Prior to the TCJA, Reg. §1.451-5
provided special rules for advanced payment for goods and long term contracts.
These rules were superseded by revised IRC §451(c). The prior regulations
implementing IRC §451 allowed taxpayers generally to defer the recognition of
advance payment for goods until the tax year in which the payments were properly
accruable under the taxpayer's method of accounting for tax purposes if that
method results in the payments being included in gross income no later than
when they are includible in gross receipts under the taxpayer's method of
accounting for financial reporting purposes.[1]
Revised IRC §451(c) and its
election to defer advance payments removed the deferral method provided by Reg.
§1.451-5.[2]
On July 15, 2019 the Treasury issued T.D. 9870 and removed Reg. §1.451-5 and
its cross references. Removing Reg. §1.451-5 ensures that the new deferral
rules of IRC §451(c) apply uniformly and consistently to all taxpayers and
simplifies tax administration. The rules of IRC §446 regarding changes in methods
of accounting apply to taxpayers changing a method of accounting for advance payments
from a method described in Reg. §1.451-5 to another method of accounting[3].
The removal of Reg. §1.451-5 is
effective for tax years ending on or after Jul. 15, 2019.
Code §451(c) generally requires an accrual method taxpayer that receives any
advance payment described in IRC §451(c)(4) during the tax
year to include the advance payment in income in the tax year of receipt or
make an election to:
(1) include any portion of the
advance payment in income in the tax year of receipt to the extent required
under Code Sec. 451(b); and
(2) include the remaining portion
of the advance payment in income in the following tax year.
Under IRC 451(c)(2) a taxpayer may
make a deferral election for any portion of the advance payment that is otherwise
required to be included in gross income under financial statement rules. If the election is made the advance payment
would be included in gross income in the tax year in which it is received and
the remaining portion of the advance payment would be included in gross income
in the tax year following the tax year in which it is received.[4]
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.[5]
Treasury
and the IRS expect to issue guidance for the treatment of advance payments to implement
the TCJA amendments to IRC §451. In the meantime, taxpayers with or without applicable financial statements may continue to rely on Rev. Proc. 2004-34 for the treatment of advance payments.
Until new guidance is issued, the IRS will not challenge a taxpayer’s use
of Rev Proc 2004-34 to satisfy the requirements of IRC § 451, although it will continue to verify on
examination that taxpayers are properly applying Rev Proc 2004-34[6].
How to elect to defer inclusion of
advance payments in income. The IRS is instructed to provide details on making the election to
defer the inclusion of advance payments in income. This includes the time, form
and manner, and the categories of advance payments. The election will be
effective for the tax year with respect to which it is first made and for all
subsequent tax years, unless the taxpayer obtains the IRS's consent to revoke
the election.[7]
Change of accounting method. The computation of taxable income
under the deferral election for advance payments is treated as a method of
accounting.[8]
In the case of any qualified change of accounting method for the taxpayer's
first tax year beginning after December 31, 2017, the change is treated as
initiated by the taxpayer and made with the IRS's consent. A qualified change
of accounting method is any change of accounting method that is required by the
new income recognition rules or was prohibited and is now permitted under the
new rules.[9]
For a qualified change of accounting method involving income from a debt
instrument with original issue discount (OID), taxpayers should use a six-year
period for taking into account any required IRC §481 adjustments.[10]
What
is an Advance Payment?
Rev. Proc. 2004-34 allows a
one-year deferral in certain cases of prepaid income. The ruling pertains to
prepayment for services to be rendered before the end of the next succeeding
year. In particular, Rev. Proc. 2004-34 provides that a payment received by
a taxpayer is an advance payment if:
(1) the inclusion of the
payment in gross income for the taxable year of receipt is a permissible method
of accounting for federal income tax purposes;
(2) the payment is recognized
by the taxpayer (in whole or in part) in revenues in the taxpayer's applicable
financial statement for a subsequent taxable year or, for taxpayers without an
applicable financial statement, the payment is earned by the taxpayer (in whole
or in part) in a subsequent taxable year; and
(3) the payment is for
(a) services;
(b) the
sale of goods;
(c) the
use (including by license or lease) of intellectual property;
(d) 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);
(e) the
sale, lease, or license of computer software;
(f) guaranty
or warranty contracts ancillary to an item or items described in subparagraph
(a), (b), (c), (d), or (e), above;
(g) subscriptions
(other than subscriptions for which an election under IRC §455 is in effect),
whether or not provided in a tangible or intangible format;
(h) memberships
in an organization (other than memberships for which an election under IRC §456
is in effect);
(i)
an
eligible gift card sale; or
(j) any
combination of items described in subparagraphs (a) through (i) above.
Under Rev. Proc. 2004-34, the term “advance
payment” does not include:
• Insurance
premiums, to the extent the recognition of those premiums are 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,
financial derivatives, etc.), including purported prepayments of interest;
• Payments
with respect to service warranty contracts for which the taxpayer uses the
accounting method provided in Rev. Proc. 97-38;[11]
• Payments
with respect to warranty and guaranty contracts under which a third party is
the primary obligor;
• Payments
subject to IRC §§871(a), 881, 1441, or 1442;
• Payments
in property to which IRC §83 applies;
• Rent;
and
• Any
other payment identified by the IRS for this purpose.[12]
Advance Payment” Defined Under IRC §451(c)(4)
Under IRC §451(c)(4) an “advance payment” is any payment:[13]
- the full
inclusion of which in the taxpayer’s gross income for the tax year of
receipt is a permissible method of accounting under IRC §451 (determined without regard to IRC §451[14];
- any portion
of which is included in revenue by the taxpayer in a financial statement
described in IRC §451(b)(1)(A)(i) or IRC §451(b)(1)(A)(ii) for a later tax year[15]
and
- which is for
goods, services, or other items as the IRS may identify for these purposes[16].
Except as otherwise provided by the IRS, an advance
payment does not include:
- rent[17];
- insurance
premiums governed by subchapter L (IRC §801 through IRC §848)[18];
- payments as
to financial instruments[19];
- payments as
to warranty or guarantee contracts under which a third party is the
primary obligor[20];
- payments
subject to:
- IRC §871(a) (i.e., the tax on income of
nonresident alien individuals not connected with a U.S. business),
- IRC §881 (i.e., the tax on income of
foreign corporations not connected with a U.S. business),
- IRC §1441 (i.e., the tax withheld on
certain amounts paid to foreign persons), or
- IRC §1442 (i.e., the tax withheld from
income of foreign corporations)[21].
- payments in
property to which IRC
§83 (taxation of property transferred in
connection with the performance of services., and
- any other
payment identified by the IRS for purposes of IRC §451(c)(4)(B)[22].
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[23].
Until
Treasury issues new guidance regarding advance payment for goods, taxpayer can
rely on IRC §451(c)(4) for treatment of advance payments.
[16] IRC § 451(c)(4)(A)(iii).
[18] IRC § 451(c)(4)(B)(ii)
[19] IRC § 451(c)(4)(B)(iii)
[20] IRC § 451(c)(4)(B)(iv)
[21] IRC § 451(c)(4)(B)(v)
[22] IRC § 451(c)(4)(B)(vii)
[23] IRC § 451(c)(4)(C).
