Funeral Home Company Seeks Relief Under Tax Accounting Regs

November 5, 2019

Courier's Desk
Commissioner of Internal Revenue
Internal Revenue Service
Attn: CC:PA:LPD:PR (Reg-104870-18 and Reg-104554-18)
1111 Constitution Avenue, NW
Washington, D.C. 20224

Re: Comments on Proposed Regulations under Sections 451(b) and (c) Reg-104870-18 and Reg-104554-18

Dear Sir:

On September 9, 2019, the Treasury Department and Internal Revenue Service issued proposed regulations under section 451(b) and section 451(c) of the Internal Revenue Code (“Code”) that were published in the Federal Register, with a request for comments from interested parties with respect to the two sets of proposed regulations. Service Corporation International and its affiliates (hereinafter “SCI”) is submitting these comments in response to the request for comments in the proposed regulations.

SCI is North America's largest provider of deathcare products and services, with a network of 24,000 associates dedicated to providing caring assistance to client families at their most difficult times. SCI operates 1,481 funeral service locations and 481 cemeteries (including 286 funeral service/cemetery combination locations), which are geographically diversified across 44 states, eight Canadian provinces, the District of Columbia, and Puerto Rico. SCI's funeral service locations provide all professional services related to funerals and cremations, including the use of funeral home facilities and motor vehicles, arranging and directing services, removal, preparation, embalming, cremations, memorialization, and catering. Funeral merchandise, including burial caskets and related accessories, urns and other cremation receptacles, outer burial containers and flowers are sold at funeral service locations. SCI cemeteries provide cemetery property interment rights, including developed lots, lawn crypts, mausoleum spaces, niches, and other cremation memorialization and interment options. Cemetery merchandise and services, including memorial markers and bases, outer burial containers, flowers and floral placement, other ancillary merchandise, graveside services, merchandise installation, and interments, are sold at our cemeteries.

It is SCI's understanding that the International Cemetery, Cremation and Funeral Association (“ICCFA”), of which SCI is the largest member, is also filing comments with respect to these proposed regulations. Since the facts with respect to certain members of ICCFA may differ from the facts in SCTs case, SCI is submitting these comments separately to address its own particular facts and circumstances. However, SCI also endorses ICCFA's comments that address a broader variety of factual situations in the death care industry.

The topics covered in SCF s comments relate to the potential impact of sections 451(b) and 451(c) on the tax treatment of proceeds from contracts for the sale of burial plots and cemetery and funeral merchandise and services that are entered into by customers on a pre-need basis. These transactions account for a significant portion of the income earned by SCI. SCI believes that the proposed regulations as presently drafted would have an extremely detrimental economic effect on the death care industry in general and on SCI in particular. SCI submits that no other industry would incur greater economic harm if these proposed regulations were adopted in their present form.

The reason for expressing this alarm at the potential effects on the death care industry of sections 451(b) and 451(c), as they would be implemented by the proposed regulations, is that under ASC 606, SCI and other members of the death care industry are required to recognize their entire income from pre-need contracts for the sale of burial plots at the time a pre-need sales contract is entered into by the parties. This event could occur many years before a customer dies and the customer's contract goes at-need.

Moreover, as discussed in more detail below, in addition to the time interval between the execution of a pre-need sales contract and when the contract goes at need (when the customer is deceased), there is an extended period of time between the time when a pre-need contract is entered into by the parties and the time when the proceeds from the pre-need sales contract are collected from the customer. If section 451(b) of the Code is interpreted in these circumstances as requiring the reporting of revenue for tax purposes when a pre-need contract is entered into by the parties in order to match the reporting of the revenue in SCI's or another members' applicable financial statements, but without an offset against that revenue inclusion for the costs of the burial plot and cemetery and funeral merchandise, the economic effects would be disastrous.

Accordingly, SCI's comments address the following three issues posed by the proposed regulations:

Executive summary of SCFs comments with respect to these issues

SCI requests that each of the foregoing points should be clarified in the final regulations.

Prior to presenting SCI's detailed comments in support of each of the foregoing conclusions, the factual background with respect to the types of situations where the foregoing comments are pertinent is described below.

1. Treatment of revenue from pre-need contracts for the sale of burial plots (Comment 1)

A. Description of the nature of the business and the terms of SCI's pre-need contracts

As noted above, SCI owns and operates both cemeteries and funeral providers, as well as combinations of the two types of businesses. Individual companies within SCI that operate exclusively as cemeteries typically sell to customers burial plots and cemetery merchandise (such as a plot liner, a marker or a monument), as well as services, such as opening and closing of a grave site. Individual companies within SCI that operate exclusively as funeral providers typically sell to customers funeral merchandise (such as a caskets, burial vaults and floral arrangements) and provide funeral services such as performing the funeral service and arranging for the burial of the decedent. Individual companies within SCI that have combined cemetery and funeral operations provide all of the foregoing types of merchandise and services to customers.

