New IRS Guidance Allows Some Construction and Real Estate Businesses to Change Tax Accounting Method to Conform with New Financial Statement Revenue Recognition Rules
Accounting methods are an integral piece of tax strategy for every business, especially the construction and real estate industries. The methods used by a business impact when income is recognized, as well as the timing of deducting various expenses. Businesses need to take into consideration both the general and specific tax rules that apply to their industry. Additionally, there is often a different set of accounting methods that a company must use for its financial statements (its “book method”). Recent tax law changes as well as a new financial accounting standard will impact the tax and book accounting methods used by many businesses in 2018 or 2019. Recently, the IRS issued guidance that makes changing tax accounting methods easier so that the same accounting method can be used for book and tax purposes.
On May 28, 2014, the top two governing bodies that set accounting standards in the U.S. and the world—the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB)—jointly announced new financial accounting standards for revenue recognition. The new standard for income recognition is titled “Revenue from Contracts with Customers,” and is often referred to as “financial accounting standard ASC 606” (“ASC 606” or “Topic 606”). Publicly-traded entities and certain not-for-profit entities are required to adopt the new FASB/IASB revenue recognition standards for annual reporting periods beginning after December 15, 2017. All other entities are required to adopt these standards for annual reporting periods beginning after December 15, 2018. Earlier adoption of these new rules is permitted. These revenue recognition requirements apply across the board to all industries, and thus will impact construction and real estate businesses.
Under the new revenue recognition standards for book purposes, an entity recognizes revenue for promised goods and services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services based on the following five sequential steps:
- Identify the contracts with a customer;
- Identify the performance obligations in the contract;
- Determine the transaction price;
- Allocate the transaction price to the performance obligations; and
- Recognize revenue as the entity satisfies a performance obligation.
These new standards have led to much discussion and commentary over the past several years, and companies should evaluate these new rules now, if they have not already, to see what impact they will have. Your Sikich accounting professional can assist you in this process (please click here for our Sikich article addressing the new revenue recognition standards under ASC 606).
Tax Rules vs. Book Rules in Making Changes in Accounting Methods
Often tax accounting method rules differ from book methods and there are also specific IRS rules that must be followed to change a tax accounting method. In prior guidance, the IRS had announced that it was aware of the new ASC 606 issued by the FASB/IASB, and that they were studying the situation to see what impact this might have for tax purposes. On May 10, 2018, the IRS issued its first formal guidance to assist companies impacted by the new financial statement revenue recognition rules and to allow this new method to be used for tax purposes. The IRS issued Revenue Procedure 2018-29 to address this situation (please click here for a copy of Rev Proc 2018-29).
What does Rev Proc 2018-29 provide for?
This revenue procedure responds to comments by tax practitioners and allows for more conformity for book and tax accounting methods. Under new automatic method change procedures, taxpayers can easily file requests for accounting method changes associated with adopting the ASC 606 standards. Additionally, the small business exception can apply to more taxpayers, and taxpayers are given options of how to implement the accounting method change.
Rev Proc 2018-29 applies to a taxpayer who wants to change its method of accounting for the recognition of income for federal income tax purposes to a method under the new ASC 606 standards for:
- Identifying performance obligations;
- Allocating transaction price to performance obligations; and/or
- Considering performance obligations satisfied.
The above standards are items 2, 4, and 5 in the five items listed for ASC 606 above. A taxpayer may request a change under the Rev Proc 2018-29 only if: (1) the taxpayer’s new method of accounting is otherwise permissible for federal income tax purposes, and (2) the change in method of accounting is made for the same taxable year in which the taxpayer adopts the new standards for financial accounting purposes. In addition, a taxpayer’s allocation of transaction price to performance obligations to comply with the new standards is deemed to be an allocation based on objective criteria.
When is Rev Proc 2018-29 not available?
As noted above, Rev Proc 2018-29 addresses when a change can be made, but it also offers certain situations in which a change cannot be made. The change does not apply to:
- a change in the manner in which the taxpayer identifies contracts or determines the transaction price (including the inclusion and exclusion of variable consideration in the transaction price) under the new ASC 606 standards;
- a change in method of accounting for recognizing income that is made in a year that is different from the year that the taxpayer adopts the new standards;
- a change in method of accounting that does not comply with Section 451 or other guidance;
- any change in method of accounting that qualifies under another automatic change described in the List of Automatic Changes provided in Rev Proc 2018-29 (or any successor); or
- any change in the method of accounting for income from a “long-term contract,” as defined in §460, unless the long-term contract is excepted from required use of the “percentage-of-completion” (“POC”) method by Section 460(e). (This exception would apply to contractors with average gross receipts over $25 million who are required to use the percentage-of-completion method, and therefore cannot adopt the book revenue recognition rules for tax purposes).
It should be noted that Rev Proc 2018-29 does not include guidance on the following two provisions included in the Tax Cuts and Jobs Act (TCJA), enacted on December 22, 2017:
- Section 451(b) dealing with the “all-events test” for a taxpayer with an applicable financial statement, and
- Section 451(c) involving advanced payments for good and services.
The IRS intends to issue guidance later this year addressing the changes made in Sections 451(b) and 451(c) by the TCJA.
Businesses that adopt ASC 606 for financial statement purposes concerning revenue recognition should explore whether a similar change should also be made for tax purposes. IRS Rev Proc 2018-29 offers guidance on how and when this change can be made, as well as exceptions where this change is not allowed. While the IRS guidance permits book and tax revenue recognition conformity, this conformity may be limited in its application to construction and real estate businesses. Your Sikich tax advisor can assist you in reviewing how these new financial statement and tax rules apply to your business.