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Consultant Fine Tunes Comments on Proposed Tax Accounting Regs

NOV. 22, 2019

Consultant Fine Tunes Comments on Proposed Tax Accounting Regs

DATED NOV. 22, 2019
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November 22, 2019

The Honorable David J. Kautter
Assistant Secretary for Tax Policy
U.S. Department of the Treasury
1500 Pennsylvania Ave., NW
Washington, DC 20220

The Honorable Michael J. Desmond
Chief Counsel
Internal Revenue Service
1111 Constitution Ave, NW
Washington, DC 20224

Re: Supplemental Comments on REG-104870-18

Dear Assistant Secretary Kautter and Chief Counsel Desmond:

This letter supplements earlier comments that I filed on October 29, 2019 relating to REG-104870-18, and it provides a contrary view to two comments on this same set of proposed regulations that have been provided to the Treasury by other commentators. The first section of this letter responds to a suggestion in one filed comment that the proper tax treatment of unbilled receivables for the performance of services does not involve a realization concept. The second section of this letter responds to a commentator's suggestion that these regulations should allow taxpayers to elect to use their book percentage of completion method instead of the accrual method in cases where financial reporting under ASC-606 requires over time reporting.

A. Unbilled Receivables for the Performance of Services.

In my prior comment letter, I explained that “Congress made it clear in three important ways that the newly enacted section 451(b) only applies to an item of income that has been realized for Federal income tax purposes.” After reviewing comments that have also been filed on this same set of proposed regulatory provisions, it appears that one certain comment suggests that the proper tax treatment of unbilled receivables for the performance of services does not involve a realization concept. Rather, the comment suggests that the recognition of income from contracts for the performance of services only depends on the newly added financial statement conformity rule for recognition and does not first require a finding that the financial statement income has been realized. While I agree that many administrative and judicial decisions that address contracts for the performance of services focus on the all-events test, these same decisions only require the current recognition of income under the all-events test where the subject income has been realized, i.e., is paid to the taxpayer, is an amount due to the taxpayer, or has been earned by the taxpayer's complete performance of a separate performance obligation entitling it to be paid. Income is realized for tax purposes when a taxpayer has an unconditional right to payment. Administrative and judicial decisions addressing the recognition of income relating to the performance of services only require the recognition of income that has been realized by reason of the taxpayer having an unconditional right to payment under the contract.

Realization is, and has been, a precondition not only to the recognition of income derived from the sale of goods but also from the rendition of services. Under the accrual method, income is not realized and is not subject to tax, whether for goods or for services, until payment for said goods or services has been made or is unconditionally due.

The Supreme Court has decided numerous cases addressing the question of whether income has been realized. Certain of these decisions determine that income has been realized in advance of the performance of services, but only in the case where the service provider has sold or transferred his or her right to the future payment, and has thus realized an immediate and quantifiable economic benefit.1 In cases where a taxpayer has not anticipatorily transferred a future right to income and does not have an unconditional right to payment (and has not yet received payment), the Supreme Court has been consistent in holding that income is only recognized when the income is realized, i.e., when a taxpayer has an unconditional right to payment.2

The Supreme Court cases summarized below all require realization in advance or coterminous with recognition, and these decisions do not find a difference when income is realized with respect to the performance of services or the sale of property:

1. North American Oil Consolidated v. Burnet, 286 U.S. 417 (1932)

The net profits were not taxable to the company as income of 1916. For the company was not required in 1916 to report as income an amount which it might never receive. See Burnet v. Logan, 283 U.S. 404, 283 U.S. 413. Compare Lucas v. American Code Co., 280 U.S. 445, 280 U.S. 452; Burnet v. Sanford & Brooks Co., 282 U.S. 359, 282 U.S. 363. . . . Nor is it material, for the purposes of this case, whether the company's return was filed on the cash receipts and disbursements basis, or on the accrual basis. In neither event was it taxable in 1916 on account of income which it had not yet received and which it might never receive. 286 U.S. at 423–424.

2. Security Flour Mills Co. v. Commissioner, 321 U.S. 281 (1944)

The uniform result has been denial both to government and taxpayer of the privilege of allocating income or outgo to a year other than the year of actual receipt or payment, or, applying the accrual basis, the year in which the right to receive or the obligation to pay, has become final and definite in amount. 321 U.S. at 286–287.