Focusing in this section of SCI's comments on the sale of burial plots, a contract for the sale of a burial plot is entered into either when the burial plot is needed upon the death of the customer (“at-need”) or in advance of the death of the customer (“pre-need”). In a case where the sales contract is entered into after the customer has died, the cemetery enters into a contract with a family member of the decedent, or a representative of the decedent's estate, to provide a burial plot, In an at-need sales contract, the terms of the sales contract typically provide that the purchaser is required to pay the entire sales price immediately, and the right to be buried in the burial plot is immediately transferred to the decedent or the decedent's estate.

In these situations, the customer or decedent's estate does not receive legal title to the burial plot, but rather is entitled to a perpetual easement right in the burial plot. Accordingly, in these circumstances, since the right to be buried in the burial plot passes immediately to the purchaser, state law does not require the use of a trust to hold any of the proceeds of the sale to insure delivery' of the burial plot to the decedent when it is needed.

Sections 451(b) and (c) generally have no application to at-need sales. Accordingly, our comments do not generally pertain to at-need sales of a burial plot.

In contrast, SCI frequently enters into contracts to sell burial plots on a pre-need basis, i.e., while the customer is still living. In the case of a pre-need contract for the sale of a burial plot, a customer contracts with the cemetery to purchase a burial plot that will be occupied at some point in the future. In the case of a pre-need sale contract, the terms of the contract typically provide that the purchaser is required to make a down payment of a portion of the total sales price of the burial plot at the time the contract is entered into and agree to pay the balance of the sales price, plus interest, over a period of several years.

In a limited number of instances, the purchaser may choose to pay the entire sales price of the burial plot upon entering into the pre-need contract, in which case the right to be buried in the burial plot passes immediately to the customer. This type of transaction is treated in the same manner as an at-need sale of the burial plot.

In the case of a pre-need contract for the sale of a burial plot that is paid for by the customer in installments, the purchaser does not receive the right to be buried in the burial plot until the sales price of the burial plot is paid in full by the customer. This is true even if the purchaser dies and the sales contract goes “at need” before the total sales price is folly paid. In these circumstances, the decedent is not entitled to be buried in the burial plot unless the decedent's estate pays the unpaid balance of the total sales price of the burial plot.

It should be noted that for federal income tax purposes, sales of burial plots have been treated like a sale of real property, despite the fact that a purchaser's interest in the burial plot is only a burial right and not fee ownership in the underlying land. National Museum Memorial Park v. Commissioner, 145 F.2d 1008, 1014 (4th Cir. 1944); Community Mausoleum Co. v. Commissioner, 33 B.T.A. 19 (1935).

One aspect of the terms of pre-need contracts for the sale of burial plots that is particularly important to the issues posed by the proposed regulations relates to the consequences if a customer cancels the pre-need contract prior to paying the entire purchase price of the burial plot, In this situation, SCI's pre-need contracts for the sale of burial plots typically include contractual terms governed by applicable state law that provide that if a customer cancels the pre-need contract for the purchase of a burial plot prior to paying the entire purchase price for the burial plot, SCI's sole remedy under the contract is to retain all or a portion of the installment payments previously received from the customer as liquidated damages. In those circumstances, SCI may not seek specific performance of the contract and, thus, the customer would not be liable to SCI for the unpaid balance of the total purchase price of the burial plot.

In a few cases, companies other than SCI may enter into pre-need contracts for the sale of burial plots with different terms. For example, some pre-need contracts may provide that if a customer defaults and fails to pay the balance of the sales price of the burial plot, the cemetery may specifically enforce the contract and sue the customer for the unpaid balance of the sales price. SCI's contracts do not provide for such remedies and, accordingly, SCI's comments do not address that type of factual situation.

B. Financial reporting treatment of pre-need contracts for sales of burial plots

As noted above, under ASC 606 for financial reporting purposes, SCI treats pre-need contracts for the sale of burial plots as a completed sale of the burial plot at the time the pre-need contract is entered into with the customer. Accordingly, the entire sales price is included as sales revenue in SCI's AFS in the year in which the contract is entered into, and SCI's allocable cost basis in the burial plot is offset against the revenue reported on the sate of the plot. Required future installment payments from customers are treated as receivables in SCI's AFS until the installment payments are paid by the customer.

C. Pre-2018 tax treatment of pre-need sales of burial plots

Prior to the adoption of ASC 606 for financial reporting purposes, and prior to the enactment of sections 451(b) and 451(c) for tax purposes, the IRS's position with respect to a pre-need contract for the sale of a burial plot was that if the taxpayer could not specifically enforce the pre-need contract against the customer and seek collection of the unpaid balance of the sales price of the plot in the event of cancellation of the contract by the customer, then a completed sale of the burial plot was not deemed to take place for tax purposes until the entire sales price was paid by the customer and the right to be buried in the burial plot passed to the customer or his or her estate.

