Company Outlines Consequences of Revenue Recognition Regs

June 5, 2020

Commissioner of Internal Revenue
Internal Revenue Service
CC:PA:LPD:PR (REG-104870-18),
Room 5205, P.O. Box 7604,
Ben Franklin Station, Washington, DC 20044.

Re: Comments with Respect to Proposed section 1.451-3 Regulations

Dear Sirs:

We are submitting comments on behalf of our clients on the Proposed section 1.451-3 Regulations.¹ RSM is a leading audit, tax and consulting firm, focused on the middle market. The middle market is commonly referred to as mid-range companies with revenues between $10 million to $1 billion. Middle market firms are responsible for about 30 million jobs and about one-third of U.S. total revenue, making the middle market business the backbone of the U.S. economy.

The tax law changes passed on December 22, 2017, (commonly referred to as the Tax Cuts and Jobs Act or TCJA) amended §451 of the Internal Revenue Code² which created significant differences in the time when recognition of income occurs for Federal income tax purposes. Generally effective for taxable years beginning after December 31, 2017, the changes provided that, for a taxpayer using an accrual method of accounting, the all events test with respect to any item of gross income (or portion thereof) is not treated as met any later than when the item (or portion thereof) is included in revenue for financial accounting purposes on an applicable financial statement (AFS). In other words, if a taxpayer's AFS recognizes income earlier than general Federal income tax principles, then the taxpayer has to recognize that income.

Prior to TCJA, §451 and Treas. Reg. §1.451-1 generally required accrual method taxpayers to include items of income in gross income in the taxable year when all the events occur that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy (the all events test). All the events that fix the right to receive income occur when (1) the required performance takes place, (2) payment is due, or (3) payment is made, whichever happens first.

With the passage of TCJA, §451(b)(1) modified when taxpayers recognize income. In addition to the all events test, accrual method taxpayers with an AFS must recognize gross income, or portion thereof, no later than when such item, or portion thereof, has been recognized as revenue (the AFS income inclusion rule). The AFS income inclusion rule generally increases financial accounting and tax accounting conformity.³

At the time of the TCJA's passage, the changes to §451(b) had a limited impact on a middle market taxpayer as they were generally applying ASC 605 on their AFS. An AFS is generally prepared in accordance with generally accepted accounting principles (GAAP). Under GAAP, ASC 605 applies to multiple-deliverable revenue arrangements. With the exception of pure service contracts, ASC 605 often did not significantly differ from Federal income tax principles on when taxpayers earn revenue, the first prong of the all events test.

GAAP is in the process of replacing ASC 605 with ASC 606. The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued new financial accounting standards in May 2014. The FASB issued ASC 606, Revenue from Contracts with Customers, and the IASB issued IFRS 15, Revenue from Contracts with Customers. In general, these new revenue standards have become part of the larger collection of standards for financial reporting. The new standards under GAAP often cause companies to recognize revenues earlier than under the previous standards. The earlier recognition is often based on estimates where the company is likely, but not certain, to receive some or all of the income it stands to gain under the contract.

The effective dates for the new guidance are staggered and was effective as of January 1, 2018 for public entities with calendar year ends. For all nonpublic entities with calendar year ends, the new guidance was effective in the year ending December 31, 2019. On Wednesday May 20, 2020, FASB voted to allow certain companies to defer the adoption date of the ASC 606 revenue recognition standard to annual reporting periods beginning after December 15, 2019, and interim reporting periods within annual reporting periods beginning after December 15, 2020. Impacted companies are nonpublic entities that have not yet issued their financial statements.

ASC 606 provides a robust framework for addressing revenue recognition issues, and upon its effective date, replaces almost all pre-existing revenue recognition guidance in current GAAP. The new revenue recognition guidance brings monumental change to how many middle-market companies account for revenue and disclose revenue-related information. Both the timing and amount of revenue recognized could significantly change. Systems changes may be required in many cases to capture and track information needed to apply the new guidance for accounting and disclosure purposes. Many middle market companies will have to dedicate significant resources to properly assess and implement these changes. If not properly managed in advance, these changes could be overwhelming, particularly because middle market companies usually do not have the same level of resources that large companies have to assess and implement new accounting standards. Nonpublic middle market companies should have been well on their way to assessing how the new guidance will affect their revenue recognition policies and disclosures, developing an implementation plan and completing that implementation plan before the coronavirus pandemic caused our taxpayers to instead focus on survival.

