IRS Releases Advance Payment Proposed Regulations for Accrual Method Taxpayers, Providing One-Year Deferral

On September 5, the IRS released guidance in the form of proposed regulations (Prop. Reg. §1.451-8) that address the receipt of payments from customers for goods and services (along with additional other items) in advance of when the property or service is delivered or performed by the taxpayer. The proposed regs provide guidance on Internal Revenue Code (IRC) Section 451(c), which was added as part of the Tax Cuts and Jobs Act. New IRC §451(c) essentially codified previously existing IRS guidance under Revenue Procedure 2004-34, which regulated when income from advance payments must be recognized for tax purposes compared to when that income is recognized for financial reporting purposes.

The general rule of Section 451(c)(1)(A) requires that an accrual method taxpayer who receives an advance payment include that amount in income in the taxable year of receipt. Section 451(c)(1)(B), however,  provides an exception that allows accrual method taxpayers to elect to defer the inclusion of income associated with certain advance payments for one year, or to the taxable year following the taxable year of receipt of such income. The election, once made, is effective for all subsequent tax years, unless the taxpayer obtains the consent of the IRS to change.

The proposed regulations define what is both included and excluded in the term “advance payment.” They also include guidance for taxpayers with short tax years of 92 days or less, when deferrals must be accelerated, and the tax consequences of financial statement adjustments.

Due to the language in the IRC as passed by Congress, the proposed regs appear to unnecessarily complicate analysis and implementation by providing separate rules for those taxpayers with applicable financial statements – or AFS (generally think audited statements) – and those without AFS, such as compiled or reviewed statements. The practical difference in results between those with and those without, arising from the different sets of rules, appears to be immaterial.

For those already applying the benefits of Revenue Procedure 2004-34, there will likely be no noticeable change in tax consequences and tax liability. For those not already using the deferral method, a change of accounting method will be necessary, though that change should generally be automatic, as provided under the guidance of Rev. Proc. 2019-37.

The ultimate economic consequences to taxpayers of these proposed regulations depend in part on their interaction with other sections of the IRC governing the timing of deductions for federal income tax purposes, including provisions for determining when costs can be recovered under the percentage of completion method and when costs incurred by a taxpayer satisfy the all events test for tax deductibility. Additionally, changes to the accelerated cost offset rules could result in a mismatch of income and expense.

The advanced payment deferral methods found in Proposed Reg. §1.451-8(c) or Reg. §1.451-8(d) are to be the sole method for avoiding immediate inclusion in income when an advance payment is received by a taxpayer. Confused? Don’t hesitate to contact us for more details or for assistance in implementing the rules.