In the Tax Cuts and Jobs Act, Congress added IRC §451(c) in order to put into the Code an accounting method the IRS had defined in Revenue Procedure 2004-34 to optionally account for advance payments. On September 5, 2019, the IRS released proposed regulations to implement this provision.[1] Specifically, the IRS has proposed to add Proposed Reg. §1.451-8, Advance payments for goods, services and other items to the existing regulations under IRC §451.

The IRS makes clear in the preamble that, for the most part, the proposed regulations will follow the previously existing guidance:

Because new section 451(c)(1)(B) was intended to generally codify the Revenue Procedure deferral method, the Treasury Department and the IRS believe that rules similar to the Revenue Procedure deferral method are necessary and appropriate for the proper application of section 451(c). See H.R. Rep. No. 115-466, at 429 (2017) (Conf. Rep.).[2]

Regulation Provides Only Methods to Defer Recognition of an Advance Payment

The regulation begins by noting that the advanced payment deferral methods found in Proposed Reg. §1.451-8(c) or (d) are the sole method to avoid immediate inclusion in income when an advance payment is received by the taxpayer.[3]

Definition of an Advance Payment

The regulations outline what is and is not considered to be an advance payment subject to these rules. An advance payment is a payment received by the taxpayer if:

Full inclusion of the payment in the taxpayer’s income for the year of receipt would otherwise be a permissible method of accounting for tax purposes (that is, no other provision of the IRC requires deferral of recognition);
Any portion of the payment in question is included by the taxpayer in an applicable financial statement (AFS) for a subsequent taxable year (AFS has the same meaning it does under the revenue conformity regulations for §451(b)[4]); and
The payment is for:
- Services;
- The sale of goods;
- The use, including by license or lease, of intellectual property, including copyrights, patents, trademarks, service marks, trade names, and similar intangible property rights, such as franchise rights and arena naming rights;
- The occupancy or use of property if the occupancy or use is ancillary to the provision of services, for example, advance payments for the use of rooms or other quarters in a hotel, booth space at a trade show, campsite space at a mobile home park, and recreational or banquet facilities, or other uses of property, so long as the use is ancillary to the provision of services to the property user;
- The sale, lease, or license of computer software;
- Guaranty or warranty contracts ancillary to an item or items described in the preceding bullets;
- Subscriptions in tangible or intangible format other than those for which an election under section 455 is in effect;
- Memberships in an organization other than those for which an election under section 456 is in effect;
- An eligible gift card sale;
- Any other payment specified by the Secretary in other guidance published in the Internal Revenue Bulletin; or
- Any combination of items described in the preceding bullets.[5]

The following items are specifically excluded from being treated as an advance payment:

Rent, except for those rents specifically included as advance payments in the prior list;
Insurance premiums, to the extent the inclusion of those premiums is governed by subchapter L;
Payments with respect to financial instruments (for example, debt instruments, deposits, letters of credit, notional principal contracts, options, forward contracts, futures contracts, foreign currency contracts, credit card agreements (including rewards or loyalty points under such agreements), financial derivatives, or similar items), including purported prepayments of interest;
Payments with respect to service warranty contracts for which the taxpayer uses the accounting method provided in Revenue Procedure 97-38 (1997-2 CB 479);
Payments with respect to warranty and guaranty contracts under which a third party is the primary obligor;
Payments subject to section 871(a) (income of a nonresident alien not connected with the United States), 881(taxation of income of foreign corporations not connected with the United States), 1441 (withholding tax on nonresident aliens), or 1442 (withholding of tax on foreign corporations);
Payments in property to which section 83 applies (property transferred in connection with the performance of services); and
Payments received in a taxable year earlier than the taxable year immediately preceding the taxable year of the contractual delivery date for a specified good.[6]

For purposes of the last item listed, a specified good is defined as a good for which:

During the taxable year a payment is received, the taxpayer does not have on hand (or available to it in such year through its normal source of supply) goods of a substantially similar kind and in a sufficient quantity to satisfy the contract to transfer the good to the customer; and
All the revenue from the sale of the good is recognized in the taxpayer’s AFS in the year of delivery.[7]

The contractual delivery date is the month and year of delivery listed in the written contract to the transaction. [8] Thus, a written contract must exist to defer the recognition past the year following the receipt of payment, even if all other conditions for the longer deferral of recognition are met.

