TCJA – Could 2019 Taxable Income be Higher than Projected?

As we approach the end of 2019, two separate changes in reporting of gross income from providing goods and/or services could combine for an unpleasant surprise that increases taxable income for privately held companies. The first change results from a change in reporting gross income for financial reporting purposes while the second change is a result of a change in the tax law brought by the 2017 Tax Cuts and Jobs Act (TCJA). These two changes could combine to accelerate the recognition of gross income into 2019, with a resulting increase in taxable income, compared to what it would have been without these rule changes.

The TCJA amended §451(b) to generally require conformity between the reporting of gross income for tax purposes to revenue reported for financial statements for accrual basis taxpayers. The GAAP accounting rules under ASC 606, generally effective for private companies in 2019, can change the analysis of when income is generally recognized for GAAP purposes from a point in time (i.e., job completion or date of shipment) to the recognition of income over a period of time.  

Before the TCJA, all accrual basis taxpayers recognized income under the earlier of one of three prongs of the “all events test”:

(1) When it is received (cash in hand);

(2) When it is due and payable (essentially billed or invoiced); or

(3) When it is earned through the required performance.  

The TCJA now adds a fourth prong. This fourth prong requires income to be recognized at the same time as it is being recognized for financial reporting purposes (with certain exceptions) but only for taxpayers having an applicable financial statement (AFS).

An AFS generally is an audited financial statement prepared under GAAP (or IFRS) for the SEC, shareholders, creditors, or other government authorities (state or local) and agencies.

The fourth prong of the test does not apply to taxpayers that do not have an AFS (reviewed or compiled statements). This rule then can treat identical taxpayers differently (businesses with an AFS versus those without an AFS) causing their tax liabilities to be different in any one year (but theoretically the same over a period of years - all else being equal).  

These new rules can affect almost any industry, but businesses in the contract manufacturing, construction, engineering, technology, professional service industries can be particularly impacted. As with many provisions in the tax code though, there are exceptions that can apply and accounting method change alternatives to be analyzed that can possibly mitigate potentially negative 2019 consequences.

The potential impact of these rules will need to be addressed on a taxpayer by taxpayer basis; the final result is likely unknown for tax purposes until the financial reporting impact is finalized and potential tax alternatives can be considered. This change will require co-operation between financial reporting professionals and tax professionals, and between the business and their outside accounting firm, so as to fully understand and document the revenue recognition process imbedded in their contractual arrangements with their customers.

If you have any questions on the potential impact to your business of the ASC 606 rules, the TCJA provisions, or both, please do not hesitate to call Schneider Downs.