing at the end of the taxable year, it can be established to the satisfaction of the Commissioner that the amount is contingent on the occurrence or nonoccurrence of a future event.

Commenters requested that the final regulations remove the rebuttable presumption regarding contingent consideration. Commenters reasoned that the rebuttable presumption imposes a higher standard of proof upon taxpayers than is ordinarily required to establish that consideration is contingent. Additionally, commenters noted that basing the presumption on the treatment of the consideration for financial reporting purposes is not sensible because the financial accounting rules do not make the conclusion dependent on whether the consideration is or is not contingent on the occurrence or non-occurrence of a future event. Rather, under the Financial Accounting Standards Board (FASB) and International Accounting Standards Board, Accounting Standards Codification (ASC) Topic 606 and International Financial Reporting Standards (IFRS) 15,

Revenue from Contracts with Customers

(collectively, ASC 606), the recognition of contingent consideration is based on a determination of the likely outcome of the contingency. Accordingly, commenters recommended that the final regulations eliminate the presumption in favor of noncontingency.

As noted earlier, the final regulations have been revised to remove the reference to “contingent consideration” entirely. The concept is now subsumed by the general rule that, to determine when an item of gross income is “taken into account as AFS revenue” under the AFS Income Inclusion Rule, AFS revenue is reduced by amounts that the taxpayer does not have an enforceable right to recover if the customer terminates the contract at the end of the taxable year. Given this change, the final regulations remove the rebuttable presumption that a taxpayer has an enforceable right to amounts included in AFS revenue.

5. Proposed § 1.451-3(c)(6)(ii): Enforceable Right to Payment

Commenters requested that the final regulations clarify or remove the rule in proposed § 1.451-3(c)(6)(ii) that treats amounts for which the taxpayer has an “enforceable right to payment” for performance completed to date as not contingent on the occurrence or nonoccurrence of a future event. First, commenters reasoned that the rule is ambiguous, resulting in controversies with exam. Second, commenters asserted that, assuming the phrase “enforceable right to payment” is based on the financial statement rules in ASC 606, this standard effectively overrides the tax realization requirement requiring a fixed, unconditional right to payment. Further, commenters reasoned that the rule is inconsistent with the exception for increases in consideration to which a taxpayer's entitlement is contingent on the occurrence or nonoccurrence of a future event.

The Treasury Department and the IRS agree with these comments. As discussed earlier, the final regulations modify the general AFS Income Inclusion Rule by reducing the AFS revenue that is accelerated and included in gross income. Under the AFS Income Inclusion Rule, to determine when the item of gross income is “taken into account as AFS revenue,” AFS revenue is reduced by amounts that the taxpayer does not have an “enforceable right” to recover if the customer were to terminate the contract on the last day of the taxable year. The term “enforceable right” is specifically defined in § 1.451-3(a)(9) as any right that a taxpayer has under the terms of a contract or under applicable federal, state, or international law, including rights to amounts recoverable in equity or liquidated damages.

6. Proposed § 1.451-3(c)(6)(iii): Reductions for Amounts Subject to Section 461 and Disputed Income

Proposed § 1.451-3(c)(6)(iii) provides that the “transaction price” does not include reductions for amounts subject to section 461, including amounts anticipated to be in dispute, returns, and rewards issued in credit card transactions. One commenter recommended that the final regulations clarify that rewards issued in credit card transactions are subject to section 461 and do not reduce original issue discount (OID) income in any circumstance, regardless of the structure of the credit card program. The commenter requested this clarification because taxpayers have taken different positions on the treatment of these rewards while the IRS has taken the position that rewards do not reduce OID income. The commenter stated that the better approach is to treat these rewards as liabilities under section 461. The commenter further explained that treating these rewards as amounts subject to section 461 in all circumstances would create uniformity among credit card issuers, reduce controversy between taxpayers and the IRS, and ease the compliance burden on taxpayers by eliminating the need for a facts and circumstances analysis of each credit card program. The Treasury Department and the IRS agree with the commenter and have modified the final regulations in § 1.451-3(b)(2)(i)(A)(

1

) to clarify that rewards issued in a credit card transaction are items subject to section 461.

Commenters also questioned whether the AFS Income Inclusion Rule modifies the treatment of income amounts subject to an actual dispute or a clerical error (disputed income amounts). The AFS Income Inclusion Rule does not modify the treatment of disputed income amounts. The principles set forth in Revenue Ruling 2003-10, 2003-1 C.B. 288, continue to apply. For example, an accrual method taxpayer does not accrue gross income in the taxable year of sale if, during the year of sale, the customer disputes its liability to the taxpayer. In addition, if an accrual method taxpayer overbills a customer due to a clerical mistake, and the customer disputes the liability in the subsequent taxable year, the taxpayer must accrue gross income in the taxable year of sale for the correct amount.

Lastly, if a taxpayer ships excess quantities of goods and the customer does not dispute the shipment and agrees to pay for the excess quantities of goods, the taxpayer accrues gross income in the amount of the agreed payment in the taxable year of the sale.

In response to these comments, the final regulations clarify that, under the AFS Income Inclusion Rule, to the extent that AFS revenue was reduced for amounts anticipated to be in dispute or anticipated to be uncollectable, AFS revenue is increased by such amounts. Accordingly, although ASC 606 reduces the transaction price for anticipated disputes to determine the amount of revenue to include on an AFS, see ASC 606-10-32-6, AFS revenue is increased for amounts anticipated to be in dispute or anticipated to be uncollectable, because those amounts are included in gross income until they are actually disputed.

C. Proposed § 1.451-3(c)(5): Special Method of Accounting

Proposed § 1.451-3(c)(5) provides a non-exhaustive list of examples of special methods of accounting to which the AFS Income Inclusion Rule generally does not apply. Commenters requested that the final regulations include the methods of accounting for notional principal contracts under § 1.446-3 and the timing rules for stripped bonds under section 1286 as examples of special methods of accounting. The Treasury Department and the IRS adopt these comments in the final regulations and have added additional special methods for clarification purposes. The list of special methods of accounting remains non-exhaustive.

D. Proposed § 1.451-3(d): Exceptions to the AFS Income Inclusion Rule

Proposed § 1.451-3(d) describes the exceptions to the AFS Income Inclusion Rule. The proposed rule clarifies that the AFS Income Inclusion Rule does not apply unless all of the taxpayer's entire taxable year is covered by an AFS. In addition, the AFS Income Inclusion Rule does not cover items of income in connection with a mortgage servicing contract. A commenter requested that an exception be added for any amount that has not yet been realized for Federal income tax purposes. As discussed earlier, the Treasury Department and the IRS decline to adopt this suggestion because providing rules on realization is beyond the scope of these final regulations.

E. Proposed § 1.451-3(g): Contracts With Multiple Performance Obligations

1. Proposed § 1.451-3(g): Allocation of Transaction Price to Contracts With Multiple Performance Obligations Subject to Section 451(b)

Proposed § 1.451-3(g) provides that if a taxpayer's contract with a customer has multiple performance obligations subject to section 451(b), transaction price is allocated to performance obligations as transaction price is allocated to performance obligations in the taxpayer's AFS.

The final regulations clarify that each performance obligation yields an item of gross income that must be accounted for separately under the AFS Income Inclusion Rule. When a contract contains multiple performance obligations, to determine the amount of gross income allocated to each performance obligation, the transaction price determined under the taxpayer's applicable accounting principles, is allocated to each corresponding item of gross income in accordance with how the transaction price is allocated to each performance obligation for AFS purposes. If the accounting standards used to prepare the AFS identify a single performance obligation that yields more than one corresponding item of gross income, the portion of the transaction price amount that is allocated to the single performance obligation for AFS purposes must be further allocated among the corresponding items of gross income using any reasonable method.

The final regulations simplify the definition of transaction price. The final regulations define the term transaction price to mean the total amount of consideration to which a taxpayer is, or expects to be, entitled from all performance obligations under a contract. The transaction price is determined under the standards the taxpayer uses to prepare its AFS. Accordingly, adjustments to the transaction price that were reflected in the transaction price definition in the proposed regulations have, to the extent relevant under these final regulations, been moved to operative rules to ensure clarity. See § 1.451-3(b)(2) and (d)(3).

In addition, the final regulations clarify how the transaction price should be allocated to the extent the transaction price includes a reduction for liabilities, amounts anticipated to be in dispute or anticipated to be uncollectable, or a significant financing component that is deemed to exist under the standards the taxpayer uses to prepare its AFS. The final regulations clarify that the taxpayer must determine the specific performance obligation to which such reduction relates and increase the transaction price allocable to the corresponding item of gross income by the amount of the reduction (specific identification approach). If it is impracticable from the taxpayer's records to use the specific identification approach, the final regulations allow taxpayers to use any reasonable method to allocate the amount to the items of gross income in the contract. The final regulations also provide that a pro-rata allocation of this amount across all items of gross income under the contract based on the relative transaction price amounts allocated to the items for AFS purposes is a reasonable method.

Similarly, the final regulations clarify how the transaction price should be allocated if the transaction price was increased because a significant financing component is deemed to exist under the standards the taxpayer uses to prepare its AFS. In this situation, the taxpayer must determine the specific performance obligation to which such amount relates and decrease the transaction price amount allocable to the corresponding item of gross income by such amount (the “specific identification approach”). If it is impracticable from the taxpayer's records to use the specific identification approach, the taxpayer may use any reasonable method to allocate such amount to the items of gross income in the contract. The final regulations provide that a pro-rata allocation of such amount across all items of gross income under the contract based on the relative transaction price amounts allocated to the items for AFS purposes is a reasonable method.

2. Proposed § 1.451-3(g): Contracts With Income Subject to § 1.451-3 and Income Subject to a Special Method of Accounting

In the proposed regulations, the Treasury Department and the IRS requested comments on the allocation of the transaction price for contracts that include both income subject to section 451 and income subject to a special method of accounting provision, specifically, section 460. A commenter to the proposed regulations suggested that the allocation provisions under section 460 and the regulations thereunder, and not section 451(b)(4), should control the amount of gross income from a long-term contract that is accounted for under section 460. The commenter noted that using this approach is appropriate in light of section 451(b)(2), which reflects Congress's intent to not disturb the treatment of amounts for which the

taxpayer uses a special method of accounting.

The Treasury Department and the IRS believe that a rule is necessary to address the application of section 451(b)(2) and (4) to contracts with income that is accounted for in part under § 1.451-3 and in part under a special method of accounting and suggested rules for public comment in the preamble of a separate notice of proposed rulemaking published in the

Federal Register

on August 5, 2020 (85 FR 47508). The suggested rules provided that if an accrual method taxpayer with an AFS has a contract with a customer that includes one or more items of gross income subject to a special method of accounting (as defined in proposed § 1.451-3(c)(5)) and one or more items of gross income subject to section 451, the allocation rules under section 451(b)(4) do not apply to determine the amount of each item of gross income that is accounted for under the special method of accounting provision. Rather, the taxpayer first allocates the transaction price to the item(s) of gross income subject to a special method of accounting (as determined under the special method of accounting). The remainder of the transaction price, the “residual amount”, is then allocated to the items of gross income that are subject to § 1.451-3. To the extent the contract contains more than one item of gross income that is subject to section 451, the residual amount would be allocated to each such item in proportion to the amounts allocated to the corresponding performance obligations for AFS purposes. The Treasury Department and the IRS requested comments on these suggested allocation rules. However, no formal comments were received regarding these suggested rules.