This issue was addressed in TAM 199935060, which held that a completed sale of a burial plot did not occur for tax purposes at the time a pre-need sales contract was entered into in situations where the cemetery lacked an enforceable right to the entire sales price of the burial plot in the event a customer cancelled the contract. Accordingly, in that situation, the TAM held that the cemetery was required to include in gross income for tax purposes only the installment payments that had been received from the customer, but any unpaid deferred installments were not subject to current taxation prior to the time the payments were made.

This TAM obviously predated the adoption of ASC 606 and the enactment of the book conformity provision for income accrual in section 451(b). However, it is noteworthy that in this TAM, it was the taxpayer's practice for financial reporting purposes to include in income the entire sales price of each burial plot that was the subject to a pre-need sales contract in the year in which the contract was executed by the parties, even though this practice predated the issuance of ASC 606. Nevertheless, the taxpayer's financial reporting treatment of the transaction was not considered relevant to the resolution of the tax issue.

Two things have changed since this TAM was issued — ASC 606 was issued, and sections 451(b) and 451(c) were enacted. However, the first of these two developments seems to be of little importance to the tax issue, since as noted above, in the TAM the taxpayer included the entire sales price of each burial plot in income in the taxpayer's financial statements for the year in which the pre-need sales contract was entered into by the parties. This was equally true in SCI's case. Accordingly, the promulgation of ASC 606 has not changed SCI's treatment of pre-need contracts for the sale of burial plots for financial reporting purposes.

However, the enactment of section 451(b) and the issuance of the proposed regulations under section 451(b) are now at issue, because if that statutory provision and the proposed regulations in their present form were applicable, SCI might be required to include the entire sales price of a burial plot in gross income for tax purposes no later than the time when such income is reported in SCI's AFS, regardless of the terms of the pre-need contract for the sale of a burial plot.

D. Treatment of pre-need contracts for the sale of burial plots under section 451(b) and section 451(c)

The issue that is posed by section 451(b) and the proposed regulations thereunder is whether, notwithstanding the terms of SCFs pre-need sales contracts, SCI is required by section 451(b) to follow the treatment of sales proceeds in its AFS and report the entire sales price of a burial plot as revenue for tax purposes at the time the pre-need contract is entered into by the parties. The proposed regulations do not address this issue directly, but SCI submits that guidance on this issue is provided in the legislative history of section 451(b), as well as in the preamble to the proposed regulations under that section.

SCI submits that this guidance leads to the conclusion that SCI is not required to include the entire sales price of a burial plot in gross income for tax purposes at the time a pre-need contract for the sale of a burial plot is entered into by the parties, if SCI does not have an enforceable right to payment of the entire sales price of the burial plot in the event the customer cancels the pre-need contract. SCI submits that this conclusion applies regardless of a cemetery's treatment of the transaction in its AFS.

If the IRS agrees with this conclusion, SCI requests that this conclusion be made explicit in the preamble to the regulations. This treatment could also be clarified in the final regulations by adding an example that addresses this situation.

In support of this position, SCI notes that the express provisions of section 451(b) seem on their face to apply to the present situation and do not contain any type of exception from the financial conformity requirement in section 451(b) that would be applicable in these circumstances. However, both the legislative history of section 451(b) and the preamble to the proposed regulations suggest that an exception from section 451(b) might be applicable in those circumstances where a realization event has not occurred.

First, examining the legislative history, it is noteworthy that the Conference Report, which is the only tax report issued by Congress that covers section 451(b) (the House bill did not include a book conformity provision, and there was no Senate Finance Committee report), provides that section 451(b) does not change existing tax law with respect to the need for a realization event to occur in order for income to be recognized for tax purposes. In this regard, the Conference Report states:

The provision [new section 451(b)] 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. For example, the provision does not require the recharacterization of a transaction from sale to lease, or vice versa, to conform to how the transaction is reported in the taxpayer's applicable financial statement. Similarly, the provision does not require the recognition of gain or loss from securities that are marked to market for financial reporting purposes if the gain or loss from such investments is not realized for Federal income tax purposes until such time that the taxpayer sells or otherwise disposes of the investment. As a further example, income from investments in corporations or partnerships that are accounted for under the equity method for financial reporting purposes will not result in the recognition of income for Federal income tax purposes until such time that the Federal income tax realization event has occurred (e.g., when the taxpayer receives a dividend from the corporation in which it owns less than a controlling interest or when the taxpayer receives its allocable share of income, deductions, gains, and losses on its Schedule K-l from the partnership).

H.R. Rep. No. 115-466 at 428 n.872 (2017).

