United States: Method madness

In brief

The IRS recently issued guidance describing how taxpayers may obtain automatic consent to change their methods of accounting to comply with new final regulations under Code Section 451.


Contents

In more detail  

For accrual-basis taxpayers, income is included in gross income when the “all-events test” is satisfied. Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), the “all-events test” for income recognition was satisfied when performance occurred, payment was due, or when payment was received. Then, in 2017, the TCJA amended the income recognition provisions in Sections 451(b) and (c). Under new section 451(b)(1)(A), an accrual-basis taxpayer recognizes revenue at the time the “all-events test” has been satisfied, but no later than when the taxpayer takes that item of income into account as revenue in an applicable financial statement ( AFS) or such other financial statement as the Treasury Secretary may specify. Additionally, under new section 451(b), specified credit card fees are subject to the AFS inclusion rules instead of the original issue discount timing rules. The TCJA also added new section 451(c) which requires accrual-basis taxpayers to recognize advance payments in income in the year of receipt and provides an election to defer recognition to the following taxable year if the taxpayer also defers that income for AFS purposes. The IRS published final section 451 regulations (“Final Section 451 Regulations”) on 6 January 2021. The Final Section 451 Regulations provide deferral for taxpayers with and without an AFS. Treasury Regulations section 1.451-3 provides guidance under section 451(b) regarding the general rule for the timing of income recognition. Treasury Regulations section 1.451-8 provides guidance under section 451(c) regarding advance payments for goods, services, and certain other items.

The changes to sections 451(b) and (c) and the regulations thereunder created a need for procedural guidance from the IRS on accounting method changes. A taxpayer generally must obtain consent from the Commissioner of Internal Revenue (“Commissioner”) to change its accounting method, and the regulations under section 446 authorize the Commissioner to issue guidance providing the terms and conditions necessary for a taxpayer to obtain consent to change its accounting method. For certain accounting method changes, a taxpayer is eligible for “automatic” consent from the Commissioner to change its method. Taxpayers generally change their methods of accounting by filing Form 3115, Application for Change in Accounting Method. Revenue Procedure 2015-13 provides the general procedures for obtaining non-automatic consent when certain scope and eligibility requirements are satisfied, and the procedures for obtaining automatic consent for accounting method changes described in Rev. Proc. 2019-43. In addition to other transitional guidance, in 2018, the IRS issued Rev. Proc. 

2018-60, which provides automatic procedures for taxpayers to obtain consent to change their methods of accounting to comply with section 451(b). Then the IRS issued Rev. Proc. 2019-37 to provide taxpayers the ability to obtain automatic consent to change their methods of accounting to comply with the proposed regulations under sections 451(b) and (c). In November 2019, the IRS issued Rev. Proc. 2019-43, which provides a comprehensive list of automatic changes to which the automatic consent procedures in Rev. Proc. 2015-13 apply. After the Treasury and the IRS issued the Final Section 451 Regulations, the IRS issued additional guidance with respect to method changes to comply with the Final Section 451 Regulations in the form of Rev. Proc. 2021-34 and Rev. Proc. 2021-35. The revenue procedures modify Rev. Procs. 2019-43 and 2015-13 to amend existing automatic method changes and add new ones to account for the Final Section 451 Regulations.

Taxpayers should pay special attention to Rev. Proc. 2021-34, which provides the general rules that will apply to most taxpayers. Revenue Procedure 2021-35 refers to some of the rules set out in Rev. Proc. 2021-34 and is much more limited in its application (as described further below).

In general, Rev. Proc. 2021-34 modifies Rev. Procs. 2019-43 and 2015-13 to describe how taxpayers may obtain automatic consent to change their methods of accounting to comply with the Final Section 451 Regulations. Revenue Procedure 2021-34 modifies Rev. Proc. 2019-43 to remove automatic changes to comply with old section 451(b), keeps and modifies automatic changes to comply with the proposed section 451 regulations, and adds new automatic method changes to comply with the Final Section 451 Regulations. The revenue procedure also provides procedures for taxpayers to obtain automatic consent for changes to methods of accounting for certain inventory costs to comply with Sections 263A, 461, and 471 if made in connection with a method change to adopt the Final Section 451 Regulations. With respect to advance payments, Rev. Proc. 2021-34 modifies Rev. Proc. 2019-43 to reflect the fact Rev. Proc. 2004-34 (which the Final Section 451 Regulations generally codified, with some modifications) is now obsolete. Under the Final Section 451 Regulations, taxpayers with an AFS are required to use the full inclusion method or deferral method under Treas. Reg. § 1.451-8(b) or (c), and taxpayers without an AFS are required to use the methods in Treas. Reg. § 1.451-8(b) or (d)(3). Revenue Procedure 2021-34 provides automatic consent for method changes to comply with those regulations.