On Sept. 9, 2019, the IRS published proposed regulations (Proposed section 1.451-3 Regulations) in the Federal Register regarding the overall timing of income recognition for accrual method taxpayers with an AFS.⁴ These proposed regulations clarify how taxpayers are to interpret the potential acceleration of taxable income under §451(b), the AFS income inclusion rule. As part of the proposed regulations, they also requested written or electronic comments by November 8, 2019. The proposed regulations cement the view of the IRS that §451(b) is intended to accelerate income in circumstances where financial accounting has accelerated revenue at a point prior to when receipt of payment, delivery, acceptance, title transfer or the right to bill occurs.

So why are we commenting nearly seven months after the request for written comments due date? It is only recently that middle market taxpayers have begun implementing ASC 606 in significant numbers. At a time when our great country is experiencing an unprecedented public health and economic challenge as a result of the global coronavirus pandemic, the onerous consequences being heaped on the middle market taxpayers could not have come at a worse time. It is in these circumstances that we respectfully ask the Internal Revenue Service (IRS) and the Department of the Treasury to reconsider the approach taken in the proposed regulations.

While ASC 606 is a financial accounting concept, it is what is driving most of the onerous consequences of the Proposed section 1.451-3 Regulations. We began to see some of the consequences in middle market taxpayers as they early adopted ASC 606. Several taxpayers that began the process of early adopting, were so concerned by the Federal income tax results, they decided to defer the adoption to another year. Unfortunately those lessons ended up being a harbinger of things to come in 2019.

For example, we had one middle market taxpayer, a software solution provider, that tried to early adopt the ASC 606 standard for its 2018 reporting year, but ended up delaying the adoption after the taxpayer was faced with significant Federal income tax consequences. The adoption of ASC 606 caused their revenue activity to go from recognizing the revenue over time to recognizing at a point in time. The point in time occurred before the corresponding expenses would have been taken into account by the taxpayer. The taxpayer usually earned approximately a 3% return on these types of transactions and while not a huge profit percentage, it made up for that margin with significant volume in the $40-$50 million range. Due to the timing of the expense being recognized in the subsequent year, the taxpayer would have recognized and paid taxes on more than $40 million in 2018 (at least an additional $8.4 million of cash tax payments if taxed as a corporation).⁵ In order to pay for the additional Federal income taxes dues, they would have had to borrow funds to make the payment. The middle market taxpayer did not anticipate that they would have to pay taxes on $40 million of gross receipts on a transaction that would have generated only $1.2 million of profit.

Now while the disparity between revenue and expenses may be considered a timing item, the impact can have significant cash flow implications. Assume that this was the only revenue the taxpayer generated and that revenue and expenses remain constant. That would cause the expenses attributable to the revenue recognize in 2018 to be recognized in the 2019 and offset the revenue recognized in 2019 returning to the net income of $1.2 million to $1.5 million for the year. It would only be in the final year of the taxpayer's trade or business that the middle market taxpayer would finally get to recoup (assuming they could take advantage of the deduction in the final year) the taxes paid on $40 million in 2018. If the final year the taxpayer cannot use the $40 million deduction, it becomes a permanent item and not a timing item.

As the adoption of ASC 606 began in earnest in 2019, we began to see more and more examples of middle market taxpayers being put into situations where they would have to recognize more income on a transaction (sometimes the full gross receipts for the transaction) than the entire profit from the transaction. While FASB provided some limited relief by allowing certain taxpayers to defer the adoption of ASC 606 for another year, all it does is kick the can down the road.⁶

This year the middle market taxpayers continue to struggle with the Federal income tax consequences of adopting ASC 606. For example, a taxpayer that sold custom goods under ASC 606 would go from recognizing at a point in time to over time as taxpayer incurred the costs. Since the transaction is the sale of inventory, the middle market taxpayer does not get to recognize related costs of goods sold until the sale closes. If the transaction closes at the beginning of a tax year, but the taxpayer incurred all the costs of goods sold in the earlier year, that transaction could require taxpayers to pay tax on 100% of the gross receipts in the earlier tax year. We are unsure of the policy goals of taxing gross receipts.