The General Explanation of Public Law No. 115-97 (December 2018) (the so-called “Blue Book”) was prepared by the staff of the Joint Committee on Taxation. The Blue Book also confirms the need for a realization event in order lor section 451(b) to apply to a transaction. Although the Blue Book is not an official part of the legislative history of the TCJA, nevertheless, the Blue Book confirms the interpretation in the Conference Report and notes that the provisions in section 451(b) were not intended to override the requirement in the tax law that a realization event must occur with respect to a transaction before that transaction may be taken into account for federal income tax purposes, notwithstanding the enactment of section 451(b). Thus, the Blue Book states:

The provision [section 451(b)] does not revise the rules regarding 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 taxation event has not year occurred, . . . In addition, the provision does not change any Federal income tax realization rule prescribed by the Code.

Id. at 165 (footnotes omitted).

There are numerous authorities dealing with the question of when income must be reported by a taxpayer that engages in a transaction to sell real property to a customer while the contract of sale is still executory. These authorities date back to a Supreme Court decision in 1930. In Lucas v. North Texas Lumber Co., 281 U.S. 11 (1930), the Supreme Court held that a seller of property that enters into a binding, but executory, contract for the sale of property is not taxable on the sale of the property until the transaction is closed and title to the property passes to the purchaser. In this case, the Court reasoned:

An executory contract of sale was created by the option and notice, December 30, 1916. In the notice, the purchaser declared itself ready to close the transaction and pay the purchase price “as soon as the papers were prepared.” Respondent did not prepare the papers necessary to effect the transfer or make tender of title or possession or demand the purchase price in 1916. The title and right of possession remained in it until the transaction was closed. Consequently unconditional liability of the vendee for the purchase price was not created in that year. . . . The entry of the purchase price in respondent's accounts as income in that year [1916] was not warranted. Respondent was not entitled to make return or have the tax computed on that basis, as clearly it did not reflect 1916 income.

Id. at 13-14 (citations omitted).

The IRS has long followed this same position, as explained in Rev. Rul. 69-93, 1969-1 C.B. 139, superseding A.R.R. 13, 2 C.B. 78, which explicitly stated that the taxpayer “did not realize gain or loss” (emphasis added) on the date the contract was executed, thus making clear that the execution of the sales contract did not represent a realization event for tax purposes. Moreover, in G.C.M. 36957 (Dec. 20,1976), after a branch of the IRS National Office had drafted a revenue ruling that would have reversed the holding in Rev. Rul. 69-93, the Chief Counsel's office rejected the proposed ruling and indicated that the IRS would adhere to its position as stated in Rev. Rul. 69-93 that no income is realized by the seller of real estate in a case where the contract of sale is still executory prior to a closing with respect to the sale of the property ("It is our view Rev. Rul. 69-93 sets forth the conclusions expressed in this memorandum.").

While neither the Supreme Court decision in North Texas Lumber nor G.C.M. 36957 uses the term “realization” in reaching its conclusion, nevertheless, Rev. Rul. 69-93 does use that term, and it seems clear that in each case the issue turned on when a sale of real property is considered complete for tax purposes, and that issue is the same as the issue of whether a realization event has occurred with respect to the sale of property. Accordingly, since in SCFs case, its pre-need contracts for the sale of a burial plot to a customer are not enforceable against the customer with respect to unpaid installments, SCI has not yet had a realization event for tax purposes with respect to the unpaid balance of the sales price at the time the contract is entered into.

In contrast, a realization event has obviously occurred with respect to any installments that are actually received by SCI in this situation. Accordingly, these payments represent income in the taxable year in which they are received or become due and payable under section 451(c), unless the installment payments are eligible for deferral under that section. In the present situation, since SCI is including the entire sales price of the burial plot in income in its AFS for the years in which the payments are received from a customer, those installment payments would not be eligible for deferral for tax purposes pursuant to section 451(c), by reason of the financial conformity requirement for deferral in section 451(c). The treatment of the taxpayer's basis in the burial plot is addressed separately in the next section of the comment letter.

Turning back to the issue of the applicability of section 451(b), even apart from the principle of realization, the authorities cited above that do not frame the test with respect to income inclusion in terms of "realization” reach the same result by focusing instead on whether the seller of real property has a fixed right to the entire sales price at the time the contract of sale is entered into by the parties, and by holding that the sale can be treated as occurring at the time the contract is entered into only in cases where there is such a fixed right to the entire sales price. Using this alternative analysis supports the conclusion that section 451(b) does not apply to unpaid installments of the sales price of a burial plot subject to a pre-need sales contract, since SCI lacks an enforceable right to payment of the unpaid installments in the event the customer cancels the contract.

For example, as noted above, the above-quoted excerpt from the Supreme Court's opinion in North Texas Lumber and the IRS's reasoning in TAM 9533002 adopt that same analysis. Both of those authorities tie their holding to the fact that the taxpayer in each case either had, or lacked, an enforceable right to payment under the applicable contract with the purchaser.

Moreover, the preamble to the proposed regulations under section 451(b) states that section 451(b) was intended to accelerate income where "the taxpayer has a right to partial payment, even when a contract requires delivery, acceptance, and title transfer before a taxpayer can bill its customer.” 84 Fed. Reg. at 47193. The preamble cites examples in the Blue Book as support for this conclusion, including an example that made clear that the taxpayer had a right to be paid for partial performance in the event the customer canceled the contract prior to completion. However, this language in no way suggests that section 451(b) was intended to extend to the portion of the sales price of property to which a taxpayer does not have an enforceable right to payment.