3. Helvering v. Horst, 311 U.S. 112 (1940)

Admittedly not all economic gain of the taxpayer is taxable income. From the beginning, the revenue laws have been interpreted as defining “realization” of income as the taxable event, rather than the acquisition of the right to receive it. . . . Where the taxpayer does not receive payment of income in money or property, realization may occur when the last step is taken by which he obtains the fruition of the economic gain which has already accrued to him. Old Colony Trust Co. v. Commissioner, 279 U.S. 716; Corliss v. Bowers, 281 U.S. 376, 281 U.S. 378. Cf. Burnet v. Wells, 289 U.S. 670. 311 U.S. at 115.

4. Schlude v. Commissioner, 372 U.S. 128 (1963)

For an accrual basis [service] taxpayer “it is the right to receive, and not the actual receipt, that determines the inclusion of the amount in gross income,” Spring City Foundry Co. v. Commissioner, 292 U.S. 182, 292 U.S. 184; Commissioner v. Hansen, 360 U.S. 446, and here the right to receive these installments had become fixed at least at the time they were due and payable. 372 U.S. at 137.

fn 6 — Upon reconsideration, however, we concede the error of accruing future payments which are neither due as a matter of contract nor matured by performance of the related services. Indeed, the Studio's right to collect the installment on its due date depends on its continuing ability and willingness to perform. Until that time, its right to receive payment has not fully ripened.

5. Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955)

Here, we have instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion. 348 U.S. at 431.

6. Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203 (1990)

The question, therefore, cannot be resolved simply by noting that respondent derives some economic benefit from receipt of these deposits. Rather, the issue turns upon the nature of the rights and obligations that IPL assumed when the deposits were made. In determining what sort of economic benefits qualify as income, this Court has invoked various formulations. It has referred, for example, to “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955). It also has stated: “When a taxpayer acquires earnings, lawfully or unlawfully, without the consensual recognition, express or implied, of an obligation to repay and without restriction as to their disposition, 'he has received income . . .'” James v. United States, 366 U.S., at 219, quoting North American Oil Consolidated v. Burnet, 286 U.S. 417, 424 (1932). 493 U.S. 208–209

Other lower courts have reached the same conclusion:

1. Williamson v. United States, 292 F.2d 524 (Ct.Cl. 1961)

Under the accrual method, income is held to be realized when there arises in the taxpayer a fixed and unconditional right to receive it. 292 F.2d at 530.

It is fundamental that all economic gain is not taxable income and that it is the realization of income that is the taxable event. But the law contemplates that there is some point at which all income which has accrued, in the sense of having been fully earned, will be realized and taxable to him who earned it regardless of the accounting method involved. An acceptable accounting method should simply indicate this point logically and consistently. 292 F.2d at 530. See also Commissioner v. Kuckenberg, 309 F.2d 202,205 (9th Cir. 1962); Idaho First National Bank v. United States, 265 F.2d 6 (9th Cir. 1959).

2. Schneer v. Commissioner, 97 T.C. 643 (1991)

To meet the requirements of the all-events test, there can be no substantial contingency to a taxpayer's right of receipt or as to the certainty of the amount to be received. 97 T.C. at 650.

The IRS itself has reached the same conclusion for service contracts:

1. Rev. Rul. 79-195, 1979-1 C.B. 177

The School's right to receive a tuition payment is conditioned upon the School rendering the educational instruction for a lesson and the student's completion of the lesson. As payment is neither due nor made, all the events that fix the School's right to receive the tuition payment for a lesson under section 1.451-1(a) of the regulations occur when the student completes a lesson. Therefore, tuition income is realized by the School as each lesson is completed by the student.

2. T.A.M. 200803017 (1/18/2008)

For both amounts, the required performance has not occurred prior to the time the amounts under the contract are due. Therefore, Taxpayer does not have a fixed right to receive income under its Government contracts until the amounts become due.