The final regulations largely adopt the rules suggested in the preamble to the separate notice of proposed rulemaking published in the

Federal Register

on August 5, 2020 (85 FR 47508). Accordingly, the final regulations provide that the transaction price allocation rule in § 1.451-3(d)(1) does not apply to determine the amount of each item of gross income that is subject to a special method of accounting. Rather, the final regulations provide that the transaction price is first allocated to items of gross income subject to a special method of accounting, as determined under the special method of accounting. For this purpose, a special method of accounting has the meaning set forth in § 1.451-3(a)(13), except as otherwise provided in guidance published in the Internal Revenue Bulletin (see § 601.601(d)).

To determine the transaction price allocated to items of gross income subject to a special method of accounting, the taxpayer must first adjust the AFS transaction price by the amounts described in the final paragraph of part II.B.1 of this Summary of Comments and Explanation of Revisions. Accordingly, if the AFS transaction price includes a reduction for cost of goods sold, liabilities, amounts expected to be in dispute or anticipated to be uncollectible, or a significant financing component that exists under the standards the taxpayer uses to prepare its AFS, the taxpayer must increase the transaction price amount by the amount of such reduction. If the AFS transaction price has been increased because a significant financing component exists under the standards the taxpayer uses to prepare its AFS, the taxpayer must decrease the transaction price amount by the amount of such increase.

After the taxpayer makes the adjustments to the transaction price described earlier, the taxpayer first allocates such amount to the item(s) of gross income subject to a special method of accounting, and then allocates the remainder (residual amount) to the item(s) of gross income that are subject to § 1.451-3. If the contract, contains more than one item of gross income that is subject to § 1.451-3, the taxpayer allocates the residual amount to these items in proportion to the amounts allocated to the corresponding performance obligations for AFS purposes or as otherwise provided in guidance published in the Internal Revenue Bulletin (see § 601.601(d)).

F. Proposed § 1.451-3(i): Special Ordering Rule for Certain Items of Income for Debt Instruments

Under proposed § 1.451-3(i), if a fee is not treated by a taxpayer as discount or as an adjustment to the yield of a debt instrument over the life of the instrument (such as points) in its AFS, and the fee otherwise would be treated as creating or increasing OID for Federal income tax purposes (specified fee), then the rules in the proposed regulations under section 451(b) apply before the rules in sections 1271 through 1275 and the corresponding regulations. Proposed § 1.451-3(i)(2) provides three examples of specified fees: Credit card late fees, credit card cash advance fees, and interchange fees (specified credit card fees). Interchange fees are sometimes labeled merchant discount in certain private label credit card transactions.

Commenters requested that the final regulations provide that promotional discount, which also is sometimes labeled merchant discount, is not a specified fee. Promotional discount arises when a credit card issuer charges a fee to a merchant as compensation for accepting a below market interest rate on a credit card balance during a promotional period. Commenters explained that promotional discount is generally included in income over a promotional or similar period on a taxpayer's AFS and, despite possible alternative labeling, is, in substance, an adjustment to the yield of a debt instrument for AFS purposes. The Treasury Department and the IRS agree that any fee that adjusts the yield of a debt instrument for AFS purposes over the life of the instrument or another period should not be a specified fee. Therefore, the final regulations do not include the phrase “over the life of the instrument” in the definition of a specified fee but add the phrase “spread over a period of time” to clarify the definition. Thus, a fee that adjusts the yield of a debt instrument over a promotional or similar period for AFS purposes, such as promotional discount, is not a specified fee under the final regulations.

One commenter agreed that section 451(b) was not intended to affect the application of the general OID timing rules to OID other than for certain fees that are not treated as discount for AFS purposes, including the specified credit card fees. Accordingly, the commenter agreed with the rules in proposed § 1.451-3(i) and the inclusion of the general OID timing rules as a special method of accounting. Except as provided in the preceding paragraph, the definition of specified fees in the proposed regulations is adopted in the final regulations.

G. Proposed § 1.451-3(k): Cumulative Rule for Multi-Year Contracts

The proposed regulations provide that for a multi-year contract, a taxpayer must take into account the cumulative amounts included in income in prior taxable years on the contract in order to determine the amount to be included for the taxable years remaining in the contract. The proposed regulations contain two examples that illustrate this rule.

The final regulations clarify that if the item of gross income from a multi-year contract is from the sale of an item of inventory and the taxpayer uses the AFS cost offset method, the taxpayer must first determine the “AFS inventory

inclusion amount” for the taxable year. The taxpayer determines the AFS inventory inclusion amount for the taxable year by first taking the greater of: (1) The cumulative amount of revenue from the item of inventory that satisfies the all events test under § 1.451-1(a) through the last day of the taxable year, less the portion of any advance payment received that is deferred to a subsequent taxable year under § 1.451-8, if applicable, or (2) the cumulative amount of revenue from the item of inventory that is treated as taken into account as AFS revenue through the last day of the taxable year and identifies the larger of the two amounts or if the two amounts are equal, the equal amount. The taxpayer then reduces such amount by the prior year AFS inventory inclusion amount for that item of inventory, if any, to determine the AFS inventory inclusion amount for the current taxable year. Lastly, the taxpayer reduces the AFS inventory inclusion amount for the taxable year by the cost of goods in progress offset for the taxable year (which generally equals the costs of goods in progress for the item of inventory as of the end of the year less the portion of such costs that were taken into account as a cost of goods in progress offset for a prior taxable year). This net amount is the amount required to be included in gross income in the taxable year. However, in the taxable year in which ownership of the item of inventory is transferred to the customer, the taxpayer performs the same “greater of” computation noted earlier, but rather than subtract the prior year AFS inventory inclusion amount for the item of inventory (which is gross of cost offsets) from the result of the “greater of” computation, the taxpayer subtracts all prior year gross income inclusions for the item of inventory from the result of the “greater of” computation. This net amount is the amount required to be included in gross income in the taxable year of ownership transfer. The effect of this computation is that any revenue reduced by a cost offset in a prior year is included in gross in the taxable year in which ownership of the item of inventory is transferred to the customer. Although no cost offset is permitted in such year, the taxpayer would recover costs capitalized and allocated to the item of inventory transferred as cost of goods sold in such year in accordance with sections 471 and 263A or any other applicable provision of the Code.

In the case of any other item of gross income from a multi-year contract, the taxpayer first compares the cumulative amount of the item of gross income that satisfies the all events test under § 1.451-1(a) through the last day of the taxable year with the cumulative amount of revenue from the item of gross income that is treated as taken into account as AFS revenue through the last day of the taxable year and identifies the larger of the two amounts (or, if the two amounts are equal, the equal amount). The taxpayer then reduces such amount by all prior year inclusion amounts attributable to the item of gross income, if any, to determine the amount required to be included in gross income in the current taxable year. Special coordination rules for applying § 1.451-8 are also provided to the extent certain payments received under a multi-year contract are advance payments. The analysis in the examples is updated to reflect the clarifications to the rule.

H. Proposed § 1.1275-2(l): OID Rule for Income Item Subject to Section 451(b)

Under proposed § 1.1275-2(l), notwithstanding any other rule in sections 1271 through 1275 and §§ 1.1271-1 through 1.1275-7, if, and to the extent, a taxpayer's item of income for a debt instrument is subject to the timing rules in proposed § 1.451-3(i) (including credit card late fees, credit card cash advance fees, or interchange fees), then the taxpayer does not take the item into account to determine whether the debt instrument has any OID. As a result, the taxpayer does not treat the item as creating or increasing any OID on the debt instrument. Commenters agree with these rules and note that these rules confirm that the current treatment of items other than specified fees will not be affected by section 451(b). The commenters also note that removing specified fees, including specified credit card fees, from the calculation of OID will permit taxpayers to apply only the rules of section 451(b) to these fees, without also having to apply the OID rules, thereby reducing taxpayer compliance burdens. Accordingly, the Treasury Department and the IRS adopt the rules in proposed § 1.1275-2(l) in the final regulations.

I. Other Comments

1. Burial Plots and Interment Rights

Commenters request clarification on the treatment of income from contracts with customers for the sale of burial plots or interment rights, on a pre-need basis (pre-need contracts). The terms of the pre-need contracts typically require the customer to make an initial down payment and pay the balance of the sales price over several years. If the purchaser cancels or fails to perform under the contract before the entire purchase price is paid, commenters represent that, under every state law, the taxpayer's sole remedy is to keep all or a portion of the installment payments previously received from the customer as liquidated damages. Commenters highlighted that there may be an extended period of time between the date the pre-need contract is executed and the date the taxpayer collects the full sales price from the customer.

Commenters represented that ASC 606 requires the entire transaction price from a pre-need contract, net of costs, to be included in revenue in the year in which the parties execute the contract. However, for Federal income tax purposes, commenters requested that the final regulations clarify that taxpayers with pre-need contracts should not include the unpaid balance of the transaction price in income in the taxable year the contract is executed under the AFS Income Inclusion Rule. In commenters' view, the sale of a burial plot should not be treated as a completed sale for tax purposes until the entire sales price of the burial plot is paid by the customer and ownership rights in the burial plot are transferred. Further, the taxpayer does not have an enforceable right to payment for the entire transaction price of the plot if the customer cancels or fails to perform under the contract.

Commenters concluded that these taxpayers should be entitled to recover any allocable cost basis in the burial plot before including in gross income any of the installment payments received from the customer. Commenters viewed the sale of a burial plot as the sale of an interest in real property and assert that the basis recovery rules of sections 1016 and 1001 apply to prepayments for burial plots. Under this approach, prepayments for the purchase price of a burial plot before the sale of the plot first decrease the taxpayer's basis in the burial plot. See § 1.1016-2(a). When the prepayments exceed the taxpayer's basis in the burial plot, the taxpayer recognizes the excess amount as gain. See § 1.1001-1(c)(1). Accordingly, commenters requested that the final regulations clarify the application of sections 1001 and 1016 to the sale of pre-need burial plots.

Commenters also requested clarification on the income recognition treatment of pre-need contracts with customers for the sale of interment rights. Commenters noted that the ASC 606 treatment for pre-need contracts for the sale of interment rights resemble the treatment for pre-need contracts for the sale of burial rights. Commenters viewed the receipt of any installment payments prior to the transfer of those rights and prior to the payment of the

entire transaction price to be controlled by sections 1001 and 1016, rather than by sections 451 and 471. Under this rationale, a taxpayer's treatment of the down payment and the installment payments from pre-need contracts in its AFS should not determine the timing of income for tax purposes. Instead, commenters suggested that the amounts received before the transfer of the interment rights should be viewed as a return of capital and a reduction in the taxpayer's basis in the interment space.

The IRS and the Treasury Department agree that the sale of burial plots and interment rights are governed by sections 1001 and 1016 but consider the determination of whether a sale has occurred to be a factual issue. If a sale has occurred under the facts and circumstances, any income resulting from the sale is realized under section 1001 and the right to the income is fixed, therefore the AFS Income Inclusion Rule does not result in the acceleration of AFS revenue. If the sale has not occurred, and the right to the future payments is extinguished if the customer cancels the contract, the AFS Income Inclusion Rule does not require acceleration because there is no enforceable right to the future payments if the contract is cancelled by the customer provided that the taxpayer is not using the alternative AFS revenue method in § 1.451-3(b)(2)(ii).