The middle market taxpayer is facing unprecedented times with the impact of COVID-19, and the accompanying shelter-in-place edicts to curb the spread of the virus. While various regions are easing shelter-in-place, it is a phased approach that may not allow companies to function at 100% of capacity for the near future. This is not the time to increase the taxation burden on middle market firms.

According to a news release by the Department of Labor issued on May 28, 2020, more than 2.1 million Americans filed initial unemployment claims last week, bringing the total job losses to 40.8 million in just 10 weeks. COVID-19's impact on the economy has been particularly disabling for the middle market, with smaller midsize companies bearing the brunt of the pressure.⁷ Smaller middle market businesses sought lending relief at significantly higher rates than their larger counterparts and appeared less able to shift to remote work. More than half of executives at companies with annual sales of $10 million to $50 million said they sought special financing to ensure liquidity amid the swift business downturn spurred by the pandemic, while 43% said they planned to do so over the next six months according to the MMBI.⁸ Thirty-four percent of their larger middle market counterparts, or those with revenues of $50 million to $1 billion, sought this type of financing, while just 28% of them expected to do so in the next six months.⁹

Problems securing loans for the middle market were underscored by difficulties around the rollout of the federal government's Paycheck Protection Program under the CARES Act, which was quickly oversubscribed, making access to financing hard for applicants. The MMBI survey responses highlighted the growing pressure on middle market companies' cash flows: within U.S. operations, 66% of executives overall said their companies lost revenue because of the pandemic, with smaller midsize businesses experiencing losses at a higher 74% rate, and 72% of them expecting to see revenue decline over the next six months.¹⁰

Congress has responded to the global pandemic with $2.9 trillion in aid to financially distressed companies and workers and added nearly $650 billion in liquidity commitments. The response has been historic to confront the carnage wrought by the pandemic. As Congress and the Executive branch launch initiatives to help struggling businesses, is this the time to put increased pressure on the backbone of the economy as they struggle to survive.

FASB recognized that we are in unprecedented times and is looking for ways to assist the survival of private companies. To that intent, FASB voted on May 20, 2020, to extend by one year the effective date of its revenue recognition standard to all nonpublic entities that have not yet issued their financial statements. It was suggested in a comment letter that a one year deferral to adopt ASC 606 was warranted. The comment letter pointed out that for private companies nearly all their attention “is focused on addressing entities' survival through the months of decreased or non-existent operations. Management has had to turn all energy to understanding the various Federal relief packages offered and identifying the best options for their business. Rather than GAAP based financial reporting, many private entities are focused on 13-week cash flow analysis and projections based on various economic scenarios related to the pandemic. In addition, companies are devoting significant time and energy to develop safety plans for employees once they can return to work. The ability for businesses to devote their attention and resources to adopting accounting standards is extremely limited at this time.”¹¹ The feedback FASB received on the proposal related to coronavirus pandemic challenges convinced the board that a broader extension was needed.

Under the TCJA, the question arises as to whether §451 can require a taxpayer to recognize revenue, that while probable, are in fact contingent on the occurrence of future events. In such cases, §61 should hold that the taxpayer is not entitled to realize the revenues until the future event occurs. While many of the provisions of §§61 and 451 work together and use similar language, these sections describe distinct concepts. Section 61 determines whether or not income has been realized, or essentially whether income exists for Federal income tax purposes. Indeed, because §451(b)(1)(A) modifies “the all events test with respect to any item of gross income (or portion thereof)”, and §61 defines the term “gross income”, Congress' statutory text in §451(b) contemplates that the provision only addresses recognition of income that has already been realized under §61. Accordingly, §451 does not apply until after §61 concludes that a taxpayer has realized an item of income.