The precedents that address the timing of income recognition for contracts involving the performance of services first ask the question of whether payment is due or has been made. If payment is due or has been made, there is realization and recognition of the amount of the payment, provided that the payment is not characterized as a loan or as a deposit (see Indianapolis Power and Light, supra). Similarly, if a payment is received in exchange for the sale of the right to receive a payment for future services (see Helvering v. Horst, supra), there is current realization and recognition of the amount of the payment since income has been received (i.e., a realization and recognition event). Importantly, however, when no payment for services has been made or is due, the precedents are uniform in not requiring the realization or recognition of income until performance is complete and the taxpayer has an unconditional right to receive the income (see Security Flour Mills Co. v. Commissioner, supra; Schlude v. Commissioner, supra; Rev. Rul. 79-195, supra). If Congress had intended to reverse a set of rules so ingrained in, and central to, the tax system, which rules have been the fabric of income realization and recognition for nearly 100 years, surely the statute and the legislative history relating to any such legislation would have clearly stated an intention to change such a long-standing rule. As noted in my initial comments, the Congressional purpose to retain the realization rule as a precondition to recognition was expressly stated, and there is no indication anywhere in the statute or the legislative history that this realization rule is to apply solely to contracts calling for the sale of goods and does not apply to contracts for the performance of services. Any suggestion to the contrary by individuals presenting comments on these proposed regulations must be dismissed.

B. Election to Follow a Book Percentage of Completion Method.

While I concur with the Treasury Department's interest in reducing administrative and compliance burdens, I do not think it advisable to include in the regulations to be issued under section 451(b) or section 451(c) a rule that allows accrual basis taxpayers to report income from goods or services subject to over time reporting under ASC 606 (i.e., essentially a percentage of completion method (“PCM”)) under that same method for tax purposes. Rather, any special administrative convenience rule allowing taxpayers to report such income for tax purposes on their financial statement method needs to be in informal guidance for the reasons stated below.

First, an election to employ PCM under section 451 is not found in the statute. PCM is not an accrual method, and the rules in 451(b) and 451(c) are only addressing an accrual method taxpayer. Second, given the decision that section 451(c) is described in the legislative history as not allowing a cost offset for advance payments that are included in income in advance of the delivery of goods, having an apparently contrary rule in regulations interpreting a statute (rather than adding an administrative convenience rule in an informal administrative guidance document allowing a taxpayer to use their financial statement PCM method for tax purposes) will undoubtedly add confusion to this entire set of rules and generate compliance uncertainty and financial statement reserve uncertainty. Third, and perhaps most important, providing a PCM rule in the section 451(b) or 451(c) regulations will suggest to the IRS Examination Division that such a PCM method clearly reflects the income of an accrual method taxpayer. The Commissioner is given broad discretion to require taxpayers to employ a method of accounting that clearly reflects income, and a regulatory provision in the accrual method provisions of section 451 may empower IRS Exam to propose changing accrual method taxpayers reporting taxable income under an accrual method to PCM in order to, in the view of Exam, more clearly reflect income. Any rules adopted in these regulations should add certainty and relieve compliance burdens. If an administrative convenience rule is to be adopted here, it belongs in an informal pronouncement and not in a set of set of section 451 regulations.

Respectfully yours,

Michael F. Solomon
MFSOLOMON TAX CONSULTNING, LLC
Rancho Santa Fe, CA

cc:
Jeffrey Van Hove, Senior Advisor, U.S. Treasury (Office of Tax Policy)
Ellen Martin, Attorney-Advisor, U.S. Treasury (Office of Tax Policy)
Charles Culmer, Senior Technician Reviewer, IRS Office of Chief Counsel
Charles Gorham, Special Counsel, IRS Office of Chief Counsel

FOOTNOTES

1See e.g., Helvering v. Horst, 311 U.S. 112, 118 (1940) (“The power to dispose of income is the equivalent of ownership of it. The exercise of that power to procure the payment of income to another is the enjoyment, and hence the realization, of the income by him who exercises it. We have had no difficulty in applying that proposition where the assignment preceded the rendition of services.” (emphasis added)); Commissioner v. PG Lake, 356 U.S. 260, 267 (1958) (“We have held that if one, entitled to receive at a future date interest on a bond or compensation for services, makes a grant of it by anticipatory assignment, he realizes taxable income as if he had collected the interest or received the salary and then paid it over.” (emphasis added)); Harrison v Schaffner, 312 U.S. 579, 580 (1941) (“Since granting certiori we have held following the reasoning of Lucas v. Earl, supra, that one who is entitled to receive, at a future date, interest or compensation for services and who makes a gift of it by anticipatory assignment, realizes taxable income quite as much as if he had collected the income and paid it over to the object of his bounty.” (emphasis added)).

2See e.g., Indianapolis Power & Light, 493 U.S. 203, 209, 213-14 (1990) (taxpayer did not realize income from deposits for utility services since no payment had been made (only a deposit) and taxpayer had no right to retain the deposit based on performance to date.

END FOOTNOTES

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