2. Book Percentage-of-Completion Method (Book PCM)

One commenter expressed interest in a Book PCM option as a special method of accounting that taxpayers with contracts accounted for using an over-time method of accounting for revenue under ASC 606 could elect to include the full amount of revenue reported on its AFS without regard to any offset or exception provided in these regulations, but with an offset for the allocable costs reported on its AFS, with some potential tax adjustments. Under ASC 606, the over-time method, where taxpayers recognize revenue over time (as opposed to at a point in time) is used for the following contracts where control over promised goods or services is transferred over time: (1) Where the customer controls the asset as it is created or enhanced by the entity's performance under the contract; (2) where the customer receives and consumes the benefits of the entity's performance as it performs under the contract; or (3) where the entity's performance creates or enhances an asset that has no alternative use to the entity, and the entity has the right to receive payment for work performed to date and expects to fulfill the contract as promised. An entity using an “over-time method” recognizes revenue using either: (1) An output method, which measures the value of the goods and services transferred to date to the customer (for example, units produced); or (2) an input method, which recognizes revenue based on the entity's efforts or inputs (for example, labor hours expended, costs incurred) as compared to the expected total costs to satisfy the performance obligation.

Other commenters expressed concern about allowing a Book PCM option. Some commenters suggested that limiting a Book PCM option to only taxpayers that must report revenue on a particular over-time basis, such as an input cost-incurred method, could create more complexity, not less. Other commenters suggested that, while a Book PCM option might achieve some book-tax conformity, they would still want the opportunity to take advantage of tax rules that provide more beneficial timing than available under Book PCM, such as additional first year depreciation. The Treasury Department and the IRS will continue studying the feasibility and efficacy of an optional Book PCM approach. At this time, however, the Treasury Department and the IRS decline to adopt the Book PCM option set forth by commenters because of the concerns raised regarding the complexity and the desire by some taxpayers to obtain more beneficial timing under tax rules when using a Book PCM method.

3. AFS Issues

No formal comments were received regarding the definition of AFS in proposed § 1.451-3(c)(1). Accordingly, the definition of AFS remains largely unchanged in these final regulations. See § 1.451-3(a)(5). One commenter questioned the statutory language in section 451(b) regarding financial statements prepared using international financial reporting standards (IFRS). Specifically, section 451(b)(3)(B) provides that a financial statement made on the basis of IFRS is an AFS for section 451(b) if the financial statement is filed with a foreign government agency that is equivalent to the United States Securities and Exchange Commission (SEC) and has financial reporting standards not less stringent than the standards imposed by the SEC. Proposed § 1.451-3(c)(1)(iii)(A) and the final regulations § 1.451-3(a)(5)(ii)(A) mirror the statutory language. The commenter questioned whether the requirement in section 451(b)(3)(B) that the financial reporting standards of a foreign agency or government be not less stringent than the standards required by the SEC, refers solely to reporting standards related to revenue or if it also refers to reporting standards for other items that are not related to revenue. The statutory language does not distinguish the reporting standards between revenue and other items that are not related to revenue. Additionally, Revenue Procedure 2004-34, which was the model for the definition of AFS in section 451(b)(3), did not have similar language. Accordingly, based on the plain language of the statute, if the financial reporting standard for any item is less stringent than SEC reporting standards, even if that standard does not relate to revenue reporting, the statement will not be an AFS under proposed § 1.451-3(c)(1)(iii)(A) or § 1.451-3(a)(5)(ii)(A) of the final regulations. However, the financial reporting standards relativity requirement does not prevent the IFRS financial statements from qualifying as an AFS under proposed § 1.451-3(c)(1)(iii)(B) or (C) or § 1.451-3(a)(5)(ii)(B) or (C) of the final regulations.

No formal comments were received regarding the AFS issues addressed in proposed § 1.451-3(h)(1). Accordingly, the rules regarding an AFS that covers a group of entities (consolidated AFS rules) and mismatched reporting periods remain largely unchanged in these final regulations. However, the Treasury Department and the IRS are aware of questions regarding the application of certain aspects of the consolidated AFS rules. Under proposed § 1.451-3(h)(1)(i), if a taxpayer's results are reported on the AFS for a group of entities, the taxpayer's AFS is the group's AFS. Proposed § 1.451-3(h)(3) provides that if a group's AFS does not separately state items, the portion of the revenue allocable to the taxpayer is determined by relying on the source documents that were used to create the group's AFS.

Under the proposed regulations, it was unclear whether the portion of the AFS revenue allocable to the taxpayer includes amounts that are subsequently eliminated in the group's AFS (consolidated AFS). Accordingly, the final regulations clarify that, if the consolidated AFS does not separately state items, the portion of the AFS revenue allocable to the taxpayer is determined by relying on the taxpayer's separate source documents used to create the consolidated AFS and includes amounts that are subsequently eliminated in the consolidated AFS.

III. Comments and Revisions Regarding § 1.451-8

A. Proposed § 1.451-8(b)(1)(i): Definition of Advance Payment

1. Prepayments for Pre-Need Burial Plots

Under section 451(c)(4)(A), the term advance payment means any payment that meets the following three requirements: (1) The full inclusion of the payment in gross income in the year of receipt is a permissible method of accounting; (2) any portion of the advance payment is included in revenue in an AFS for a subsequent tax year; and (3) the advance payment is for goods, services, or such other items that the Secretary has identified. Proposed § 1.451-8(b)(1)(i) largely mirrors the definition of an advance payment in section 4.01 of Revenue Procedure 2004-34, which expands upon the goods, services, and other items for which a payment can qualify as an advance payment.

One commenter requested that the Secretary exercise the authority to broaden the definition of advance payment to include prepayments for the sale of an interest in real property, including pre-need burial plots. If the comment is adopted, prepayments for pre-need burial plots would be eligible for the one-year deferral of income.

Commenters agreed that taxpayers in the death care industry uniformly treat the entire amount of the sales price for pre-need burial plots as income on an AFS in the year the pre-need contract is executed. To qualify as an advance payment, a portion of the prepayment must be included in revenue by the taxpayer in an AFS for a subsequent taxable year. Section 451(c)(4)(A)(ii). Since prepayments for pre-need burial plots cannot meet this requirement, these prepayments cannot qualify as advance payments. For this reason, the Treasury Department and the IRS decline to adopt this comment in the final regulations.

No other requests were received to expand the definition of advance payment. Accordingly, the list of items that are included in the definition of advance payment under proposed § 1.451-8(b)(1)(i) is unchanged.

2. Amount of Payment Included in AFS Revenue in a Subsequent Year

Under section 451(c)(4)(A) and proposed § 1.451-8(a)(1)(i), for a payment to qualify as an advance payment, a portion of the payment must be included in revenue in an AFS for a subsequent tax year. The final regulations clarify that to determine the amount of the payment that is taken into account as AFS revenue, the taxpayer must adjust AFS revenue for any amounts described in § 1.451-3(b)(2)(i)(A), (C), and (D). As a result, to the extent that AFS revenue in the taxable year of receipt reflects, for example, a reduction for liabilities that are required to be accounted for under provisions such as section 461 or amounts anticipated to be in dispute, AFS revenue in the taxable year of receipt must be increased by such amounts.

The final regulations make similar clarifying changes to the deferral method for taxpayers with an AFS in § 1.451-8(c). Under § 1.451-8(c), a taxpayer that uses the deferral method must include all or a portion of the advance payment in gross income in the taxable year of receipt to the extent “taken into account as AFS revenue” as of the end of the taxable year of receipt, and include the remaining portion of the advance payment in gross income in the following taxable year. To determine the extent that an advance payment is treated as “taken into account as AFS revenue” as of the end of the taxable year of receipt, the taxpayer must adjust AFS revenue by the amounts described in § 1.451-3(b)(2)(i)(A), (C), and (D). Accordingly, to the extent that AFS revenue reflects a reduction for liabilities that are accounted for under other provisions of the Code such as section 461 or amounts anticipated to be in dispute, AFS revenue is increased by such amounts. Further, if the transaction price, as defined in § 1.451-3(a)(14), was increased because a significant financing component is deemed to exist under the standards the taxpayer uses to prepare its AFS, then any AFS revenue attributable to such increase is disregarded.

B. Proposed § 1.451-8(b)(1)(ii)(H): Specified Good Exception

Proposed § 1.451-8(b)(1)(ii) lists exceptions to the definition of an advance payment. Specifically, proposed § 1.451-8(b)(1)(ii)(H) provides that an advance payment does not include a payment received in a taxable year earlier than the taxable year immediately preceding the taxable year of the contractual delivery date for a specified good. Proposed § 1.451-8(b)(8) defines the “contractual delivery date” as the month and year of delivery listed in the written contract to the transaction. A “specified good” is defined in proposed § 1.451-8(b)(9) as a good for which: (1) The taxpayer does not have the goods of a substantially similar kind and in a sufficient quantity at the end of the taxable year the upfront payment is received; and (2) the taxpayer recognizes all of the revenue from the sale of the good in its AFS in the year of delivery. If the prepayment satisfies the specified good exception, the prepayment is analyzed under section 451(b) and § 1.451-1.

1. Contractual Delivery Date Requirement

Some commenters generally requested that the Treasury Department and the IRS re-examine the contractual delivery date requirement. One commenter requested that the definition of contractual delivery date be broadened to include contracts where the delivery date can be reasonably determined based on all the facts and circumstances as provided in the contract. Another commenter requested that the exception be modified to cover any contract for the sale or production of goods where, based on all of the facts and circumstances, it is reasonably certain that the taxpayer's performance to which the advance payment relates will in fact take place. The same commenter also suggested that if the definition of the contractual delivery date was broadened, the requirement regarding the period of time between when an advance payment is received and the delivery date for a specified good could be modified to require that the expected delivery date occur more than 24 months after the advance payment is received.

The Treasury Department and the IRS decline to adopt the comments to broaden the definition of contractual delivery date in the final regulations because the suggested approaches would decrease administrability and increase uncertainty for taxpayers and the potential for litigation. Therefore, the definition of contractual delivery date in the final regulations continues to be limited to situations where the written contract provides the month and year of delivery for the goods.

In addition, because the Treasury Department and the IRS are not broadening the definition of contractual delivery date, it is not necessary to limit the specified good exception to situations where there is more than 24 months between the date the advance payment is received and the contractual delivery date. The recommended rule is more restrictive than the rule in the proposed regulation which requires the payment to be received in a taxable year earlier than the taxable year immediately preceding the taxable year of the contractual delivery date. Accordingly, the Treasury Department and the IRS decline to adopt this recommendation.

2. Requirement That AFS Revenue Must Be Recognized in the Year of Delivery

One commenter questioned why the specified good exception in the proposed section 451(c) regulations is restricted to situations where all the revenue from the sale of the good is recognized in the taxpayer's AFS in the year of delivery. The commenter requested that the exception be expanded to include situations where the taxpayer recognizes the revenue for Federal income tax purposes no later than the time when the revenue related to the production of the goods is recognized for financial accounting purposes. As a result, taxpayers using the over-time method to report revenue under ASC 606 could be eligible for the exception.

Payments that qualify for the specified good exception are subject to the general accrual method of accounting rules under section 451(a) and (b), including the all events test under section 451(b)(1)(C) and § 1.451-1(a) and the existing case law that addresses the all events test. The specified good exception was narrowly crafted to allow a taxpayer meeting the requirements to evaluate its treatment of qualifying payments under the all events test under section 451(b)(1)(C) and § 1.451-1(a) and the existing case law that addresses the all events test. Taxpayers that meet the specified good exception criteria, unlike those taxpayers that use the over-time method to report revenue from the sale of goods under ASC 606, are generally not required to test the payment for inclusion under the AFS income inclusion rule in section 451(b)(1)(A), as the payment is not taken into account as AFS revenue until the specified good is delivered to the customer, and is only required to analyze the payment for inclusion under the all events test in section 451(b)(1)(C). Additionally, taxpayers that use the over-time method under ASC 606 generally incur production costs as AFS revenue is recognized and can therefore benefit from the advance payment cost offset method under § 1.451-8(e). However, taxpayers that use the point-in-time method to report revenue from the sale of goods under ASC 606 and that meet the rest of the specified good exception criteria generally don't incur production costs until closer to the delivery date and may not be able to benefit from the advance payment cost offset method under § 1.451-8(e). For these reasons, the Treasury Department and the IRS decline to expand the specified good exception to situations where taxpayers are using the over-time method to report revenue under ASC 606.