Since the proposed regulations adopt the position that section 451(b) was not intended to change the requirement for a realization event under existing law, there should be no change in SCI's tax treatment in the situation where there is a pre-need contract for the sale of a burial plot, but under the terms of the contract and applicable state law the purchaser is not obligated to pay the unpaid balance of the purchase price in the event the purchaser cancels the sales contract.

However, SCI is concerned that since this conclusion is not expressly stated anywhere in the proposed regulations, there is a possibility that in a future taxable year, an IRS agent might take the position that section 451(b) should apply to pre-need sales contracts and require income acceleration under section 451(b), despite the fact that SCI does not have an enforceable right to payment of the entire sales price of the burial plot in the event the customer cancels the contract.

Rather than leave this issue in a state of uncertainty, SCI requests that the resolution of this issue be clarified by including an express provision in the preamble to the final regulations, as well as adding an example in the final regulations, providing that section 451(b) is not applicable to a pre-need contract for the sale of a burial plot where the cemetery does not have an enforceable right to the entire sales price of the burial plot in the event a customer cancels the sales contract.

2. Treatment of cemetery's basis in burial plots (Comment 2)

As discussed in our comments with respect to the preceding issue, since under the terms of its pre-need sales contracts and applicable state law, SCI may only retain the installment payments already received from the customer if the customer cancels the contract, and has no right to obtain the unpaid portion of the sales price from the customer in these circumstances, the IRS treats the transaction as not representing a completed sale of the burial plot until the entire sales price is paid by the customer and title and the right to be buried in the burial plot transfers to the customer. As discussed in our comments with respect to the preceding issue, in that situation SCI should be required to treat the installment payments as gross income on receipt, or when due and payable, but the unpaid balance of the sales price of the burial plot should not be included in SCI's income for tax purposes until the sale is complete, upon the customer's payment of the entire sales price. In this situation, the issue that is posed is whether SCI is entitled to offset its adjusted basis in a burial plot to be sold to a customer against any installment payments that are received from the customer and that are included in SCI's gross income.

SCI notes that the proposed regulations address this basis offset issue only in the context of whether a taxpayer is entitled to offset its actual and estimated costs of performing a contract for the sale of inventoriable goods against advance payments that are received by the taxpayer and that are includible in the taxpayer's gross income under section 451(c). The death care industry has this same issue in the context of sales of cemetery and funeral merchandise, which are inventoriable goods. Accordingly, the treatment of inventoriable merchandise is addressed separately in the following section of these comments. However, the issue of the timing of a basis offset in the case of a pre-need contract for the sale of a burial plot is a separate issue that was not addressed in the proposed regulations.

The proposed regulations take the position that a taxpayer selling inventoriable goods may not offset the cost of the goods to be sold to a customer against any advance payments received from a customer that are included in the taxpayer's gross income. Accordingly, a preliminary question that needs to be considered is whether the IRS' position with respect to the tax treatment of the cost of goods sold with respect to inventoriable goods necessarily governs the tax treatment of the cost of real property, such as burial plots, in advance of the completion of the sale of such property.

SCI submits that the treatment of sales of inventory and the timing of the inclusion of costs In cost of goods sold are primarily governed by section 471 of the Code, although sections 1001 and 1016 have some applicability, as explained in the following section of the comment letter. However, in any event, it is clear that real property held for sale to customers in the ordinary course of business is not treated as inventory for purposes of section 471. Atlantic Coast Realty Co. v. Commissioner, 11 B.T.A. 416 (1928); W.C. and A.N. Miller Development Co. v. Commissioner, 81 T.C. 619 (1983); Homes by Ayres v. Commissioner, T.C. Memo. 1984-175, aff'd. 795 F.2d 832 (9th Cir. 1986). Moreover, this conforms with the long-standing position of the IRS. O.D, 848, 4 C.B. 47 (1921), superseded by Rev. Rul. 69-536,1969-2 C.B. 109; Rev. Rul. 86-149, 1986-2 C.B. 67.

Since real property may not be treated as inventory, the treatment of a taxpayer's basis in real property is governed exclusively by section 1001 and section 1016 of the Code, and section 471 has no applicability. This distinction is important in the case of the sale of burial plots because much of the legal analysis by the Treasury and the IRS that is reflected in the preamble to the proposed regulations under section 451(b) to explain why no cost offset is permitted for inventoriable goods prior to the actual sale of such goods relies on inventory principles, as well as the intent behind Congress's repeal of sections 452 and 462. While SCI does not agree with this analysis, and this position is explained in the next section of this comment letter, none of this history is relevant in dealing with sales of real estate because such sales are governed exclusively by section 1001 and section 1016. Accordingly, a separate analysis of the basis offset issue in the context of section 451(b) and section 451(c) is required in the case of sales of real property.