In Lucas v. North Texas Lumber Co., 281 U.S. 11 (1930), the Supreme Court held that with the sale of property, “title and right of possession remained in [the seller] until the transaction closed.” In other words, no realization until the transaction closed. The IRS has explicitly embraced this concept of realization when it held in Rev. Rul. 69-93 that taxpayer “did not realize gain or loss in October 1967 since on that date there was a mere execution of the contract to sell real estate in the future. The sale occurred at the time the deed passed or at the time possession and the burdens and benefits of ownership were, from a practical standpoint, transferred to the buyer” (emphasis added). This concept of realization was again reiterated by the Supreme Court in Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203 (1990).¹² In Indianapolis, the Court held that while Indianapolis derived an economic benefit from deposits for utility services, it did not realize taxable income from every event that improves its economic condition.

Congress never intended to deviate from the requirement to have a realization event before a taxpayer can recognize income. In fact, the TCJA Conference Report states:

Under §61(a), gross income generally includes all income from whatever source derived, except as otherwise provided in Subtitle A of the Code. Thus, gross income generally includes income realized in any from, whether in money, property, or services, except to the extent provided in other sections of the Code. Once it is determined that an item of gross income is clearly realized for Federal income tax purposes, §451 and the regulations thereunder provide the general rules as to the timing of when such item is to be included in gross income.

Nothing in the TCJA changed the realization requirement under §61. In fact, footnote 872 of TCJA's Conference Report specifically states that “[t]he provision does not revise the rules associated with when an item is realized for Federal income tax purposes and, accordingly, does not require the recognition of income in situations where the Federal income tax realization event has not yet occurred.” The statement reconfirms that Congress did not intend to change when realization occurred, only when an amount may be recognized under §451.

Under an accrual method of accounting, income is includible in gross income when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy (the “all-events” test).

TAM 200903079 examines the all-events test in regards to revenue recognition under multiple types of contracts. Under the first prong of the all-events test, all the events that fix a right to receive income occur at the earlier of when (1) payment is made ("paid"); (2) the required performance occurs ("earned"), or (3) payment is due ("due"). With respect to whether income is "earned", income from the provision of services generally accrues when performance is complete, not as the taxpayer engages in the activity. However, if services are "severable," a portion of the income is proportionally allocated to each service provided under the contract. Minor or ministerial duties (e.g., submitting the invoice) do not delay accrual of income.

Perhaps the intent of §451(b) is to codify Rev. Rul. 79-195, which requires realization upon a taxpayer completing requirements of an applicable performance obligation under a contract, as opposed to only upon completing all performance obligations under the contract. Rev. Rul. 79-195 is premised on Schlude v. Commissioner, 372 U.S. 128 (1963) which held that taxpayer does not realize income for a taxable year in which no services were rendered, no payment received, nor any payment due. Section 451(b)(4) supplements this position by requiring allocation of transaction price among performance obligations when a contract has multiple performance obligations.

In conclusion, we submit that the IRS should continue to follow the realization concept under §61 when promulgating the regulations under §451(b) consistent with its statutory language and legislative history.¹³

Thank you for providing taxpayers with this opportunity to comment on the rules in section 451(b). If you would like to discuss any of these comments in more detail, please feel free to contact the undersigned at (202) 370–8218.

Sincerely,

Christian Wood
RSM US LLP
Washington, DC

CC:
Steven Mnuchin, Secretary of the Treasury
David Kautter, Assistant Secretary (Tax Policy), US Treasury Department
Jeffrey Van Hove, Senior Advisor, Office of Tax Policy, US Treasury Department
Kevin Hassett, Senior Advisor, US Treasury Department
Wendy Friese, Tax Policy Advisor, U.S. Department of the Treasury
Charles Rettig, Commissioner, IRS Michael Desmond, Chief Counsel, IRS
John Moriarty, Associate Chief Counsel (Income Tax & Accounting), Office of Chief Counsel, IRS
Charles Gorham, Special Counsel, Income Tax & Accounting, Office of Chief Counsel, IRS
Thomas Philipson, Acting Chairman Council of Economic Advisers
Larry Kudlow, Director of the United States National Economic Council