For this reason, the Treasury Department and the IRS do not adopt this comment. Therefore, the definition of specified good in the final regulations retains the requirement that the taxpayer recognizes all of the revenue from the sale of the good in its AFS in the year of delivery.

3. Integral Services

A commenter requested that the definition of “specified good” in proposed § 1.451-8(b)(8) be expanded to include “integral services” furnished for the good. However, the commenter provided no definition of integral services, a term which could be broadly construed resulting in audit controversies. Moreover, the Conference Report expresses Congress' intent for section 451(c) to override former § 1.451-5, which defined an advance payment to include prepayments for services that were integral to the sale or disposition of goods. See H.R. Rep. No. 115-466, at 429 fn. 880 (2017) (Conf. Rep.). For these reasons, the Treasury Department and the IRS decline to accept this comment.

4. Reasonable Estimate of Unused Net Operating Loss (NOL)

One commenter requested that, if certain proposed changes to the specified good exception are not adopted, the Treasury Department and the IRS should include an exclusion to the definition of “advance payment” for prepayments where the taxpayer reasonably estimates, based on the facts at the time the agreement is entered into, that it will have a NOL that remains unused for the 5-year period after the year the prepayments received are included in the taxpayer's taxable income. The requested rule would be difficult to administer because it requires a taxpayer to estimate that it will have an NOL that remains unused for a 5-year period after the advance payments are included in gross income. Accordingly, the Treasury Department and the IRS decline to adopt this comment in the final regulations.

5. Tax Consequences of Meeting the Specified Good Exception

Several commenters provided examples in which payments that qualify for the specified good exception in proposed § 1.451-8(a)(1)(ii)(H) are deferred and included in gross income when the payment is recognized as revenue in the taxpayer's AFS in the year the good is delivered. As mentioned in part III.B.2 of this Summary of Comments and Explanation of Revisions and for additional clarification, payments that qualify for the specified good exception are subject to the general accrual method of accounting rules under section 451(a) and (b), including the all events test under section 451(b)(1)(C) and § 1.451-1 and the existing case law that addresses the all events test.

6. Method To Treat Prepayments Satisfying the Specified Good Exception as Advance Payments

One commenter asked that the specified good exception be made optional, particularly if meeting the specified good exception does not result in deferral of the prepayment to match the book timing of the payment. The commenter noted that some taxpayers may prefer the section 451(c) regime, especially if there is some uncertainty whether the contract meets the specified good exception. Further, some taxpayers that had the choice of a longer deferral under § 1.451-5 or a one-year deferral under Revenue Procedure 2004-34 still chose the 1-year deferral.

The Treasury Department and the IRS agree with this comment. Accordingly, the final regulations allow taxpayers to treat all prepayments that satisfy the specified good exception as advance payments subject to section 451(c), the “specified good section 451(c) method.” See § 1.451-8(f). The requested election provides flexibility for taxpayers. If the taxpayer does not use the specified good section 451(c) method, payments satisfying the specified good exception are not eligible for the deferral method provided in section 451(c) and § 1.451-8 but are subject to section 451(b) and § 1.451-1(a). If the taxpayer uses the specified good section 451(c) method, the prepayment is generally deferred for one year; however, if a taxpayer also uses the advance payment cost offset method under § 1.451-8(e) to account for such prepayments, a portion of the prepayment may be deferred until the year in which ownership of the good is transferred to the customer.

The specified good section 451(c) method is a method of accounting. The method applies to all payments that satisfy the specified good exception that are received by each trade or business that uses the method. The use of this method results in the adoption of, or a change in, a method of accounting under section 446. See § 1.451-8(g).

C. Proposed § 1.451-8(c)(2)(i)(B): Acceleration of Advance Payments

Under proposed § 1.451-8(c)(2)(i)(B), a taxpayer that uses the deferral method generally includes an advance payment in gross income when it satisfies its

obligation for the advance payment. Example 11 of proposed § 1.451-8(c)(8)(xi) provides an example of a travel agent that received commission income when it purchased and delivered the ticket to the customer but did not include the commission in revenue in its AFS until the following year. The example concludes that the commission is not an advance payment because it was not earned by the taxpayer in a subsequent taxable year.

Example 11 incorrectly concludes that the payment for the commission is not an advance payment. The payment for the commission income is an advance payment because it meets the definition of an advance payment under section 451(c)(4), including the requirement that a portion of the payment is included in the taxpayer's revenue in an AFS for a subsequent taxable year. However, the commission income is included in income in the year of receipt because the taxpayer's obligation with respect to the advance payment was satisfied in that year. Accordingly, in the final regulations, this example has been moved and revised into an example of the rules on the acceleration of advance payments. In addition, the analysis has been changed to clarify that (1) the commission income is an advance payment, and (2) the taxpayer's satisfaction of its obligation for the advance payment caused the commission to be included in income in the year of receipt.

D. Proposed § 1.451-8(c)(5): Contracts With Multiple Performance Obligations

Section 451(c)(4) provides that for purposes of the rules for advance payments, rules similar to the rules in section 451(b)(4), which allocate transaction price among multiple performance obligations, apply. Proposed § 1.451-8(c)(5) provides rules for taxpayers with an AFS for allocating the transaction price when there is more than one performance obligation in a contract. Specifically, those taxpayers allocate the transaction price based on the method in proposed § 1.451-3(g), namely, using the allocation in the taxpayer's AFS. No formal comments were received on this provision.

Under the proposed regulations it was not clear whether the taxpayer was required to allocate the payment to multiple performance obligations based on their relative transaction price or based on the payment allocation used for AFS purposes. Accordingly, the final regulations clarify that advance payments received under a contract with multiple performance obligations are allocated to the corresponding item of gross income in the same manner that the payments are allocated to the performance obligations in the taxpayer's AFS. This rule is consistent with the requirement in section 451(c)(4)(D) that “rules similar to the rules in [section 451](b)(4) shall apply,” because it follows the manner in which the taxpayer allocates the payment for AFS purposes.

The rule for taxpayers without an AFS remains unchanged. See § 1.451-8(d)(4).

2. Proposed § 1.451-8(c)(6): Contracts With Advance Payments That Include Items Subject to a Special Method of Accounting

The proposed regulations requested comments on the allocation of a payment when the contract includes income subject to section 451(c) and income subject to section 460, but no comments were received.

Consistent with the objective criteria standard under Section 5.02(4) of Rev. Proc. 2004-34, the final regulations provide that if (1) a contract with a customer includes item(s) of gross income subject to a special method of accounting and item(s) of gross income described in § 1.451-8(a)(1)(i)(C), and (2) the taxpayer receives an allocable payment, then the taxpayer must determine the portion of the payment allocable to the items of gross income described in § 1.451-8(a)(1)(i)(C) based on objective criteria. The taxpayer is deemed to satisfy the objective criteria standard when it allocates the payment to each item of gross income in proportion to the amounts determined in § 1.451-3(d)(5) or as otherwise provided in guidance published in the Internal Revenue Bulletin (see § 601.601(d)).

This rule is consistent with the requirement in section 451(c)(4)(D) that “rules similar to the rules in [section 451](b)(4) shall apply.” The final regulations also provide a similar allocation rule for taxpayers using the non-AFS deferral method.

E. Cost Offset for Advance Payments

The proposed regulations do not provide for a cost offset. The preamble to the proposed regulations explains the rationale for rejecting a cost offset and requests comments on this issue.

As they did with respect to the proposed section 451(b) regulations, commenters requested that the final regulations under section 451(c) provide a cost offset, such as a COGS offset for expected future costs against advance payments for the sale of goods. Commenters asserted that a COGS offset is supported by the definition of “receipt” in section 451(c)(4)(C), which refers to an “item of gross income.” Under section 61 and § 1.61-3(a), for the sale of goods, an item of gross income generally means total sales revenue minus the cost of goods sold. Commenters cited

Hagen Advertising Displays, Inc.

v.

Commissioner,

407 F.2d 1105 (6th Cir. 1969), as support for this position. In

Hagen Advertising,

the Sixth Circuit Court of Appeals acknowledged that, to determine the proper amount of gross income for advance payments for the sale of goods to be delivered in the future, it would be appropriate for a taxpayer to reduce the amount of the advance payment by the estimated cost of the goods to be delivered. Otherwise, denying an offset for related COGS would tax the return of capital.

Id.

at 1110. Accordingly, commenters asserted that denying a COGS offset could result in an impermissible tax on gross receipts.

Commenters also asserted that not allowing a cost offset could result in a mismatch of revenue and costs and fails to clearly reflect income. According to commenters, a taxpayer would be required to report the full amount of an advance payment in income, in excess of the expected profit associated with that portion of the total contract price being reported. When the costs are actually incurred in subsequent years, the taxpayer would report losses with no associated revenue, which, in extreme cases where the losses cannot be used, could result in a permanent loss of the tax benefit of the cost. For a limited-life business, the acceleration of revenue recognition may result in NOLs that are permanently lost, as expenses trail income throughout the life cycle of the business. The commenters pointed out that this mismatch of income and associated costs does not reflect the reality of the overall amount of gross income realized by the taxpayer on the contract as a whole.

Further, commenters reasoned that allowing a cost offset under section 451(c) will not violate the economic performance requirement of section 461(h). Since the acceleration of advance payments under section 451(c) is a departure from accrual method accounting, the costs related to the payments should also depart from accrual method concepts. Commenters pointed out that the allowance of a cost offset for expected future COGS against substantial advance payments under former § 1.451-5(c), based on

Hagen Advertising,

coexisted with section 461(h) for over 33 years. In addition, the purpose of section 461(h) was not to eliminate an offset for estimated COGS for inventory to be delivered in the near future, but to defer a deduction for costs where the obligation was fixed but was

going to be performed many years in the future. Here, commenters asserted that a COGS offset would help to determine the proper amount of gross income to be accelerated, which is not what the economic performance requirement was intended to prevent.

Commenters also reasoned that section 451(c) was not meant to codify all aspects of Revenue Procedure 2004-34, including the lack of a cost offset in Revenue Procedure 2004-34. Announcement 2004-48, 2004-1 C.B. 998, explains that a COGS offset was not permitted in Revenue Procedure 2004-34 because it was inconsistent with the simplification that the revenue procedure was meant to achieve, and taxpayers could still qualify for a COGS offset under former § 1.451-5(c). Commenters also found it significant that the term “receipt” in section 451(c) uses the specific term “an item of gross income,” while the definition of received in Revenue Procedure 2004-34 uses the general term “income.”

The Treasury Department and the IRS have considered these comments and have determined that a cost offset based on estimates of future costs would be inappropriate. As discussed in the preamble to the proposed section 451(c) regulations, allowing a cost offset based on estimated costs would be inconsistent with sections 461, 263A, and 471, and the regulations under those sections of the Code and difficult for the IRS to administer. Additionally, allowing a cost offset based on estimated costs is inconsistent with Congress' intent to override former § 1.451-5(c). Former § 1.451-5(c) permitted a cost offset for both incurred and estimated costs against certain advance payments that were required to be included in gross income in a taxable year prior to the year in which ownership of the item of inventory was transferred to the customer, and was recently withdrawn in final regulations published in the

Federal Register

on July 15, 2019. See H.R. Rep. No. 115-466, at 429 fn. 880 (2017) (Conf. Rep.); see also, 84 FR 33691 (July 15, 2019). However, the Treasury Department and the IRS agree with comments suggesting that taxpayers should be afforded the flexibility of applying an offset for costs incurred against advance payments for the future sale of inventory. In this case, the final regulations provide that a taxpayer determines the amount of the advance payment that is included in gross income for the taxable year by reducing the amount that would otherwise be included in gross income for such taxable year under the taxpayer's full inclusion method or deferral method, as applicable (advance payment inventory inclusion amount) by the cost of goods related to the item of inventory, the “cost of goods in progress offset.” The method allows taxpayers to offset advance payments included in income under either the full inclusion method or under the deferral method. The portion of any advance payment that is offset by a cost of goods in progress offset for a taxable year is deferred and generally included in gross income in the taxable year in which ownership of the item of inventory is transferred to the customer.