In this regard, Treas. Reg. § 1.1001-1(c)(1) provides:

Even though property is not sold, or otherwise disposed of, gain is realized if the sum of all amounts received which are required by section 1016 and other applicable provisions of Subtitle A of the Code to be applied against the basis of property exceeds such basis. . . .

(Emphasis added.)

Treas. Reg. § 1.1016-2(a) provides:

The cost or other basis shall be properly adjusted for an expenditure, receipt, loss or other item, properly chargeable to capital account, including the cost of improvements and betterments made to the property.

(Emphasis added).

Most of the authorities that have interpreted the meaning of the foregoing regulations provisions have involved situations where a taxpayer received proceeds either from insurance, condemnation proceedings, or as a result of a lawsuit seeking to recover compensation for damage to the taxpayer's property. In these situations, any proceeds received by a taxpayer have been treated as a recovery of the taxpayer's basis in the property, with the proceeds being held to be taxable only to the extent the proceeds received exceeded the taxpayer's basis in the property that was damaged. These cases rely on the above-quoted provisions in the regulations under sections 1001 and 1016, Raytheon Production Corp. v. Commissioner, 144 F.2d 110 (1st Cir. 1944); Vaira v. Commissioner, 444 F.2d 770 (3d Cir. 1971); Stine v. Commissioner, T.C. Memo. 1976-339; Rev. Rul. 81-152, 1981-1 C.B. 433; PLR 200513011.

These authorities clearly interpret the foregoing regulations provisions in a way that would support the conclusion that if a taxpayer is required to include in gross income for tax purposes any proceeds that are received in connection with a sale of an interest in real property where the sale will be completed in the future, the taxpayer is entitled to recover its adjusted basis in the property before being subjected to lax on any of the proceeds received by the taxpayer. In fact, the IRS itself has adopted this same conclusion in situations where a taxpayer has received proceeds from an executory contract to sell real property, and where those proceeds were received in a taxable year prior to the taxable year in which there was a completed sale of the property.

For example, as discussed in the preceding section of these comments, in one of the earliest authorities dealing with the issue of when a sale of real estate is considered a completed transaction for tax purposes, A.R.R. 13, 2 C.B. 78 (1920), the IRS addressed the income tax treatment of any proceeds received by the seller in advance of a completed sale of the property. In the A.R.R., a taxpayer entered into a contract to sell certain real property in 1917. The execution of the contract was accompanied by the taxpayer/seller's receipt of a down payment from the prospective purchaser of the property. The balance of the sales price was received in 1918, at which time title to and possession of the property were transferred to the purchaser.

On these facts, the IRS held that a sale of the real property did not occur until either legal title to the property or the benefits and burdens of ownership of the property passed to the purchaser in 1918. Accordingly, the IRS held that the taxpayer was not required to include the entire sales price of the property in gross income in 1917.

In this early ruling, the IRS also addressed the tax treatment of the down payment received by the taxpayer in 1917, which was prior to the taxable year in which the sale was held to occur. On tills issue, the ruling states:

The Committee, therefore, recommends that the income arising out of this transaction be taxable as for the year 1918 under the income tax and not for the year 1917 under the income tax and possibly the excess profits tax. The advance payment is to be regarded as a return of capital, and, assuming it to be less than the cost, no part is subject to income or profits tax for the year 1917.

Id. at 80. Although A.R.R. 13 was subsequently superseded by Rev. Rul. 69-93,1969-1 C.B. 139, the conclusions in A.R.R. 13 would still be valid under the facts in A.R.R. 13. In Rev. Rul. 69-93, in contrast to A.R.R. 13, the reasoning used to justify the non-taxability of the nominal down payment was that the down payment was in the nature of a deposit. However, unless the down payment was refundable in the event settlement did not occur (a fact not mentioned in the ruling), such a conclusion would be inconsistent with the holding in Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203 (1990).

More recently, in TAM 8009004, this same type of analysis was adopted by the IRS in a type of situation that is closely analogous to a pre-need contract for the sale of burial plots. In this technical advice memorandum, a taxpayer entered into what are referred to as bond-for-deed sales contracts with customers for the transfer of subdivided, but undeveloped, lots. The purchasers of the lots agreed to pay for the lots in monthly payments over a period of years. However, title to and possession of each lot did not pass to the purchasers until the entire sales price for each lot was paid. The taxpayer did not report any of the installment payments as income under the theory that the executory sales contracts were in fact in the nature of options, relying on the holding in Rev. Rul. 69-93, as well as authorities dealing specifically with options.

The IRS rejected this argument and concluded that the executory contracts were not options and the installment payments were not option payments, but instead represented installment payments of the entire sales price of property, where a completed sale of the property would take place at a future date. Accordingly, the IRS ruled that the installment payments could not be treated as non-taxable deposits that could be deferred in their entirety until the taxable year in which a completed sale of the lots was deemed to occur for tax purposes.

