The recent “Tax Cuts and Jobs Act” (TCJA) ushered in comprehensive tax reform
There were many incentives designed to encourage businesses to be more competitive. Among these incentives were a drop in the tax rate on business income and an expansion of 100% bonus depreciation. But there were also several other TCJA changes that were not as taxpayer-friendly and many businesses are now dealing with these.
For instance, the following TCJA changes involve how revenue is recognized for tax purposes:
- “All Events Test.” The TCJA brought about a change in the “all events test” for recognizing revenue.
- “Advanced Payments.” The TCJA also brought about a change in recognizing revenue for advanced payments.
Changes to the “All Events” Test
Before considering TCJA changes, it is helpful to explore the background of income recognition for tax purposes. In determining whether gross income is taxable and thus subject to tax generally involves a two-step process. First, is there a realization event? Has the taxpayer entered into a transaction, such as a sale or other contract? Next, after realization occurs, the next step involves recognition – when should the taxpayer recognize gross income from this event? Gross income is generally recognized under the taxpayer’s overall method of accounting, which for most taxpayers is either the cash method or the accrual method.
Under the cash method – a taxpayer generally recognizes items of income when cash is actually or constructively received.
Under the accrual method – a taxpayer usually recognizes items of income when all the events have occurred that fix the right to receive the income and the amount can be determined with reasonable accuracy. This is referred to as the “all events test.” The tax rules then indicate that taxpayers have a fixed right to receive income upon the earliest of when an amount is:
- Paid, or
Tax Cuts and Jobs Act Changes to the Accrual Method
First, the cash method of accounting was not changed by the TCJA; rather it was the accrual method that saw several changes and complexities under TCJA. As noted above, under the accrual method, income is generally recognized for tax purposes upon the earliest of when an amount is due, paid or earned. The TCJA changed this by adding a new fourth standard to this “all events test” of when the item is recognized for book purposes in the Company’s “Applicable Financial Statements” (AFS). Thus, income is recognized at the earliest of when it is due, paid, earned, or recognized in the Company’s AFS.
This expanded definition is complicated enough but becomes seemingly three-dimensional when you consider that there is also a major revision under Generally Accepted Accounting Principles (GAAP) for how and when income is recognized for book purposes. “ASC 606” is the new accounting standard that dictates how much income to recognize and when to recognize it in a Company’s books. ASC 606 has been in the works for many years and is first effective for the 2019 year for non-public companies (it was first effective in 2018 for publicly traded companies).
Thus, at the same time the rules for tax purposes are revised for when income should be recognized to now include when it is recognized for book purposes in an AFS, the standard for recognizing revenue for books is also undergoing a major transformation. In many situations, the new ASC 606 will result in revenue being recognized in a Company’s AFS earlier than it would have under the previous rules, which then in turn under the new “all events test” addressed above will result in revenue recognized for tax purposes earlier as well.
A few comments about this whirlwind of accounting method changes for the 2019 year:
- First, it should be noted that the above change for the “all events test” only applies if a company has an AFS. An AFS is generally defined to include audited financial statements, but it does not apply for companies that have reviewed or compiled financial statements unless they are otherwise filed with a Federal or a state government or any Federal or state agency other than the SEC or the IRS. Thus, companies that do not have audited financial statements generally will not be required to make the above changes and will not need to accelerate any additional income that might be triggered under ASC 606 for book purposes.
- These tax changes and the ASC 606 book changes are complicated provisions, and there are many details and exceptions to evaluate. For instance, there are some changes under ASC 606 that could accelerate income for contracts that contain certain incentives if target amounts or dates within the contract are met. For tax purposes, however, the taxpayer might be able to document that income should not be recognized in this contract as the contract incentive is not assured to be met. This is just one of many situations in which Companies need to understand how these new accounting rules and related tax rules impact their business. Your Sikich tax or accounting adviser can assist you in these efforts.
- The TCJA changes addressed above apply to recognizing revenue, however, the IRS indicates the changes do not apply for any expenses related to additional accrued revenue. This treatment differs for book purposes where ASC 606 matches related expenses with the corresponding accelerated revenue. Thus, for tax purposes a Company with an AFS many need to recognize some additional revenue as this was spelled out in ASC 606, but not be allowed any offsetting cost deductions even though these expenses are required for book purposes under ASC 606.
- Keep in mind, there are often exceptions with the tax law, and this applies here. There are certain special methods of accounting that are not subject to the new “all events test.” Thus, contractors involved with long-term contracts for tax purposes are exempted from these new rules. So, a contractor even with AFS will not be generating additional income for tax purposes with these changes.
To implement these tax changes for 2019, there will most likely need to be a change of accounting method form filed with the IRS. The change is filed on IRS Form 3115 and there are many various items to include with this filing. Your Sikich tax adviser can assist you with this filing.
Changes with Advanced Payments
In addition to the above change under the “all events test,” the TCJA also ushered in some new tax rules related to advanced payments. Advanced payments represent amounts paid by a customer for services or goods to be provided in the future.
First, a brief background on the tax treatment of advanced payments. For cash basis taxpayers, they will recognize revenue when amounts are paid or constructively received whether the payments are for current work/goods or for an advanced payment. For accrual basis taxpayers, the rules differ. The general rule for an accrual method taxpayer that receives advanced payments is that these payments are included in income when received. But, there is an exception that allows these amounts to be deferred if the taxpayer elects to do so and certain provisions are met. This deferral method results in the following:
- A portion of the income is recognized in the year of receipt. If the company has an AFS (see discussion above on AFS), then the same amount is recognized in the year of receipts for book and tax purposes.
- If the company does not have an AFS, then a reasonable or ratable method must be used to determine how much revenue is recognized in the year of receipts for tax purposes.
- Whether the taxpayer has an AFS or not, the balance of the advanced payments not recognized in the year of receipt is recognized in the year following the year of receipt. This is the case even if for book purposes some of the income is deferred into a third or fourth year.
- There was a different deferral than the above rules that applied with deposits on inventory orders. This permitted the deposit to be deferred until the order was fulfilled which may have occurred later than the year following the year of receipt. An election and annual statement in the tax return were needed for this method.
Tax Cuts and Jobs Act Changes to Advanced Payments
The above rules for advanced payments were developed over the years from several IRS revenue procedures and other guidance. As part of the TCJA, Congress placed these methodologies directly into the tax law. They made some changes for the above methods that permitted some deferral for inventory outside the year after the year of receipt for certain goods. These will now need to be included in income no later than the year following the year of receipt. Finally, as with the change for the “all events test” addressed above, a Form 3115 will likely need to be filed with the IRS for any accrual method company receiving advanced payments. Your Sikich tax adviser can also assist you in analyzing these tax filings.
The Tax Cuts and Jobs Act introduced many tax savings and incentives for businesses. The TCJA, however, also implemented several challenging provisions that were not as taxpayer-friendly, including the new restrictions on deducting interest expense and changes in methods of accounting. The complex changes covered above involving the “all events test” and advanced payments are issues businesses need to address for 2019 to minimize the tax impact of these changes. Please contact your Sikich tax adviser to help you in this process.
Resources on Accounting Method Changes
JIM BRANDENBURG, CPA, MST
JENNY KRAMER, CPA