Specifically, the final regulations provide that the cost of goods in progress offset for an item of inventory for each taxable year is calculated as the cost of goods incurred for such item through the last day of the taxable year, reduced by the cumulative cost of goods in progress offset amounts in prior taxable years, if any. However, the cost of goods in progress offset cannot reduce the advance payment inventory inclusion amount for the taxable year below zero. Further, the cost of goods in progress offset attributable to one item of inventory cannot reduce the advance payment inventory inclusion amount attributable to a separate item of inventory. Any incurred costs that were not used to offset the advance payment for the item of inventory because they were subject to limitation are considered when the taxpayer determines the cost of goods in progress offset in a subsequent taxable year. In addition, the cost of goods in progress offset does not apply to the advance payment inventory inclusion amount that is included in gross income as a result of the acceleration rules in § 1.451-8(c)(4), and any advance payments previously deferred by way of a cost of goods in progress offset in a prior year are accelerated under such rule.

The cost of goods in progress offset is determined by reference to the costs and expenditures related to items of inventory produced or acquired for resale, which costs have been incurred under section 461 and have been capitalized and included in inventory under sections 471 and 263A or any other applicable provision of the Code as of the end of the year. The taxpayer must be able to demonstrate that the costs are properly capitalizable under the Code to the items of inventory produced or acquired for resale under the contract to which the taxpayer is applying the cost of goods in progress offset. For a sale of a gift card or customer reward program points, this requirement cannot be met, and no cost of goods in progress offset is permitted. However, the cost of goods in progress offset does not reduce the costs that are capitalized to the items of inventory produced or acquired for resale by the taxpayer under the contract. That is, while the cost of goods in progress offset reduces the amount of the advance payment included in income, it does not affect how and when costs are capitalized to inventory under sections 471 and 263A or any other applicable provision of the Code or when those capitalized costs will be recovered.

The costs of goods comprising the cost of goods in progress offset must be determined by applying the taxpayer's inventory accounting methods. A taxpayer must calculate its cost of goods in progress offset by reference to all costs that the taxpayer has permissibly capitalized and allocated to items of inventory under its method of accounting for inventories for federal income tax purposes, but may not consider costs that are not properly capitalized under such method.

The Treasury Department and the IRS provided this cost offset method in the final regulations because it provides a reasonable matching of income from advance payments and incurred cost of goods, and more clearly reflects income. The advance payment cost offset method is a method of accounting that applies to all advance payments received by a trade or business for items of inventory that satisfy the criteria in § 1.451-8(e). If a taxpayer chooses to use the advance payment cost offset method for a trade or business, it must also use the AFS cost offset method in § 1.451-3(c) for that trade or business. See prior discussion regarding coordination between the AFS cost offset method and the advance payment cost offset method. Additional guidance on the cost offset method for advance payments may be provided in guidance published in the Internal Revenue Bulletin (see § 601.601(d)).

F. Continued Application of Revenue Procedure 2004-32 and Revenue Procedure 79-38

Commenters requested clarification of whether Revenue Procedure 2004-32, 2004-1 C.B. 988, and Revenue Procedure 79-38, 1997-2 C.B. 501, remain in effect after the enactment of section 451(c). Revenue Procedure 2004-32 allows an accrual method taxpayer to account for income from credit card annual fees ratably over the period covered by the fees, as described in section 4 of Revenue Procedure 2004-32. Revenue Procedure 79-38 generally allows accrual method manufacturers, wholesalers, and retailers of motor vehicles or other durable goods to include a portion of an

advance payment related to the sale of a multi-year service warranty contract in gross income over the life of the service warranty obligation. Revenue Procedure 2004-32 and Revenue Procedure 79-38 remain effective after the enactment of section 451(c) and may be relied upon after these regulations are finalized.

Effect on Other Documents

The preamble to proposed § 1.451-3 requested comments on the proposed obsolescence of Revenue Procedure 2004-33, 2004-1 C.B. 989 (relating to credit card late fees), Revenue Procedure 2005-47, 2005-2 C.B. 269 (relating to credit card cash advance fees), Revenue Procedure 2013-26, 2013-22 I.R.B. 1160 (relating to a safe harbor method of accounting for OID on a pool of credit card receivables), and Chief Counsel Notice CC-2010-018 (relating to interchange). Instead of obsoleting Revenue Procedure 2013-26, commenters recommended limiting the scope of Revenue Procedure 2013-26 to OID that is not subject to the timing rules in proposed § 1.451-3(i) and thus, not excluded from the OID rules under proposed § 1.1275-2(l). Commenters explained that retaining Revenue Procedure 2013-26 would allow taxpayers to continue to use the proportional method described in the revenue procedure as a safe harbor method of accounting for certain amounts that are not OID under section 1272, such as bond premium and market discount, as well as certain kinds of OID such as promotional discount. See discussion of promotional discount in part II.F. of the Summary of Comments and Explanation of Revisions. The Treasury Department and the IRS agree with the recommendations not to obsolete Revenue Procedure 2013-26. In addition, the Treasury Department and the IRS intend to modify Revenue Procedure 2013-26 to make clear that the safe harbor method does not apply to any specified fees, including the specified credit card fees. However, based on section 451(b) and the final regulations, Revenue Procedure 2004-33, Revenue Procedure 2005-47, and Chief Counsel Notice CC-2010-018 no longer provide current guidance on the treatment of the specified credit card fees. Accordingly, these items are obsolete as of January 1, 2021.

In addition, Revenue Procedure 2004-34, Revenue Procedure 2011-18, Revenue Procedure 2013-29 and Notice 2018-35 are obsolete for taxable years beginning on or after January 1, 2021. Taxpayers that relied on the now obsoleted guidance should determine whether a change in method of accounting occurs once they cease to use the obsoleted guidance.

Applicability Dates

In general, the rules in §§ 1.451-3 and 1.451-8 apply for taxable years beginning on or after January 1, 2021. However, the rules in § 1.451-3(j) for specified fees that are not specified credit card fees apply for taxable years beginning on or after January 6, 2022. Also, for a specified credit card fee as defined in § 1.451-3(j)(2), § 1.1275-2(l)(1) applies for taxable years beginning on or after January 1, 2021, and, for a specified fee that is not a specified credit card fee, § 1.1275-2(l)(1) applies for taxable years beginning on or after January 6, 2022.

However, pursuant to section 7805(b)(7), taxpayers and their related parties, within the meaning of sections 267(b) and 707(b), may apply the rules in these final regulations, in their entirety and in a consistent manner, to a taxable year beginning after December 31, 2017, and before January 1, 2021, provided that, once applied to such a taxable year, such rules are applied in their entirety and in a consistent manner to all subsequent taxable years. Notwithstanding the preceding sentence, pursuant to section 7805(b)(7), taxpayers and their related parties, within the meaning of sections 267(b) and 707(b), may apply the rules in these final regulations that apply to specified credit card fees in their entirety and in a consistent manner, to a taxable year beginning after December 31, 2018, and before January 1, 2021, provided that, once applied to such a taxable year, such rules are applied in their entirety and in a consistent manner to all subsequent taxable years. Taxpayers that choose to apply the rules in the final regulations to a taxable year beginning before January 1, 2021 must follow the rules for changes in method of accounting under section 446 and the applicable procedural guidance.

Alternatively, a taxpayer may rely on the proposed regulations for taxable years beginning after December 31, 2017 (or December 31, 2018, in the case of specified credit card fees) and before January 1, 2021.

In the case of a specified fee that is not a specified credit card fee, a taxpayer may neither choose to apply the final regulations to, nor rely on the proposed regulations for, a taxable year beginning after December 31, 2018, and before January 6, 2022.

Statement of Availability of IRS Documents

The IRS Notices, Revenue Rulings, and Revenue Procedures cited in this document are published in the Internal Revenue Bulletin (or Cumulative Bulletin) and are available from the Superintendent of Documents, U.S. Government Publishing Office, Washington, DC 20402, or by visiting the IRS website at

http://www.irs.gov

.

Special Analyses

I. Regulatory Planning and Review—Economic Analysis

Executive Orders 12866, 13563, and 13771 direct agencies to assess costs and benefits of available regulatory alternatives and, if regulation is necessary, to select regulatory approaches that maximize net benefits (including potential economic, environmental, public health and safety effects, distributive impacts, and equity). Executive Order 13563 emphasizes the importance of quantifying both costs and benefits, of reducing costs, of harmonizing rules, and of promoting flexibility. For purposes of E.O. 13771 this rule is regulatory.

These regulations have been designated as subject to review under Executive Order 12866 pursuant to the Memorandum of Agreement (April 11, 2018) between the Treasury Department and the Office of Management and Budget (OMB) regarding review of tax regulations. The Office of Information and Regulatory Affairs has designated these regulations as economically significant under section 1(c) of the MOA. Accordingly, the OMB has reviewed these regulations.

A. Need for the Final Regulations

The Tax Cuts and Jobs Act (TCJA) substantially modified the statutory rules of section 451, which generally governs when income is recognized for Federal tax purposes. As a result of those changes, the Treasury Department and the IRS recognized that questions were likely to arise regarding the definitions and rules that taxpayers are required to apply in calculating a business's gross income. To provide greater specificity, the Treasury Department and the IRS previously issued separate proposed regulations related to section 451(b) and 451(c) on September 9, 2019.

The proposed regulations regarding section 451(b): (1) Clarify how section 451(b) applies to multi-year contracts; (2) provide rules for taxpayers whose financial results are included on an Applicable Financial Statement (AFS) covering a group of entities; (3) describe and clarify the definition of transaction price and revenue; (4) specify the allocation of a transaction price in the

case of a contract which contains multiple performance obligations; and (5) specify rules for certain debt instruments.

The proposed regulations for section 451(c) describe the deferral rules for advance payments for taxpayers with and without an AFS; (2) provide acceleration rules for taxpayers that cease to exist; (3) clarify the treatment of financial statement adjustments for taxpayers with deferred advance payments; (4) provide rules relating to the treatment of short taxable years for taxpayers deferring advance payments; and (5) define and clarify the treatment of performance obligations. They also list items excluded from the definition of an advance payment. In response to taxpayer comments received during the development of the proposed regulations, that list includes goods for which (1) the taxpayer does not have goods of a substantially similar kind and in a sufficient quantity at the end of the taxable year the upfront payment is received; and (2) the taxpayer recognizes all of the revenue from the sale of the good in its AFS in the year of delivery.

Comments were received on the proposed regulations for 451(b) and 451(c) requesting further clarification of or changes to those regulations. Based on these comments, the Treasury Department and the IRS determined that final regulations are needed to bring clarity to instances where the statute may be subject to multiple interpretations in the absence of further guidance and to respond to comments received on the proposed regulations. Among other benefits, the final regulations provide greater certainty and consistency in the application of section 451 by taxpayers and the IRS.