However, in determining what portion of the installment payments was includible in the seller's gross income, the IRS ruled that the taxpayer was entitled to recover its basis in the property before recognizing any of the installment payments as gross income for tax purposes. The TAM adopted the following reasoning:

As reflected in Rev. Rul. 69-93, a sale of real estate does not occur for federal income tax purposes until either title passes or possession and the burdens and benefits of ownership are, from a practical standpoint, transferred to the buyer. At the time of contract execution herein neither of these two events have occurred as title and possession are not conveyed until the full purchase price of the lot is received by the taxpayer. Consequently, the “amount realized” provisions of section 1001(b) of the Code are not applicable for the taxable year of contract execution as a sale or other disposition of property has not occurred. However, income recognition is not postponed until a sale of the lot takes place. Section 1016(a)(1) of the Code requires taxpayer to adjust (decrease) its basis in a particular lot by the amount of the periodic payments it received pursuant to the contract to sell such lot in the future. When and to the extent the periodic payments received, less the portion attributable to any interest charge, exceed the taxpayer's basis in the lot, section 1.1001-1(c)(1) of the regulations compels the taxpayer to realize gain in the amount of the excess.

This situation is closely analogous to pre-need contract for the sale of burial plots by a cemetery, where the cemetery lacks an enforceable right to the entire sales proceeds in the event the customer cancels the contract. In that case, while there has not been a realization event with respect to any unpaid portion of the sales price, nevertheless, the installment payments received by the cemetery are subject to taxation under sections 1001 and 1016, but only to the extent the proceeds received by the cemetery exceed the cemetery's basis in the burial plot. In that circumstance, the allowance of a basis offset is a component of the computation of gain when the sales proceeds exceed the cemetery's basis in the burial plot.

Accordingly, regardless of whether the IRS ultimately denies a cost of goods sold offset with respect advance payments that are required to be included in gross income in advance of the taxable year in which a completed sale of inventoriable goods occurs, a recovery of basis is permitted in a case where a taxpayer receives advance payments with respect to the sale of an interest in real property that will be completed in a future taxable year and where the advance payments are included in the taxpayer's gross income for tax purposes in a taxable year prior to the taxable year in which a completed sale of the property is deemed to occur.

3. Timing of cost of goods sold inclusion in the case of pre-need contracts for the sale of merchandise (Comment 3)

The two preceding comments relate to the tax treatment of pre-need contracts for the sale of burial plots — the first comment relating to the tax treatment of revenue, and the second comment relating to the tax treatment of the adjusted basis of the burial plot. This third comment relates to the tax treatment of cost of goods sold with respect to pre-need contracts for the sale of merchandise, which are in the nature of inventoriable goods to SCI. This is the same issue that applies to producers of goods, although the impact of section 451(c) on members of the death care industry is in most cases far more significant and potentially adverse than in the case of producers of goods that are subject to the over-time revenue recognition rules in ASC 606, although there can be situations for certain producers of goods that are similar to the situation for all taxpayers in the death care industry.

A. Nature and economics of death care industry

SCI enters into at-need and pre-need contracts for the sale of merchandise, as well as services, to customers. As discussed above, sections 451(b) and (c) do not have any impact on at-need sales of cemetery and funeral merchandise. Accordingly, this section of SCFs comments is confined to a consideration of the impact of the proposed regulations on pre-need contracts for the sale of cemetery' and funeral merchandise.

One of the most important aspects of the death care industry is its ability to offer customers the opportunity to enter into pre-need contracts to purchase merchandise, such as grave site markers, monuments, burial plot liners, etc. from a cemetery, and caskets, urns, etc., from a funeral provider. The appeal of a pre-need contract from a customer's point of view is two-fold. First, entering into a pre-need contract relieves a customer's family of the burden of having to make difficult and emotional decisions at a time when the family is under the stress of a recent death of a family member. Second, entering into a pre-need contract locks in the purchase price of the merchandise at the prevailing price at the time the contract is entered into and thus relieves the decedent's family of the economic burden of having to pay for the merchandise and services at a later time when the merchandise is likely to be more costly.

The terms of pre-need sales contracts typically offer the customer a period of years over which to fund a pre-need contract. This deferral of the payment of the purchase price of the merchandise is financed by charging the customer interest on the deferred payments.

Another aspect of pre-need contracts for the sale of merchandise that may differ from a pre-need contract for the sale of a burial plot is the requirement under state law to deposit all, or a significant portion of, the customer's payments with respect to a pre-need contract for the sale of merchandise into a trust for the benefit of, and to protect the interests of, the customer. These trusts are closely regulated under state law and contain strict rules governing the timing of distributions from the trust to the cemetery or funeral provider.