An item of gross income is received by the taxpayer if it is actually or constructively received, or if it is due and payable to the taxpayer.[9]

Revenue, performance obligation and transaction price, when used in this regulation, has the same meanings they have under Proposed Reg. §1.451-3 that deals with the revenue conformity rule found in IRC §451(b).[10]

Eligible Gift Card Sale

As was noted in the prior section, only eligible gift card sales qualify for treatment as a an advance sale for purposes of §451(c). Such a sale is the sale of a gift card or gift certificate if:

The taxpayer is primarily liable to the customer, or holder of the gift card, for the value of the card until redemption or expiration; and
The gift card is redeemable by the taxpayer or by any other entity that is legally obligated to the taxpayer to accept the gift card from a customer as payment for items otherwise eligible for treatment as an advance payment if the payment had been made directly for that item.[11]

Deferral Method for a Taxpayer with an Applicable Financial Statement

The IRS begins by dealing with taxpayers who have an applicable financial statement. Note that the IRC itself only refers to taxpayers with an applicable financial statement under §451(b).[12] However, in a later section we’ll find that the IRS has extended the rules to cover those without an AFS, based on the fact that Revenue Procedure 2004-34 also had provisions for taxpayers without an AFS.

A taxpayer with an AFS can elect to use the deferral method under IRC §451(c) if the taxpayer is able to determine the extent to which such advanced payments are included in revenue of the AFS during the taxable year.[13]

A taxpayer using the AFS deferral method must:

Include the advance payment, or any portion thereof, in gross income in the taxable year of receipt to the extent included in revenue in its AFS; and
Include the remaining portion of such advance payment in gross income in the taxable year following the taxable year in which such payment is received.[14]

The regulations require that advance payments must be entirely included in gross income in the taxable year of receipt or, if applicable, a short taxable year where the advance payment is not otherwise required to be entirely included in income:

If, in that taxable year, the taxpayer either dies or ceases to exist in a transaction other than a transaction to which section 381(a) applies; or
If, and to the extent that, in that taxable year, the taxpayer's obligation with respect to the advance payments is satisfied or otherwise ends other than in:
- A transaction to which section 381(a) applies; or
- A section 351(a) transfer that is part of a section 351 transaction in which:
  - § Substantially all assets of the trade or business (including advance payments) are transferred;
  - § The transferee adopts or uses the deferral method in the year of transfer; and
  - § The transferee and the transferor are members of the same consolidated group, as defined in §1.1502-1(h).[15]

The regulations provide the following example:

Example (Proposed Reg. §1.451-8(c)(2)(iii))

Ceasing to Exist

If there is a financial statement adjustment where a taxpayer treats an advance payment as an item of deferred income in its AFS and it writes down or adjusts the item (or some portion) directly to an equity account, the amount is to be included in income.[16]

The IRS provides the following examples related to applying the adjustment rule:

Example (Proposed Reg. §1.451-8(c)(3)(ii))

Example 1

On May 1, 2018, A, a corporation that files its federal income tax return on a calendar year basis, received $100 as an advance payment for a 2-year contract to provide services. For financial accounting purposes, A recorded $100 as a deferred revenue liability in its AFS, expecting to report 1/4 of the advance payment in revenue in its AFS for 2018, 1/2 for 2019, and 1/4 for 2020. On August 31, 2018, C, an unrelated corporation that files its federal income tax return on a calendar year basis, acquired all of the stock of A, and A joined C’s consolidated group. A’s short taxable year ended on August 31, 2018, and, as of that date, A had included only 1/4 ($25) of the advance payment in revenue in its AFS. On September 1, 2018, after the stock acquisition, and in accordance with purchase accounting rules, C wrote down A’s deferred revenue liability to its fair value of $10 as of the date of the acquisition. The $10 will be included in revenue on A’s AFS in accordance with the method of accounting A uses for financial accounting purposes. For federal income tax purposes, A uses the deferral method. For federal income tax purposes, A must take 1/4 ($25) of the advance payment into income for its short taxable year ending August 31, 2018, and the remainder of the advance payment ($75) ($65 write down + $10 future financial statement revenue) must be included in income for A’s next succeeding taxable year.