B. Background and Overview of Final Regulations

Under section 451(a) of the Code, income is “recognized” (that is, included in gross income for tax purposes) in the year in which it is received by the taxpayer unless it is properly accounted for in a different period under the taxpayer's method of accounting. Because of this latter condition, the tax treatment of certain items of income depends on the method of accounting a taxpayer is using. For taxpayers using the accrual method of accounting, income is generally recognized in the year in which all events have occurred that fix the right to receive that income and the amount of income can be determined with reasonable accuracy (all events test).

The timing of income recognition on a firm's financial statement may deviate from these principles. Both the U.S. generally accepted accounting principles (GAAP) and the international financial reporting standards (IFRS) provide income recognition rules that differ from tax reporting rules under certain circumstances. For example, financial accounting rules may require revenue to be recognized when the costs of providing goods or services pursuant to a contract are incurred, while the all-events test may not be satisfied until the contract obligation is fulfilled. New accounting standards released by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) in 2014 further accelerated the timing of income recognition for financial reporting purposes, widening the gap between financial and tax reporting.

The timing of income recognition for tax purposes may also deviate from the all-events test in certain circumstances. For instance, receipt of payment by the business satisfies the all events test. However, recognition of certain payments for goods or services not yet provided may be deferred to the year following receipt of payment, to the extent that recognition is also deferred on the taxpayer's AFS. Such payments are referred to as “advance payments.”

Prior to the enactment of TCJA on December 22, 2017, taxpayers were generally permitted to defer the tax on these advance payments; in other words, advance payments could be recognized in a later taxable year. Under prior law, the period over which an advance payment was deferred varied depending on the alternative regulatory treatment chosen (Revenue Procedure 2004-34 or § 1.451-5) and, within § 1.451-5, the type of good for which an advance payment was accepted (inventoriable goods versus non-inventoriable goods).

Under Revenue Procedure 2004-34, a taxpayer who receives an advance payment includes the advance payment in taxable income in the year of receipt to the extent that the payment is earned (if the taxpayer does not have an AFS) or, if the taxpayer has an AFS, to the extent that the payment is included in revenues in the AFS. The taxpayer includes the remaining amount of the advance payment in taxable income in the next taxable year, unless the next taxable year is a short year of 92 days or less. In the event of such a short year, the taxpayer includes in taxable income the part of the advance payment included in revenue in the AFS for the short tax year or, in the case of a taxpayer that does not have an AFS, the part of the advance payment which is earned in the short tax year. The remaining balance of the advance payment is included in income for the taxable year following the short tax year. Revenue Procedure 2004-34 applies to numerous types of advance payments beyond advance payments for the provision of services and sales of goods. For example, it applies to advance payments for the use of intellectual property and software, the occupancy or use of property if the occupancy or use is ancillary to the provision of services, guaranty or warranty contracts, subscriptions, memberships in organizations, and eligible gift card sales.

Under § 1.451-5, advance payments were defined more narrowly than under Revenue Procedure 2004-34 to include payments received by an accrual-method taxpayer for the future sale of goods held by the taxpayer in the ordinary course of trade or business and as payments for the building, installing, constructing, or manufacturing of goods by the taxpayer in a future taxable year. Such advance payments were generally included in taxable income either in the year of receipt or in the year in which the payment was properly accruable under the taxpayer's method of accounting.

An exception to this general rule occurred in the case of certain advance payments for certain goods properly held in inventory by the taxpayer. In the case of such goods, the receipt of a substantial advance payment required that all previously unrecognized advance payments be included in taxable income by the end of the second taxable year following the taxable year in which the substantial advance payment was received. The taxpayer was considered to have received a substantial advance payment if the sum of the advance payment received in the current taxable year and prior taxable years for the same contract was greater than or equal to total inventoriable costs and expenditures.

The TCJA substantially amended section 451 providing, among other things, new rules addressing deviations from the all-events test. The amended section 451(b) more closely aligns when income is recognized for Federal tax purposes with when it is recognized on businesses' financial accounting statements. In particular, section 13221 of the TCJA amends section 451(b), such that an item of gross income must be included in gross income no later than the period when the item is included in revenue on an AFS. Thus, this new rule requires taxpayers to recognize income upon the earlier of when the all-events test is met or when the taxpayer includes the amount in revenue

(broadly defined) in its AFS (AFS income inclusion rule). For these taxpayers, income recognition is accelerated for tax purposes when income has been recognized for financial accounting purposes before the all events test has been satisfied.

The amendments made to section 451(b) only apply to taxpayers that use accrual accounting and have an AFS. Neither the statutory changes to 451(b) nor the final regulations regarding 451(b) change the time at which income is recognized for accrual method taxpayers without an AFS.

Section 451(c), added by the TCJA, allows accrual-method taxpayers to elect to recognize as income only a portion of an advance payment in the taxable year in which it is received, and then recognize the remainder in the following taxable year. Section 451(c) essentially codifies the deferral method of accounting for advance payments that was permitted in Revenue Procedure 2004-34. (Joint Committee on Taxation,

General Explanation of Public Law 115-97,

(Washington, U.S. Government Publishing Office, December 2018), at 167.) The new section 451(c), a subject of the final regulations, addresses how advance payments are defined and when they need to be recognized in a business's gross income.

C. Economic Analysis

1. Baseline

In this analysis, the Treasury Department and the IRS assess the benefits and costs of the final regulations relative to a no-action baseline reflecting anticipated Federal income tax-related behavior in the absence of these final regulations.

2. Summary of Economic Effects

The final regulations provide certainty and consistency in the application of sections 451(b) and 451(c) by providing definitions and clarifications regarding the statute's terms and rules. In the absence of the guidance provided in these final regulations, the chance that different taxpayers might interpret the statute differently is exacerbated. For example, two similarly situated taxpayers might interpret the statutory provisions pertaining to the definition of advanced payments differently, with one taxpayer pursuing a project that another comparable taxpayer might decline because of a different interpretation of how the income may be treated under section 451(c). If this second taxpayer's activity is more profitable, an economic loss arises. Similar situations may arise under each of the provisions addressed by these regulations. Certainty and clarity over tax treatment generally also reduce compliance costs for taxpayers.

An economic loss might also arise if all taxpayers have similar interpretations under the baseline of the tax treatment of particular items of income but those interpretations differ slightly from the interpretation Congress intended for these income streams. For example, the final regulations may specify a tax treatment that few or no taxpayers would adopt in the absence of specific guidance but that nonetheless advances Congressional intent. In these cases, guidance provides value by bringing economic decisions closer in line with the intent and purpose of the statute.

While no guidance can curtail all differential or inaccurate interpretations of the statute, the final regulations significantly mitigate the chance for differential or inaccurate interpretations and thereby increase economic efficiency.

Because the final regulations clarify the tax treatment of items of gross income for certain taxpayers, there is the possibility that business decisions may change as a result of these regulations. The final regulations generally have the effect of delaying the timing of tax liability, thus reducing effective tax rates for affected taxpayers. This reduction in effective tax rates, viewed in isolation, will generally lead to an increase in economic activity by these taxpayers.

This delay in the timing of tax liability, viewed in isolation, will also decrease Federal tax revenue. A decrease in Federal tax revenue either increases the deficit or necessitates increases in other taxes or a reduction in spending. This revenue effect will be mitigated to some degree by improved economic performance (and accompanying tax revenues) under these regulations due to (i) the enhanced alignment in the timing of taxes on income and costs; (ii) the enhanced certainty and clarity provided by the final regulations as described previously; and (iii) enhanced economic activity due to lower effective tax rates for affected taxpayers.

The Treasury Department and the IRS have not estimated these effects relative to the no-action baseline or alternative regulatory approaches because they do not have readily available data or models that measure: (i) The volume of cost offsets allowed under the final regulations;

1

(ii) the effect on economic activity by affected taxpayers from the enhanced alignment of income and costs under the final regulations relative to the no-action baseline or alternative regulatory approaches; (iii) the tax positions that taxpayers would take on other provisions of the final regulations, relative to the no-action baseline or alternative regulatory approaches; or (iv) the economic activities that taxpayers would engage in under those tax positions.

1

Cost offsets are not reported on current tax returns and will not be separately reported on future tax returns.

The Treasury Department and the IRS have also not made projections of any change in compliance costs arising from the final regulations, relative to the no-action baseline. Treasury generally projects that compliance costs will be lower under the final regulations relative to the no-action baseline because enhanced clarity and certainty reduce compliance costs. The Treasury Department and the IRS recognize that some taxpayers may take advantage of favorable provisions in the final regulations and that this decision could increase their compliance costs. Taxpayers would not take advantage of these provisions, however, unless the overall treatment was beneficial to the taxpayer.

The proposed regulations noted that the economic analysis of the final regulations under section 451(c) would address the economic effects of regulatory guidance, if any, under sections 460 and 461(h) or other sections of the Code that interact with section 451(c), that was issued between the proposed and final regulations. Since the release of the proposed regulations on September 5, 2019, no such regulatory guidance has been issued.

The proposed regulations for 451(b) and 451(c) solicited comments on the economic effects of the proposed regulations. No such comments were received.

3. Number of Affected Taxpayers

The Treasury Department and the IRS estimate that between 174,000 and 299,000 entities are likely to be affected by the final regulations.

Section 451(b) and (c) and the regulations under § 1.451-3 affect only those business entities that (i) use an accrual method of accounting, and (ii) have an AFS. One provision in § 1.451-8 applies to accrual method taxpayers without an AFS. Regarding the accrual method of accounting, section 13102 of TCJA modified section 448 to expand the number of taxpayers eligible to use the cash receipts and disbursements method of accounting (cash method of accounting). In general, C corporations and partnerships with a C corporation

partner are now permitted to use the cash method of accounting if average annual gross receipts are $25 million or less for taxable years beginning in 2018 (up from $5 million or less in 2017). This amount was adjusted for inflation for taxable years beginning after December 31, 2018. The amount was $26 million in taxable year 2019.

The statute and the regulations generally affect only those entities that also have an AFS although one provision in the regulations under § 1.451-8 applies to non-AFS taxpayers. The Treasury Department and the IRS do not have readily available data to measure the prevalence of these affected entities. However, Schedule M-3, which is used to reconcile an entity's net income or loss for tax purposes with its book income or loss, reports whether an entity has a certified audited income statement. Schedule M-3 is required to be filed only by entities with at least $10 million of assets. This population is more likely to possess an AFS and, conversely, entities that do not file Schedule M-3 are less likely to possess an AFS or otherwise be affected by the regulations as owners and/or creditors of such smaller entities are less likely to require the entity to certify its financial results via a financial statement audit. Data are currently available only for electronic filers.

The Treasury Department and the IRS estimated the number of affected taxpayers separately for entities with gross receipts of $26 million or less and those with gross receipts above $26 million. For taxable year 2017, 89 percent of accrual-method entities filing Forms 1120, 1120-S, and 1065 with gross receipts of $26 million or less were filers of electronic tax forms. About 11 percent, or 288,000 returns, included a Schedule M-3. About 40 percent of the returns with Schedule M-3, or 113,000, indicated they had a certified audited income statement.

2

Based on the assumption that filers of paper tax forms have the same incidence as electronic filers and that entities that do not file a Schedule M-3 generally do not have an AFS, then the Treasury Department and the IRS estimate that roughly 127,000 (113,000/0.89) entities with gross receipts of $26 million or less are accrual-method entities that have an AFS. If 5 percent of entities that do not file a Schedule M-3 also have an AFS, then approximately 251,000 of these entities are potentially impacted by the final regulations.

2

Data are based on estimates from the IRS's Research, Applied Analytics and Statistics Division using data from the Compliance Data Warehouse.