With respect to the Final Section 451 Regulations, Rev. Proc. 2021-34 allows a taxpayer with an AFS to make automatic changes to its methods of accounting under Treas. Reg. § 1.451-3(b) and under Treas. Reg. § 1.451-8. Specifically, the taxpayer can use automatic change procedures to make a change to comply with the AFS inclusion rule, to determine AFS revenue, or to apply the cost offset method under Treas. Reg. § 1.451-3(b); and can use automatic change procedures to change to the full inclusion method, to change to the deferral method, or to apply the cost offset method under Treas. Reg. § 1.451-8. A taxpayer without an AFS can also use automatic change procedures to change its method of accounting for advance payments under Treas. Reg. § 1.451-8.

Revenue Procedure 2021-34 also provides rules relating to corresponding inventory accounting changes required by the Final Section 451 Regulations. In some cases, such inventory changes and the corresponding change can be made on the same Form 3115.

A change to comply with the Final Section 451 Regulations is considered an accounting method change that requires the filing of Form 3115. Revenue Procedure 2021-34 is generally effective for Forms 3115 filed on or after 12 August 2021. Thus, all Forms 3115 filed with the IRS on or after 12 August must comply with Rev. Proc. 2021-34. In general, the taxpayer must file Form 3115 with its timely filed federal income tax return. Revenue Procedure 2021-34 does not allow taxpayers to make method changes on amended returns. Revenue Procedure 2021-34 provides “streamlined” procedures for certain method changes made for the taxpayer’s early adoption year or first taxable year beginning on or after 1 January 2021, if the change results in a section 481(a) adjustment of zero. If streamlined procedures apply, the taxpayer does not have to complete Form 3115 or attach a statement to its tax return. Taxpayers that file Form 3115 under Rev. Proc. 2021-34 generally have audit protection, but if the streamlined provisions apply, the taxpayer will not have audit protection. If a taxpayer submitted Form 3115 to the IRS National Office requesting a method change before 12 August, the change was not covered by automatic change procedures at the time of filing, and the change is now eligible for the automatic change procedures under Rev. Proc. 2021-34; the IRS will send the form back and the taxpayer can refile. If the taxpayer filed Form 3115 before 12 August under automatic change procedures that were in place at the time but were eliminated by Rev. Proc. 2021-34, the taxpayer is still eligible for an automatic change.

On the same day it issued Rev. Proc. 2021-34, the IRS issued Rev. Proc. 2021- 35, which modifies Rev. Proc. 2013-26 to reflect changes made to the treatment of certain credit card fees by section 451(b) and Treas. Reg. §§ 1.451-3 and 1.1275-2(l). Revenue Procedure 2013-26 provides taxpayers a safe harbor method of accounting, known as he “proportional method” of accounting, for original issue discount on a pool of credit card receivables for purposes of Section 1272(a)(6). Revenue Procedure 2021-35 requires taxpayers using the “proportional method” to remove specified credit card fees from its pool of credit card receivables because the “proportional method” no longer applies to such fees.

The Final Section 451 Regulations are effective for tax years beginning on or after 1 January 2021. The procedures in Rev. Proc. 2021-34 are effective immediately for Forms 3115 filed on or after 12  August 2021. 

Subject to limited exceptions, a taxpayer must file Form 3115 with its timely filed return to make an accounting method change, even under automatic change procedures. As described above, taxpayers can choose to apply the Final Section 451 Regulations to a tax year beginning after 31 December 2017, but Rev. Proc. 2021-34 does not allow taxpayers to include a method change on an amended return, so taxpayers must early adopt the regulations on original returns filed for tax years beginning before 1 January 2021. As noted above, Rev. Proc. 2021-34 provides extremely detailed information about accounting method changes and procedural requirements for each method change. Given the complexity of the Final Section 451 Regulations and the new revenue procedures, taxpayers seeking to make method changes should consult their tax advisors to avoid costly missteps when trying to navigate accounting method changes.

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