Example 2

On May 1, 2018, B, a corporation that files its federal income tax return on a calendar year basis, received $100 advance payment for a contract to be performed in 2018, 2019, and 2020. On August 31, 2018, D, a corporation that is not consolidated for federal income tax purposes, acquired all of the stock of B. Before the stock acquisition, on its AFS for 2018, B included $40 of the advance payment in revenue, and $60 as a deferred revenue liability. On September 1, 2018, after the stock acquisition and in accordance with purchase accounting rules, D wrote down its $60 deferred revenue liability to $10 (its fair value) as of the date of the acquisition. After the acquisition, B does not include in revenue any of the $10 deferred revenue liability in its 2018 AFS. B does include $5 in revenue in 2019, and $5 in revenue in 2020. For federal income tax purposes, B uses the deferral method. For federal income tax purposes, B must take $40 of the advance payment into income in 2018, and the remainder of the advance payment ($60) ($50 write down + $10 future financial statement revenue) must be included in income for B’s next succeeding taxable year, 2019.

A special rules applies if the succeeding taxable year is a short taxable year of 92 days or less. In that case, the taxpayer will include amounts related to advance payments initially treated under the deferral method in the prior year only to the extent the advance payment is included in income in the AFS for the short year. The remaining balance (if any) will be included in income in the following year.[17]

Example (Proposed Reg. §1.451-8(c)(4)(ii))

A is a calendar year taxpayer and is in the business of selling and licensing computer software (off the shelf, fully customized, and semi-customized) and providing customer support. On July 1, 2018, A receives an advance payment for a 2- year software maintenance contract. Under the contract, A will provide software updates if it develops an update within the contract period, as well as online and telephone customer support. A changes its taxable period to a fiscal year ending March 31 so that A has a short taxable year beginning January 1, 2019, and ending March 31, 2019. In its AFS, A includes 1/4 of the payment in revenue for the taxable year ending December 31, 2018; 1/6 in revenue for the short taxable year ending March 31, 2019; 1/4 in revenue for the taxable year ending March 31, 2020; and 1/4 in revenue for the taxable year ending March 31, 2021. Because the taxable year ending March 31, 2019, is 92 days or less, A must include 1/4 of the payment in gross income for the taxable year ending December 31, 2018, 1/6 in gross income for the short taxable year ending March 31, 2019, and the remaining amount in gross income for the taxable year ending March 31, 2020.

If an eligible gift card is redeemable by another entity whose financial results are not included in the AFS for the taxpayer, a payment is treated as included in the taxpayer’s AFS to the extent the gift card is redeemed by the other entity during the tax year.[18]

The IRS includes 25 examples, covering different types of advance payments, at Proposed Reg. §1.451-8(c)(8).

Deferral Method for Taxpayers Without an AFS

As was noted earlier, the provision at IRC §451(c) added by the TCJA could not be applied to a taxpayer without an AFS, since the determination of the amount to include in income is determined in the law by reference to the IRC §451(b) AFS.[19] But the IRS justified adding a non-AFS rule even thought law did not apply to taxpayers without an AFS in the preamble by stating:

The Treasury Department and the IRS have concluded that section 451(c) does not prohibit a deferral method that is otherwise permissible under Revenue Procedure 2004-34. See H.R. Rep. No. 115-466, at 429 (2017) (Conf. Rep.). See also, Joint Committee on Taxation, General Explanation of Public Law 115-97 (JCS-1-18) at 170-171 (Dec. 20, 2018). Revenue Procedure 2004- 34 permitted non-AFS taxpayers to use the Revenue Procedure deferral method based on when the income is earned (earned standard). See section 5.02(3)(b) of Revenue Procedure 2004-34. The Revenue Procedure deferral method using the earned standard is a permissible method of accounting for non-AFS taxpayers and, therefore, these proposed regulations also provide a similar deferral method for non-AFS taxpayers in proposed §1.451-8(d) (non-AFS deferral method).[20]

The non-AFS deferral method is available to taxpayers without an applicable financial statement as defined in IRC §451(b) and requires:

The taxpayer be able to determine when the extent to which advance payments are included in income in the year of receipt or, if applicable, a short taxable year.[21] That amount is included in income in the year of receipt up to the amount that is earned in that year;[22] and
The remaining amount is included in income in the following year.[23]

An amount is treated as earned for a taxpayer without an AFS when the all events test described in Reg. §1.451-1(a), without regard to when the payment is received.[24] If a taxpayer is unable to determine the extent to which a payment is earned in the year of receipt, the taxpayer may determine the amount:

On a statistical basis if adequate data are available to the taxpayer;
On a straight line ratable basis over the term of the agreement if the taxpayer receives advance payments under a fixed term agreement and if it is not unreasonable to anticipate at the end of the taxable year of receipt that the advance payment will be earned ratably over the term of the agreement; or
By the use of any other basis that in the opinion of the Commissioner results in a clear reflection of income.[25]

Allocation of Income for Contracts with More Than One Obligation

If a taxpayer without an AFS receives a payment that is attributable to more than one eligible item, the taxpayer must allocate the payment among the items in a manner that is based on an objective criteria.[26] The regulation provides that an allocation method is based on objective criteria if:

The allocation method is based on payments the taxpayer regularly receives for an item or items it regularly sells or provides separately; or
It is based on a method that may be provided in guidance published in the Internal Revenue Bulletin.[27]

Other Rules for Taxpayers Without an AFS

Rules like those for a taxpayer with an AFS apply in the following situations:

For financial statement adjustments, rules similar to those described earlier under Proposed Reg. §1.451-8(c)(3) (describing direct charges to equity accounts);[28]
A similar short taxable year rule for years of 92 days or less that is found in Proposed Reg. §1.451-8(c)(4) will apply;[29] and
As well, the same eligible gift card redemption rule as applies to taxpayers with an AFR will apply to those without an AFS.[30]

Method of Accounting Issue

The use of either the AFS deferral method or the non-AFS deferral method will be treated a method of accounting for tax purposes under IRC §446, triggering the IRS requirements for permission to change methods. Similarly, a change in the method of recognizing advance payments in an AFS that changes or could change the timing of inclusion in income is a change of accounting method. That would cover a change in the timing of recognition mandated by FASB through a future Accounting Standards Update.[31]

Any such changes in method can only be undertaken if the taxpayer has obtained the permission of the IRS to make the change.[32]

The IRS released Revenue Procedure 2019-37[33] that provides automatic permission procedures for taxpayers making the change to use the new advance payment codified rules under IRC §451(c). Note that the procedure offers taxpayers options to either use a §481(a) or cut-off adjustment in most cases.

[1] REG-104554-18, https://s3.amazonaws.com/public-inspection.federalregister.gov/2019-19197.pdf, September 5, 2019, scheduled to be published in the Federal Register on September 9, 2019

[2] Ibid, p. 4

[3] Proposed Reg. §1.451-8(a)

[4] Proposed Reg. §1.451-8(b)(2)

[5] Proposed Reg. §1.451-8(b)(1)(i)

[6] Proposed Reg. §1.451-8(b)(1)(ii)

[7] Proposed Reg. §1.451-8(b)(9)

[8] Proposed Reg. §1.451-8(b)(8)

[9] Proposed Reg. §1.451-8(b)(5)

[10] Proposed Reg. §1.451-8(b)(4), (6) and (7)

[11] Proposed Reg. §1.451-8(b)(3)

[12] IRC §451(c)(1)(B)(i)

[13] Proposed Reg. §1.451-8(c)(1)

[14] Proposed Reg. §1.451-8(c)(1)

[15] Proposed Reg. §1.451-8(c)(2)

[16] Proposed Reg. §1.451-8(c)(3)(i)

[17] Proposed Reg. §1.451-8(c)(4)(i)

[18] Proposed Reg. §1.451-8(c)(7)

[19] IRC §451(c)(1)(B)(i)

[20] REG-104554-18, https://s3.amazonaws.com/public-inspection.federalregister.gov/2019-19197.pdf, September 5, 2019, scheduled to be published in the Federal Register on September 9, 2019, p. 5

[21] Proposed Reg. §1.451-8(d)(2)

[22] Proposed Reg. §1.451-8(d)(4)

[23] Proposed Reg. §1.451-8(d)(4)

[24] Proposed Reg. §1.451-8(d)(4)(ii)

[25] Proposed Reg. §1.451-8(d)(4)(ii)

[26] Proposed Reg. §1.451-8(d)(5)(i)

[27] Proposed Reg. §1.451-8(d)(5)(ii)

[28] Proposed Reg. §1.451-8(d)(6)

[29] Proposed Reg. §1.451-8(d)(7)

[30] Proposed Reg. §1.451-8(d)(8)

[31] Proposed Reg. §1.451-8(e)

[32] Proposed Reg. §1.451-8(e)

[33] https://www.irs.gov/pub/irs-drop/rp-19-37.pdf, September 6, 2019, retrieved September 7, 2019