On November 29, 2018, the Internal Revenue Service (IRS) issued Rev. Proc. 2018-60, which provides automatic accounting method change procedures for taxpayers seeking to comply with section 451(b), relating to the timing of income recognition for federal income tax purposes for tax years beginning after December 31, 2017. This guidance provides taxpayers with the automatic accounting method change many were seeking to change to the new income recognition standard created by the Tax Cuts and Jobs Act (TCJA) in section 451(b). In certain instances, Rev. Proc. 2018-60 even allows taxpayers to make this accounting method change without having to file a Form 3115, which is generally required to effect an accounting method change. Although this streamlined approach appears to ease the administrative burden for small business taxpayers or those making the change without a section 481(a) adjustment, it should be noted that failing to file a Form 3115 does preclude a taxpayer from receiving audit protection with respect to the change; thus, depending on one’s current exposure or tolerance for Exam activity, it may be worth filing a Form 3115 irrespective of the ability to not do so.

Background

The TCJA changed the timing of income recognition for accrual-method taxpayers. Historically, an accrual-method taxpayer included an item in gross income when all the events had occurred that fix the right to receive such income and the amount could be determined with reasonable accuracy (the “All Events Test”). By adding section 451(b)(1)(A), Congress changed the standard for income recognition such that an accrual-method taxpayer must now include an item in income no later than when such item is taken into account as revenue for financial accounting purposes in the taxpayer’s applicable financial statements (AFS).¹ Thus, to the extent that an accrual-method taxpayer traditionally reports income earlier for book purposes than for tax purposes, this statutory change means that income recognition may have to be reported in an earlier tax year. The statutory change does not apply, however, to income reported under certain special methods of accounting.²

The statutory changes to section 451(b) also aligns income tax recognition more closely to the financial accounting standards for customer contracts having multiple “performance obligations.” Section 451(b)(4) modifies income recognition with a more nuanced focus on the allocation of transaction price. Specifically, section 451(b)(4) provides, in the case of a contract which contains multiple performance obligations, the allocation of transaction price to each performance obligation shall be equal to the amount allocated to each performance obligation for purposes of including such item in revenue in the applicable financial statement of the taxpayer. This provision is of particular relevance given the changes made to the revenue recognition standard for financial accounting purposes, which now places an emphasis on specific aspects of a contract, including the underlying performance obligations.

Section 451(b), as revised by the TCJA, is generally effective for tax years beginning after December 31, 2017. With respect to a debt instrument subject to original issue discount (OID), the rules of Section 451(b) apply to taxable years beginning after December 31, 2018, and the section 481(a) adjustment period for a qualified change in method of accounting is six taxable years.

Although the IRS and Treasury have not yet issued substantive guidance under section 451(b), many taxpayers, aware that the statutory change will require accounting method changes, have filed non-automatic accounting method changes. For accrual-method taxpayers with a calendar year-end, the deadline for filing non-automatic method changes will expire shortly and it is likely that Rev. Proc. 2018-60 was issued in advance of substantive guidance to alleviate concerns that such changes would be unavailable on an automatic basis.

Concurrent with enactment of the TCJA, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) also revised the standards for revenue recognition for financial accounting purposes. These new revenue recognition standards became effective for public companies beginning in 2018, and in 2019 for other entities. To assist taxpayers in their implementation of the new revenue recognition standards for financial accounting purposes, the IRS issued Rev. Proc. 2018-29 earlier this year, which provided accrual-method taxpayers with an automatic accounting method change for taxpayers that wanted to change their method of accounting for income recognition to a method they were implementing under the new revenue recognition standards for financial accounting purposes. In an earlier alert, we provide an overview of Rev. Proc. 2018-29 and its significance to taxpayers.

Rev. Proc. 2018-60

The revenue procedure provides an automatic change in method of accounting for a taxpayer seeking to change its method for income recognition for federal income tax purposes to an accounting method that complies with sections 451(b)(1)(A) or 451(b)(4). The change applies to taxable years beginning after December 31, 2017; however, in the case of income from a debt instrument with OID, the change does not apply until taxable years beginning after December 31, 2018. The automatic method change is limited to taxpayers seeking to change their method of accounting for income recognition to a method that treats an item of gross income as meeting the All Events Test no later than when such item is taken into account as revenue in its AFS and/or is not adopting the new revenue recognition standards for the year of change, and wants to allocate transaction prices to performance obligations under section 451(b)(4).

The automatic method change does not apply to taxpayers seeking to make a change for federal income tax purposes to a method that adopts the new revenue recognition standards for financial accounting purposes, because Rev. Proc. 2018-29 already provided an automatic change for such a decision. The automatic method change also does not apply to a taxpayer seeking to change to a special method of accounting described in section 451(b)(2).

To effect the change, Rev. Proc. 2018-60 allows taxpayers to file an abbreviated Form 3115, (Application for Change in Accounting Method), which limits the number of questions on the overall form that must be completed. Audit protection is available to those who file a request; audit protection is a valuable attribute as it prevents the IRS from raising the same issue in an examination context for a year prior to the year of the method change. In addition to the shortened form, the requirement to file a duplicate copy of the Form 3115 is eliminated. As noted, a streamlined approach is available for certain small business taxpayers and other taxpayers, which do not have any section 481(a) adjustment to take into account. The streamlined approach does not require the filing of a Form 3115, with the accounting method change effected by the filing of the first federal income tax return that reflects the change. Unfortunately, by not filing a Form 3115, taxpayers that pursue the streamlined approach will not receive audit protection for the accounting method change.

Rev. Proc. 2018-60 also generally allows a taxpayer that wants to make one or more concurrent method changes under the guidance to be filed on the same Form 3115. It is important to note that a taxpayer making concurrent changes under the revenue procedure must make the changes to comply with section 451(b)(4) first. A taxpayer making the change to comply with section 451(b)(1)(A) concurrently with changes to adopt the revenue recognition standards, as provided in Rev. Proc. 2018-29, must implement the changes to comply with the revenue recognition standards under Rev. Proc. 2018-29 first. If a taxpayer wants to pursue the aforementioned streamlined process, the taxpayer may not file concurrent method changes.

Lastly, the five-year eligibility rule in Rev. Proc. 2015-13 does not apply to a change made in accordance with Rev. Proc. 2018-60 for a taxpayer’s first, second, or third tax year beginning after December 31, 2017 (or December 31, 2018, in the case of income from a debt instrument with OID). Similar to the limitations of the streamlined approach with concurrent method changes, the streamlined approach also limits the waiver of the five-year eligibility rule to only the taxpayer’s first tax year beginning after December 31, 2017, if filing the change under the streamlined approach.

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