The IRS published guidance on May 10 that allows taxpayers to request a change in method of accounting to conform to certain aspects of new financial accounting standards under ASC Topic 606. Rev. Proc. 2018-29 provides taxpayers with flexibility over the manner in which transitions are made to conform income recognition for federal tax purposes with ASC Topic 606, as well as administrative ease in filing procedures needed to make these requests. However, the IRS limited the scope of its highly anticipated guidance to exclude many scenarios affected by ASC Topic 606. Because most taxpayers still need further guidance to conform completely to the new financial accounting standards, the May 10 guidance may be of limited practical use.
Background
On May 18, 2014, FASB announced new financial accounting standards for revenue recognition (ASC Topic 606). Publicly-traded entities, certain not-for-profit entities, and certain employee benefit plans are required to adopt the new standards for annual reporting periods beginning after Dec. 15, 2017. All other entities are required to adopt the new standards for annual reporting periods beginning after Dec. 15, 2018. The new standards lay out a five-step analysis to determine the amount and timing of revenue recognition for financial accounting purposes. Existing law and regulations governing the recognition of income for federal tax purposes do not conform to the new financial accounting standards. This created new complexities and potential problems for taxpayers, as discussed in a prior article.
The new tax law known as the Tax Cuts and Jobs Act (TCJA) changed the dynamic with the creation of an "Earlier of Test" for tax purposes. Under the TCJA, taxpayers are required to recognize revenue at the earlier of the time such revenue must be traditionally included under the "all events test," or the time the revenue is taken into account in an applicable financial statement. Because the new financial accounting standards generally result in faster revenue recognition, the Earlier of Test under the TCJA tends to accelerate the inclusion of income for tax purposes. This result is particularly harsh in situations where cash collections lag several years behind the required (up-front) revenue recognition. This issue has also been discussed in greater detail in a prior article.
General Scope of New Tax Guidance
The first wave of businesses adopting ASC Topic 606 generally have 2018 calendar reporting periods, and are in the midst of such tax years now. The second wave of businesses are not far behind, and will be similarly situated at this time next year. Rev. Proc. 2018-29 describes the procedures by which such businesses may make corresponding changes for tax purposes. Generally, Rev. Proc. 2018-29 applies to taxpayers changing their tax method of accounting to conform to revenue recognition principles of ASC Topic 606. As a condition to making this request, a taxpayer’s new tax method of accounting (i.e., conformity with ASC Topic 606) must be otherwise permissible under tax law. This is where the scope of the new guidance immediately becomes limited.
Pre-TCJA law and regulations generally do not align with the new financial accounting standards, which means that most tax accounting methods are not otherwise permissible if they are to mirror ASC Topic 606. The TCJA's Earlier of Test rectifies the incongruity between long-standing tax law and new financial accounting standards, but Rev. Proc. 2018-29 provides that it is not intended to provide guidance for accounting method changes to comply with the changes under the TCJA to revenue recognition, such as the Earlier of Test. A taxpayer’s determination of an otherwise permissible tax accounting method, without reference to the TCJA’s Earlier of Test, renders most attempts to conform tax accounting methods to ASC Topic 606 outside the scope of Rev. Proc. 2018-29.
This limitation is somewhat confusing in that Rev. Proc. 2018-29 later provides that a taxpayer's new method of accounting must be ". . . otherwise permissible under the Code including under amended Section 451," which conceivably includes the TCJA's Earlier of Test. At a speaking event on May 11, Scott Dinwiddie, IRS associate chief counsel (income tax and accounting) attempted to clarify the scope of this new guidance. Mr. Dinwiddie stated that Rev. Proc. 2018-29 "was really designed for early adopters; it's really designed for those who adopted ASC [Topic] 606 in 2017 and needed to know what to do." In explaining the restriction to exclude the TCJA's Earlier of Test, Mr. Dinwiddie added, "You don't know what the proper method is yet, so [Rev. Proc. 2018-29] would not be applicable in that situation." Hence, taxpayers still need guidance on the proper method to adopt the TCJA's Earlier of Test in conjunction with ASC Topic 606. On the other hand, in certain circumstances where ASC Topic 606 conforms to pre-TCJA revenue recognition laws and regulations, the new guidance is applicable.
Further Limitations of New Tax Guidance
Rev. Proc. 2018-29 covers only specific changes to conform tax accounting methods to ASC Topic 606 standards:
- Identifying performance obligations;
- Allocating transaction price to performance obligations; and
- Considering performance obligations satisfied.
