By Gary G. Wallace, CPA, Managing Partner
Section 451(b): Overview and Tax Planning Considerations for Businesses
- TCJA implemented a new income recognition metric for accrual basis taxpayers
- “All-events” test had been the applicable standard for accrual basis
- 451(b) applies to taxpayers that produce applicable financial statements
- It is not a book conformity rule per se, but some have labelled it similar
- An exception applies to following GAAP where there are unenforceable rights
- Accounting method changes based on these rules may require a Form 3115 to be filed with the IRS
- The final regulations are effective for accrual basis taxpayers for tax years beginning after January 1, 2021.
The Tax Cuts and Jobs Act (TCJA) added section 451(b) to the Internal Revenue Code (IRC) to provide more conformity with financial accounting rules regarding income recognition. Before the TCJA, income was included for accrual basis taxpayers through the “all-events” test. The all-events test is typically met when all events have taken place to fix the organization’s legal right to the income and the amount of the income can be estimated with reasonable certainty. Following the TCJA, many questions arose, and the IRS has issued regulations to address some of the questions in the new Code Section.
Recognizing Income under 451(b)
In December 2020, the final regulations for 451(b) were issued and generally apply to accrual basis taxpayers beginning on or after January 1, 2021. As a result of Section 451(b) and the recent regulations, accrual basis taxpayers may be required to recognize income earlier than would be reported under the all-events test if the income is included as revenue in an applicable financial statement (AFS).
What qualifies as an Applicable Financial Statement?
Under Section 451(b), businesses now need to determine if they issue any applicable financial statements that may require an acceleration of taxable income. In general, an AFS is qualified as follows:
- A taxpayer financial statement that is prepared under generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS) and is used
(1) to report to certain regulatory bodies or federal agencies (except the IRS),
(2) to report to shareholders, partners, proprietors, or beneficiaries, or
(3) for credit purposes.
Unenforceable Rights Exception
Based on the language of Section 451(b), taxpayers were concerned that the AFS income inclusion could be construed as overly broad and may result in income recognition in circumstances where taxpayers may not have specific rights to the income. One important aspect of the final regulations is the Unenforceable Rights Exception. The final regulations provide that AFS revenue is reduced by amounts that a taxpayer would not have an enforceable right to recover if the customer were to terminate a contract on the last day of the tax year. The regulations define an enforceable right as any right that a taxpayer has under the terms of a contract or under applicable federal, state, or international law, including rights to amounts recoverable in equity and liquidated damages.
The application of the Unenforceable Rights Exception is optional, but its use or non-use are methods of accounting that cannot be changed without the consent of the IRS commissioner. The use or non-use options may provide tax planning opportunities for businesses as they navigate possible changes in tax rates proposed by the Biden-Harris administration.
More clarification is needed whether the Unenforceable Rights Exception would apply to amounts that a business has included in AFS revenue that it anticipates receiving from someone other than a customer, i.e., a rebate or discount from a wholesaler, but to which the business does not have an enforceable right to by the end of the tax year. It would seem fitting that the exception would apply to these amounts as well.
Method changes based on these rules may require a Form 3115, Application for Change in Accounting Method to be filed with the Internal Revenue Service (IRS).
451(b) Effective Dates
The final regulations are effective for accrual basis taxpayers for tax years beginning after January 1, 2021. The regulations do allow for early adoption of this rule (for example, the 2020 tax year) provided that a taxpayer also applies the other rules provided by the final regulations.
Section 451(b) brought many changes for taxpayers that use the overall accrual method of accounting. For tax planning and compliance purposes, it is important for businesses to be familiar with the changes and accounting rule exceptions under the final regulations. Questions on the tax implications of Section 451(b) for your business? Contact your Opportunity Advisor or Email | Call: 804.747.0000. We are here to help.
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