Assessing the Impact of IRC Section 451(b) on Income Recognition

Accrual basis taxpayers have traditionally used the “all-events test” to determine the inclusion of taxable income for federal tax purposes. Under this test, income is taxable in the tax year in which all the events have occurred that fix a right to receive an item of income and the amount of that income can be determined with reasonable accuracy. While not superseded by 2017’s Tax Cuts and Jobs Act (Act), the Act adds a curve ball that entities will need to consider in determining their taxable income for any given year.

Section 451(b) of the Internal Revenue Code (IRC) states that the “all-events test” for an accrual basis taxpayer should not be treated as met any later than when such item is recorded as revenue in the applicable financial statement of the taxpayer. So, unless using a special method of accounting provided for elsewhere in the IRC, income for tax purposes will be recognized no later than when it is recognized for financial reporting purposes.

Complicating the application of Section 451(b) is the adoption by entities of Accounting Standards Codification Topic 606, Revenue from Contracts with Customers (Topic 606), in 2018 and 2019 for public business and non-public business entities, respectively. This new comprehensive accounting standard regarding revenue recognition may result in a change in timing of the recognition of revenue for many entities. Under Topic 606, entities must identify performance obligations in their revenue contracts, estimate the transaction price after considering both fixed and variable consideration and then allocate that transaction price to each performance obligation which it previously identified. For each performance obligation, an entity determines if control of the good or service passes over time or at a point in time, with revenue for financial reporting recognized correspondingly.

Common changes in the recognition of revenue for financial reporting purposes due to the adoption of Topic 606 include the following:

Identification of more performance obligations under Topic 606
A change in the transaction price used to recognize revenue due to applying Topic 606’s guidance on variable consideration
A reduction in transaction price for implied concessions that were considered bad debts under legacy guidance
Capitalization of certain contract costs under Topic 606 which were expenses under legacy accounting

Given the provisions of Section 451(b), adoption of these and other changes required under Topic 606 will likely result in an acceleration of recognition of taxable income for accrual basis taxpayers.

Differences between the tax and financial reporting recognition of income are not new. These differences generate deferred tax assets or liabilities in the financial statements of accrual basis taxpayers. These balances result from differences in the timing of income recognition between the time when entities met the “all-events test” and when they recognized revenue, as per applicable accounting rules. However, the effective date of Topic 606 will require entities to reassess when they meet the “all-events test” in light of the impact of applying this new accounting guidance.

What should entities do to prepare for this book-tax conformity requirement? First, they should determine if the entity issues an applicable financial statement (AFS). If not, Section 451(b) does not apply. Section 451 (b)(3) defines an AFS as (1) a financial statement certified as being prepared in accordance with U.S. GAAP for certain purposes, such as for U.S. Securities and Exchange Commission (SEC) filings or certain audited financial statements that the entity uses, or (2) a financial statement prepared under International Financial Reporting Standards (IFRS) and filed with certain foreign governmental entities; or (3) a financial statement filed by the taxpayer with any other regulatory or governmental body specified by the IRS and Treasury. So clearly many entities will meet this AFS requirement.

Next, an entity should see if it can utilize any of the special methods of accounting contained in Section 451. These include updated guidance on the treatment of advanced payments (Section 451(c)), and special rules for other unique, often industry or event-specific situations. Also, the conformity requirement does not apply to income items for which the taxpayer is using another “special method of accounting” per the Code, such as the installment method of Section 453 or the long-term contract method of Section 460.

However, if an entity does not meet one of these exemptions, the conformity requirement applies.

Accounting for these book-tax differences in the timing of recognizing revenue would actually be simplified by the conformity requirement, though changes in the recognition of income for tax purposes would likely resort in a change of tax method under the IRS Code, which may require IRS approval. In Revenue Procedure 2018-29, the IRS detailed the following changes in income recognition for tax purposes in order to conform with Topic 606 which it would automatically approve:

Identifying performance obligations
Allocating transaction price to performance obligations
Considering performance obligations satisfied.

A taxpayer may request these changes only if the taxpayer’s new method of accounting is otherwise permissible for federal income tax purposes and the change in method is made for the taxable year in which the entity adopts Topic 606.

However, the following changes in the tax method of recognizing income would require IRS approval, via a Form 3115:

A change in the manner in which the taxpayer identifies contracts or determines the transaction price, including the inclusion or exclusion of variable consideration in the transaction price
A change in method of accounting for recognizing income that is made in a year that is different from the year in which the entity adopts Topic 606
A change in accounting method that does not comply with Section 451, or other guidance
Any change in method of accounting that already qualifies for an automatic change, since the IRS automatically approves certain changes requested on Form 3115

An entity making such a change can use either the cut-off basis or Section 481(a) approach in making the change in method.

While for public entities, the efforts of adopting Topic 606 are winding down, they still must consider these tax implications of applying Section 451 in order to get over the finish line. For private entities still working on implementing Topic 606, they must assure that they consider these tax consequences in both their accounting for revenue under Topic 606 as well as assuring that they comply with all provisions in the Act. Either way, the effort is not yet complete.

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Rich Daisley, CPA, is Senior Director, Accounting and Financial Reporting Content for Surgent CPE. With over 26 years of experience in the accounting and auditing field, Mr. Daisley has worked in both the client service setting, mainly for PwC’s Capital Markets and Accounting Advisory Services Group and for PECO Energy’s Merger and Acquisition Group, and in the internal capacity setting as a course developer and facilitator creating leading training courses for PwC and Surgent. Rich lives in suburban Philadelphia.

Advisory