Excluded from this scope are the other two items in the five-step analysis of ASC Topic 606, which are changes in the manner in which contracts are identified, and notably, changes involving the manner in which transaction price is determined (such as the inclusion or exclusion of variable consideration, or adjustments for time value of money where financing components exist). Conformity with ASC Topic 606 is necessarily dependent on all aspects of ASC Topic 606 (not just the three items mentioned). Nuances involving the other two items are not covered by the guidance of Rev. Proc. 2018-29, and affected taxpayers may need to consider requests to change tax accounting methods under advance consent provisions unless further guidance is provided by the IRS.
Also, Rev. Proc. 2018-29 only covers changes to directly adopt ASC Topic 606 for federal tax purposes (e.g., the effects from one of the three areas noted). Businesses that evaluate ASC Topic 606's impact on financial accounting and federal tax positions often engage in a holistic review of revenue recognition that extends beyond the immediate application of ASC Topic 606. Rev. Proc. 2018-29 does not apply to any ancillary tax accounting method changes involving revenue recognition that are identified through this process.
Further, Rev. Proc. 2018-29 does not apply to any tax accounting method change described elsewhere in IRS automatic change guidance, even if it is also described in Rev. Proc. 2018-29. One obvious example described elsewhere is a change for taxpayers using the deferral method for advance payments, where the amount included in gross income in the taxpayer's applicable financial statement is changed. Taxpayers appear to be required to use this other guidance specifically for the part of ASC Topic 606 adoption relating to advance payments, while referring to Rev. Proc. 2018-29 for the parts of ASC Topic 606 adoption relating to other areas not involving advance payments. The IRS also noted in Rev. Proc. 2018-29 that separate guidance is anticipated to address tax accounting method changes for advance payments covered by the TCJA. This separate guidance may or may not supersede the example of guidance described elsewhere that was contemplated herein.
Lastly, Rev. Proc. 2018-29 does not apply to any tax accounting method change involving long-term contract accounting, unless the long-term contract is excepted from required use of the percentage-of-completion method (such as for home construction contracts, or for taxpayers who meet a $25 million average annual gross receipts test).
Procedures Provided under New Tax Guidance
The changes described under Rev. Proc. 2018-29 can be requested using automatic consent provisions. Generally this means that taxpayers must request consent to change their tax accounting method, but are not required to do so prior to the requested year of change. Assuming taxpayers comply with the provisions described, taxpayers will be granted consent automatically to change their tax accounting method. Taxpayers make their "automatic" requests by attaching Form 3115 to their tax return, and are not required to submit a duplicate copy of Form 3115 (which is typically required).
Taxpayers are covered by Rev. Proc. 2018-29 only during the year that the taxpayer adopts ASC Topic 606. Depending on the type of business and the accounting period involved, this would be the taxpayer's first, second, or third taxable year ending on or after May 10, 2018 (as is separately specified in the guidance).
Additionally, taxpayers are provided unique flexibility in the manner they transition to their new method of accounting, where they are provided the option to utilize either a "cut-off method" or a "Section 481 adjustment." Under the cut-off method, a taxpayer starts recognizing revenue from contracts pursuant to ASC Topic 606 as of the first day of the year in which the accounting method change is requested. Such taxpayers complete the revenue recognition cycle for prior contracts using the former method of accounting, which results in an overlap period during which elements of the legacy accounting method and the new accounting method are employed. Alternatively, a Section 481 adjustment roughly equates with the cumulative effect of change in accounting principle as of the first day of the year in which the accounting method change is requested. The cumulative Section 481 adjustment is recognized ratably into taxable income over a four-year period.
With this unique flexibility, taxpayers in different positions can select the transition method that poses the least amount of administrative burden. For instance, the cut-off method may require certain taxpayers to maintain two sets of books, while a Section 481 adjustment might require other taxpayers to track many individual customer contracts where they did not previously. The choice alleviates these concerns. Additionally, the choice seems to give savvy taxpayers the ability to maximize income deferral associated with change requests. For example, revenue recognition taking longer than four years under the former method of accounting for legacy contracts will benefit from the cut-off method, and revenue recognition that will occur in less than four years for such contracts will benefit from a Section 481 adjustment.
Summary
Certain taxpayers now have some guidance to assist with changes in tax methods of accounting to conform to ASC Topic 606. Because the scope of this guidance is very limited, most taxpayers must wait for additional guidance from the IRS. Nevertheless, the current guidance provides great flexibility and administrative ease to those taxpayers that qualify to use it. For more information concerning changes to adopt ASC Topic 606 for federal tax purposes, please consult your local CBIZ MHM tax advisor.
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