For entities with gross receipts above $26 million and that are accrual method entities, the comparable calculations are that 95 percent of returns are e-filed and that 73 percent of those included a Schedule M-3. Based on the assumption that filers of paper tax forms have the same incidence as electronic filers and that entities that do not include a Schedule M-3 generally do not have an AFS, the Treasury Department and the IRS estimate that 47,000 (45,000/0.95) entities with gross receipts above $26 million are accrual-method entities that have an AFS. If 5 percent of entities that do not file a Schedule M-3 also have an AFS, then approximately 48,000 of these entities are potentially affected by these regulations.

Together, these calculations imply that between 174,000 and 299,000 entities are potentially affected by the final regulations.

Corporation and Partnership Returns Using an Accrual Method of Accounting ***

[Taxable year 2017; thousands of returns]

Entities with gross receipts not

greater than $26 million

E-filed

Paper-filed

Total

Entities with gross receipts

greater than $26 million

E-filed

Paper-filed

Total

Returns

2,503

307

2,810

73

4

77

Returns with a Schedule M-3

288

* 35

* 323

62

* 3

* 65

Returns with a Schedule M-3 and an audited income statement

113

* 14

* 127

45

* 2

* 47

Returns without a Schedule M-3

2,215

* 272

* 2,487

11

* 1

* 12

Returns without a Schedule M-3, but with an audited income statement (estimated)

** 111

** 13

** 124

** 1

** 0

** 1

Returns with an audited income statement

** 224

** 27

** 251

** 46

** 2

** 48

* Estimates are obtained by assuming paper-filed returns are similar to e-filed returns as regards the incidence of a filing entity having a Schedule M-3 and an audited income statement.

** Estimates are obtained by assuming that 5 percent of returns without a Schedule M-3 have an audited income statement.

*** This table does not include sole proprietorships because the number of sole proprietorships with gross receipts above $26 million that used accrual accounting was statistically indistinguishable from zero in 2017. The number of sole proprietorships with gross receipts of $26 million or below that are affected by these regulations is projected to be minimal.

Source:

Data compiled by the IRS Research, Applied Analytics and Statistics Division using data from the Compliance Data Warehouse. The total number of accrual method returns of corporations and partnerships may differ slightly from other estimates due to different data sources.

4. Economic Effects of Provisions Under Section 451(b)

a. Provisions Substantially Revised From the Proposed Section 451(b) Regulations

i. Cost Offset Under Section 451(b)

Section 451(b) as amended by TCJA addresses the timing of revenue recognition for tax purposes but makes no mention of the timing of cost recognition. The Treasury Department and the IRS considered three options for addressing the treatment of costs under section 451(b): (i) Do not allow a cost offset; (ii) allow a cost offset for incurred costs; and (iii) expand the allowance for incurred costs by further allowing a cost offset for projected costs. The proposed regulations did not provide a cost offset for the AFS income inclusion rule.

In the proposed section 451(b) regulations (in this part C.4,

proposed regulations

), the Treasury Department and the IRS argued that allowing a cost offset would be inconsistent with the economic performance rules under section 461 and inventory accounting rules under section 471. The proposed regulations further argued that Congress did not make clear any intention to alter those sections of the Code or their

associated regulations. The proposed regulations stated, however, that the subject was still under consideration and requested comments addressing appropriate cost offset rules.

In response to the comments received, the Treasury Department and the IRS have decided to include in the final regulations an offset for the cost of goods in progress (cost offset). This cost offset allows taxpayers to reduce the amount of revenue from the sale of inventory that is otherwise required to be included in gross income under the AFS income inclusion rule in a taxable year prior to the year in which ownership of the inventory is transferred to the customer and defer such revenue to the taxable year in which the ownership of the inventory is transferred to the customer. The amount of such reduction, or cost offset, is determined by reference to the inventoriable costs incurred to date. The offset applies only to incurred costs, not estimated or projected costs. Further, the cost offset cannot reduce the amount of revenue that is included in gross income under the AFS inclusion rule below zero. Any incurred costs subject to this limitation may be carried forward to determine the cost offset in subsequent taxable years.

The cost offset in the final regulations generally reduces the amount of revenue that is required to be included in gross income in a taxable year prior to the year in which ownership of inventory is transferred to the customer relative to the proposed regulations. An improved match of income and cost timing is generally held to provide a more accurate measure of economic activity and thus would lead to a more efficient tax system than under the proposed regulations, within the context of the statute and the overall Code.

This enhanced alignment in the tax treatment of revenue and costs can be expected to reduce financing costs for at least some projects and taxpayers. This reduction in financing costs relative to the proposed regulations may arise because in some cases under the proposed regulations, the inability of taxpayers to match the timing of revenue and cost associated with a project leads to a large, front-loaded tax liability, which may require a costly rebalancing of other assets, particularly for liquidity-constrained taxpayers. Taxpayers who experience a reduction in financing costs as a result of these final regulations, relative to the proposed regulations, may, as a result, increase other expenditures, including investment. The provision of the cost offset in the final regulations may further encourage longer-run projects relative to the proposed regulations.

The Treasury Department and the IRS considered expanding the cost offset to allow for projected costs, with several possible formats for how projected costs would be accounted for. Allowing an offset for projected costs would entail a higher administrative burden than the offset (only) for incurred costs and would not definitively improve the alignment of when income and costs are recognized for tax purposes relative to the offset for incurred costs. The Treasury Department and the IRS project that under an offset for projected costs, more disputes would likely arise over the projected costs because taxpayers would have an incentive to overstate projected costs in order to delay income recognition.

The Treasury Department and the IRS have not estimated the difference in compliance costs, administrative burden, or income-cost alignment (and any subsequent effects on economic activity) between the final regulations and alternative regulatory approaches using projected costs. The Treasury Department and the IRS have not undertaken this estimation because they do not have sufficiently detailed data or models that capture possible differences in cost offset formats that use incurred costs versus projected costs.

ii. Scope of the AFS Income Inclusion Rule

The final regulations also address concerns raised by commenters regarding recent changes to the financial accounting standards. The commenters suggested that the AFS inclusion rule is overly broad in light of these new standards, which generally accelerate AFS revenue recognition relative to the prior standards, and could cause taxpayers to incur a tax liability before they receive, or have a fixed right to receive, the money to pay the liability. Accordingly, the final regulations provide that under the AFS inclusion rule, amounts taken into account as AFS revenue include only those amounts that the taxpayer has an enforceable right to recover if the customer were to terminate the contract at the end of the taxable year.

The final regulations further provide, however, that a taxpayer may treat any amount reported as AFS revenue as being taken into account as AFS revenue regardless of whether the taxpayer has an enforceable right to recover such amounts. The Treasury Department and the IRS project that this option will lead to reduced compliance burden, reduced administrative burden, and to fewer taxpayer disputes relative to an alternative regulatory approach under which amounts taken into account as AFS revenue include only those amounts that the taxpayer has an enforceable right to recover if the customer were to terminate the contract at the end of the taxable year. Under this “enforceable right” approach, taxpayers would be required to analyze each contract to determine amounts for which the taxpayer has an enforceable right to recover if the customer were to terminate the contract at the end of the year; this analysis would be potentially costly.

The Treasury Department and the IRS also considered an alternative regulatory approach under which taxpayers would be permitted to defer “increases” in the transactions price that are taken into account as AFS revenue in a given year but to which a taxpayer's entitlement is contingent on a future event (contingent transaction price approach). This alternative regulatory approach was reflected in the proposed regulations. However, commenters expressed confusion as to what constitutes an “increase” in the transaction price and the types of contingencies that were intended to be included within the scope of the rule. Because of the uncertainties created by the contingent transaction price approach, and the potential for multiple interpretations, the Treasury Department and the IRS decided against this approach. The enforceable right standard adopted by the final regulations may accelerate income inclusion relative to the contingent transaction price approach, although the Treasury Department and the IRS recognize that the opposite result may hold for some taxpayers.

The Treasury Department and the IRS have not estimated the differences in income inclusion between the final regulations and this alternative regulatory approach because they do not have readily available data on the income inclusion timing differences under an enforceable right standard versus the contingent transactions price approach. Because of this lack of data, the Treasury Department and the IRS have further not estimated the difference in compliance costs between the final regulations and the alternative regulatory approach.

b. Provisions Not Substantially Revised From the Proposed Section 451(b) Regulations

i. Application of the AFS Income Inclusion Rule to Multi-Year Contracts

The final regulations clarify how section 451(b) applies to multi-year contracts. The Treasury Department and

the IRS considered two alternative approaches for such contracts: (i) An annual approach and (ii) a cumulative approach. Under an annual approach, for each taxable year under the contract a taxpayer would compare the amount of income taken into account as AFS revenue for that taxable year and the amount of income that meets the requirements for recognition under the all events test for that same taxable year to determine its gross income inclusion for that taxable year; that is, the taxpayer would include the larger of the two amounts. The total amount of gross income recognized under the contract through the end of such taxable year is not to exceed the total contract price.

In contrast, under a cumulative approach, in each taxable year a taxpayer would compare the cumulative amount of revenue included in its AFS up to and including that taxable year with the cumulative amount of income that meets the requirements for recognition under the all events test up to and including that taxable year. The taxpayer would then take the larger of the two amounts and reduce it for any prior taxable year income inclusions with respect to that item of gross income to determine the amount that is required to be included in gross income in the current taxable year.

The difference between the annual approach and the cumulative approach are illustrated by the following example. In 2021, D, an engineering services provider, enters into a non-severable contract with a customer to provide engineering services through 2024 for a total of $100x. Under the contract, D receives payments of $25x in each calendar year of the contract. For its AFS, D reports $50x, $0, $20x, and $30x of AFS revenue from the contract for 2021, 2022, 2023, and 2024, respectively. D has an enforceable right, as defined in § 1.451-3(a)(9), to recover all amounts reported as AFS revenue through the end of a given contract year if the customer were to terminate the contract on the last day of such year. The $25x payment received for 2023 is an advance payment, as defined in § 1.451-8(a)(1), because $5x of the $25x payment is reported as AFS revenue for 2024. D uses the full inclusion method for advance payments.

The accompanying table shows the treatment of gross income under the two approaches.

2021

2022

2023

2024

Total

Payments

$25x

$25x

$25x

$25x

$100x

AFS Revenue

50x

0x

20x

30x

100x

Gross Income (cumulative approach)

50x

0x

25x

25x

100x

Gross Income (annual approach)

50x

25x

25x

0x

100x

An annual approach could accelerate the recognition of taxable income to a greater degree than what is reflected in revenue for AFS purposes. In this example, such an approach would ignore in 2022 the fact that cumulative AFS revenue of $50x had been recognized as taxable gross income in 2021. Accordingly, the annual approach would require that an additional $25x of income be recognized in 2022, since a payment of that amount was received in that year. In effect, an annual approach would accelerate the recognition of $25x from 2023 to 2022 relative to gross income recognition under the cumulative AFS income inclusion rule.

The Treasury Department and IRS concluded that the extent of acceleration of income that may occur when using an annual approach would be excessive relative to the cumulative approach when considered against the intent and purpose of the statute. The final regulations therefore adopt the cumulative approach.

The Treasury Department and the IRS have not estimated the difference in compliance costs, administrative burden, or economic activity between the final regulations and an alternative regulatory approach of using an annual comparison. The Treasury Department and the IRS have not undertaken this estimation because they do not have sufficiently detailed data or models that capture possible differences in taxpayers' income inclusions under these two alternative regulatory approaches.

ii. Applicable Financial Statement Covering a Group of Entities

The final regulations provide rules for taxpayers whose financial results are included on an AFS covering a group of entities. These rules specify that, if a taxpayer's financial results are reported on the AFS for a group of entities, the taxpayer's AFS is the group's AFS. However, if the taxpayer also reports financial results on a separate AFS that is of equal or higher priority, then the separate AFS is the taxpayer's AFS. The rules also specify how a taxpayer using a group AFS is to determine the amount of revenue allocated to the taxpayer. The Treasury Department and the IRS considered as an alternative not providing substantive rules on how taxpayers should apply the AFS income inclusion rule when their financial results are included in an AFS for a group of entities. This alternative was rejected because it would have increased compliance burdens and potentially led to similarly situated taxpayers applying the AFS income inclusion rule differently.

The Code does not specify how the AFS income inclusion rule is to function whenever the AFS accounting period and the taxable year do not coincide. The final regulations do not adopt a single, one-size-fits-all approach, but rather provide taxpayers three separate options for addressing this situation. A change from one option to another, however, would be considered a change in method of accounting requiring the permission of the IRS. By providing taxpayers with several options, the final regulations will minimize taxpayer compliance costs when dealing with non-congruent tax and financial accounting periods relative to an alternative approach of specifying a single option, with no significant revenue implications or effects on economic decisions.

iii. Revenue in an AFS

The final regulations describe and clarify the definition of AFS revenue to broadly include amounts characterized as revenue in a taxpayer's AFS as well as amounts reported in other comprehensive income or retained earnings provided such amounts relate to an item of gross income that is subject to the rules under section 451(b) and (c). The Treasury Department and the IRS considered and rejected a narrower definition of revenue or a definition that was tied to the AFS definition of revenue. The definition of revenue advanced in the final regulations is consistent with the current application of the all events test under § 1.451-1(a) and ensures that all relevant financial statement items are taken into account for tax purposes. In contrast, a narrow definition of revenue would allow, or even encourage, taxpayers to avoid the AFS income inclusion rule by not

classifying an item as revenue on their financial statement.

iv. Rules for Certain Debt Instruments

Section 451(b)(2) states that the AFS inclusion rule does not apply to items of gross income for which a taxpayer uses a special method of accounting provided under the Code. However, the Code does not apply this exception to special accounting rules that apply to original issue discount (OID), market discount, and certain other items with respect to debt instruments under part V of Subchapter P of the Code.

The final regulations implement this provision by providing a non-exhaustive list of special methods of accounting, and by clarifying how section 451(b) applies to certain credit card receivables. The final regulations specifically except from section 451(b) the timing rules for accrued market discount on bonds and the general OID timing rules, as well as the timing rules for OID determined with respect to special debt instruments (contingent payment and variable rate debt instruments, certain hedged debt instruments, and inflation-indexed debt instruments). Nevertheless, following the legislative history of the TCJA (see Conference Report, p. 276), the final regulations provide that credit card late fees, credit card cash advance fees, and interchange fees are subject to the AFS income inclusion rule. The final regulations further specify that if these credit card fees are subject to the AFS income inclusion rule, they are not to be taken into account in determining whether a debt instrument associated with them has OID. Existing rules continue to apply to these items for taxpayers not possessing an AFS. The Treasury Department and the IRS expect that this treatment will provide a straightforward application of section 451(b) consistent with Congressional intent without unnecessarily complicating OID calculations and adding to taxpayer compliance burdens.

The Treasury Department and the IRS considered and rejected a broader application of the AFS income inclusion rule to include all amounts determined under the OID and market discount accounting methods, even in cases where the items are treated as discount or as an adjustment to the yield of a debt instrument over the life of the instrument in its AFS for financial reporting purposes. The final regulations do not subject these amounts to the AFS income inclusion rule because these special accounting methods do not generally rely on the all events test to determine the timing of income inclusion and these current special accounting methods provide workable income-recognition timing rules that appropriately measure income. The Treasury Department and the IRS expect that subjecting these items to the AFS income inclusion rule of section 451(b) would disrupt and complicate current tax accounting practices with no general economic benefit.

5. Economic Effects of Provisions Under 451(c)

a. Provisions Substantially Revised From the Proposed Section 451(c) Regulations

i. Cost Offset for Advance Payments

The Treasury Department and the IRS considered three options for addressing the treatment of costs under section 451(c): (i) No cost offset; (ii) a cost offset for incurred costs; and (iii) a cost offset that further allowed for projected costs. The proposed section 451(c) regulations (in this part C.5,

proposed regulations

) did not provide for a cost offset for advanced payments. At the time, the Treasury Department and the IRS argued that Congress intentionally simplified the rules for advance payments by limiting the deferral of advance payments for taxpayers with an AFS to a prescribed statutory method that (1) does not include an accelerated cost offset, (2) is consistent with Revenue Procedure 2004-34, and (3) overrides § 1.451-5. Taxpayers commenting on the proposed regulations were concerned that the failure to provide a cost offset rule in 451(c) would cause a mismatch of income and expenses and result in the taxation of gross receipts. For example, if a business has a multi-year contract to build or manufacture a highly customized good, it would report any advance payment in income in the year of receipt or in the following taxable year. If it uses the advance payment to purchase materials and to pay workers as part of the project, it would recover those costs only when the sale takes place. Under the proposed regulations, the statute would generate a tax on the total amount of the advance payment in the first years of the contract with all related costs being recovered later in the contract.

In response to these comments on the proposed regulations, the Treasury Department and the IRS have written the final regulations to include an offset for cost of goods in progress (cost offset). This cost offset allows taxpayers to reduce the amount of an advance payment for the future sale of inventory that is required to be included in gross income in a year prior to the year in which ownership of the inventory is transferred to the customer. The amount of such reduction, or cost offset, is equal to the inventoriable costs incurred as of the end of the taxable year in which the advance payment is required to be included in gross income under the taxpayer's method of accounting for advance payments. This provision of the final regulations allows taxpayers to offset advance payments included in income under either the full inclusion method or the deferral method. However, the cost of goods in progress offset cannot reduce the amount of the advance payment income inclusion below zero. Any incurred costs subject to this limitation may be carried forward to determine the cost of goods in progress in subsequent taxable years.

The cost offset in the final regulations generally reduces the amount of the advance payment that is required to be included in gross income in a taxable year prior to the year in which ownership of the inventory is transferred to the customer relative to the proposed regulations. An improved match of income and cost timing is generally held to provide a more accurate measure of economic activity and thus provide a more efficient tax system than under the proposed regulations. For further discussion of the economic effects of the cost offset for advance payments and for income more generally see 4.a.i.

The Treasury Department and the IRS considered expanding the cost offset to allow for projected costs, with several possible formats being considered for how projected costs would be treated. Allowing an offset for projected costs would entail a higher administrative burden than the offset for incurred costs and may not definitively improve the alignment of when income and costs are recognized for tax purposes relative to the offset for incurred costs.

The Treasury Department and the IRS have not estimated the difference in compliance costs, administrative burden, or income-cost alignment (and any subsequent effects on economic activity) between the final regulations and alternative regulatory approaches using projected costs associated with advance payments. The Treasury Department and the IRS have not undertaken this estimation because they do not have sufficiently detailed data or models that capture possible differences in cost offset formats that use incurred costs versus projected costs.

b. Provisions Not Substantially Revised From the Proposed Regulations

i. Deferral Methods Under Section 451(c)

The statute prescribes a particular deferral method for accrual-method taxpayers that have an AFS (AFS taxpayers) but does not explicitly describe a deferral method to be used by taxpayers that do not have an AFS (non-AFS taxpayers). To remedy this gap, the proposed and final regulations describe and clarify that a method similar to the deferral method available to non-AFS taxpayers under Revenue Procedure 2004-34 will be available to non-AFS taxpayers.

The Treasury Department and the IRS considered and rejected a narrow interpretation of section 451(c) that would have precluded non-AFS taxpayers from using a deferral method similar to that provided in Revenue Procedure 2004-34. Section 451(c) does not explicitly prohibit the use of such a method by non-AFS taxpayers, and the Treasury Department and IRS continue to have authority under the Code to prescribe a deferral method for such taxpayers. Precluding non-AFS taxpayers from using a deferral method similar to that of AFS taxpayers would treat AFS and non-AFS taxpayers quite differently regarding business decisions they might make that are otherwise similar. Such treatment would result in a less economically efficient tax system, which generally treats similar economic decisions similarly.

ii. Advance Payment Acceleration Provisions

If a taxpayer ceases to exist by the close of a taxable year in which an advance payment has been received and deferred, then issues may arise as to when or whether the remaining amount of the payment will be recognized as taxable income because there may not be a succeeding taxable year in which such income can be recognized.

Under the statute, if the taxpayer dies or ceases to exist by the close of the taxable year in which the advance payment was received, any remaining untaxed amounts of advance payments must be included in income in the year they were received. The final regulations extend this payment “acceleration” rule to situations in which a performance obligation is satisfied or otherwise ends in the taxable year of receipt or in a succeeding short taxable year, a treatment that is consistent with a similar rule in Revenue Procedure 2004-34.

The Treasury Department and the IRS considered not modifying or expanding the acceleration rule contained in section 451(c) but rejected this alternative because the remaining amount may never be included in income, thus risking a permanent exclusion of the amount from taxable income. The possibility of a permanent exclusion of income provides incentives for taxpayers to structure payments in ways that avoid tax liability, thus reducing Federal tax revenue without providing an accompanying general economic benefit. The proposed and final regulations treat the expanded set of accelerated transactions consistently with similar types of transactions based on the timing and structure of the payments involved.

iii. Advance Payments and Financial Statement Adjustments

Under the statute, if a taxpayer counts an advance payment as an item of deferred revenue, under certain conditions (for example, certain acquisitions of one corporation by another), the taxpayer may be required by its system of accounting to adjust that item on the balance sheet in a subsequent year. The item would then not be included in current earnings or AFS revenues. In this case, taxpayers might argue that they can exclude the amount deferred from taxable income because it is never “earned” nor included in revenue under their AFS. If this argument were upheld, taxpayers could convert an income “deferral” amount into an income “exemption” amount. To address this issue and avoid this possibility, the proposed and final regulations specify that such financial statement adjustments are to be treated as “revenue.”

The Treasury Department and the IRS considered not providing clarity on the treatment of financial statement write-downs but rejected that approach because it would have risked an inappropriate permanent exclusion of income. The possibility of a permanent exclusion of income provides incentives for taxpayers to structure payments in ways that avoid tax liability, thus reducing Federal tax revenue without providing an accompanying general economic benefit.

iv. Short Taxable Years and the 92-Day Rule

Section 451(c) does not provide a rule relating to the treatment of short taxable years. In the absence of such a rule, it will be unclear to taxpayers how they should implement the deferral method provided in section 451(c) in the case of a short taxable year. To address this issue, the proposed and final regulations provide rules relating to the treatment of short taxable years for advance payments that are generally consistent with Revenue Procedure 2004-34. The Treasury Department and the IRS considered and rejected not providing short taxable year rules because such a decision would have created significant confusion among taxpayers, increased administrative costs for the IRS, and increased compliance costs for taxpayers.

v. Performance Obligations for Non-AFS Taxpayers

A performance obligation is generally a contractual arrangement with a customer to provide a good, service or a series of goods or services that are basically the same and have a routine pattern of transfer. Further, each performance obligation in a contract generally yields a separate item of gross income. The Treasury Department and the IRS interpret the statute as requiring taxpayers to allocate payments attributable to multiple items of gross income in the same manner as such payments are allocated to the corresponding performance obligations in the taxpayer's AFS. The statute does not, however, specify the allocation rules to be used by non-AFS taxpayers.

To address this issue, the proposed and final regulations provide allocation rules for non-AFS taxpayers consistent with a similar rule in Re

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