For tax purposes, sales proceeds deposited into a pre-need trust are not considered taxable income to a cemetery or funeral provider until the principal amount of such trust is distributed to SCI. While trusts are also sometimes used to hold the proceeds from pre-need contracts for the sale of burial plots that is a less common practice than in the case of merchandise.

Accordingly, an analysis of the economics of a pre-need contract for the sale of merchandise from SCFs point of view makes it clear that SCI is undertaking an obligation to deliver merchandise to a customer at an uncertain, and potentially distant, period of time in the future in exchange for a price that was fixed at the outset of the transaction. Moreover, in the case of merchandise, as compared with services, SCI may be required to incur the out-of-pocket expense of fulfilling the pre-need contract before the merchandise is needed by the customer. However, in most cases, SCI will not be in a position to access the customer's funds to pay for the merchandise because the customer's funds are held in a trust.

With the enactment of section 451(c), SCI had expected to continue to be able to rely on those aspects of current law that defer the inclusion of advance payments in gross income until the payments exceed SCFs basis in the property to be sold to a customer. As a result, it came as a tremendous shock to SCI to learn that the proposed regulations under section 451(b) and section 451(c) took the position that a cost offset of the type previously permitted either by section 1016 or by Treas. Reg. § 1.451-5(c) would no longer be permitted under section 451(c). If this position is retained in final regulations, that position would have dire economic consequences for SCI and other members of the death care industry. Smaller members of the industry in particular would be faced with an acute lack of funds with which to pay tax on a tax base that far exceeded the member's true net income from the transaction.

With this economic background in mind, SCI submits these comments to support its position that SCI should be permitted to offset the appropriate cost of goods sold amount against installment payments that are received from customers with respect to the sale of cemetery and/or funeral merchandise and that are required, pursuant to section 451(c), to be included in the taxpayer's gross income in a taxable year prior to the taxable year in which a sale of the merchandise occurs.

B. Legal arguments in support of a cost of goods sold offset under section 451(c)

1. The concept of recovery of basis under existing law applies not only to advance payments for the sale of real estate, but also to advance payments from the sale of inventoriable goods.

As noted in the preceding section of this comment letter, SCI contends that section 1001 and section 1016 of the Code clearly support the principle that a taxpayer is entitled to offset its basis in real property against the inclusion in gross income of installment payments received with respect to the real property in a taxable year prior to the taxable year in which a completed sale of the real property takes place. SCI contends that this principle of basis recovery is equally applicable in the case of advance payments received with respect to future sales of inventoriable property.

First, there is no fundamental reason why the applicability of the basis recovery principle should be inapplicable to inventory property. There is the same Constitutional prohibition against the taxation of gross receipts or the recovery of basis in the case of sales of inventory property as in the case of sales of real property. For example, this principle underlies the conclusion that section 280E does not prevent marijuana dealers from obtaining a tax benefit from expenditures related to their marijuana business to the extent those expenditures are included in the dealers' inventoriable costs.

The only argument the IRS and the Treasury could conceivably make is that they believe the principles in section 1001 and section 1016 are limited to transactions involving real property and do not apply to sales of inventory property. However, that conclusion is inconsistent with the structure of the Code and the provisions in the regulations. After all, section 1013. which is part of the same Part II of Subchapter O as section 1016, covers the basis rules for inventory property. Section 1013 provides that “[i]f the property should have been included in the last inventory, the basis shall be the last inventory value thereof.”

In addition, the regulations under section 1013 further provide:

The basis of property required to be included in inventory is the last inventory value of such property in the hands of the taxpayer. The requirements with respect to the valuation of an inventory are stated in Subpart D (sections 471 and following), part II, or subchapter E, chapter 1 of the Code, and the regulations thereunder.

Treas. Reg. § 1.1013-1. Thus, the regulations under section 1013 make clear that the treatment of inventory property is determined jointly by Part II of Subchapter O and section 471 of the Code. Illis provision eliminates any possible argument that Part II of Subchapter O is limited in its application to sales of real property and does not apply at all to sales of inventory property.

Moreover, in cases such as Gorman v. Commissioner, T.C. Memo. 1995-268, section 1016 was applied to insurance recoveries in the case of damage to a taxpayer's inventory. This case demonstrates the close relationship between the cost recovery principle in section 1016 and the inventory costing rules in section 471. In this case, the Tax Court acknowledged that if a taxpayer whose inventory was damaged retained the inventory at the time insurance proceeds were recovered, the taxpayer would have been entitled to exclude from income the insurance proceeds to the extent of the taxpayer's unrecovered basis in its inventory. However, because the taxpayer had disposed of the damaged inventory and deducted its basis as cost of goods sold, none of the insurance proceed could be reduced by the taxpayer's basis in its inventory.

If the basis recovery provisions in section 1016 apply to insurance recoveries with respect to inventory in the absence of a sale of inventory, there is no reason why the same principles would not be applicable in the case of advance payments received prior to the taxable year in which inventory property was sold.

Accordingly, rather than repeat the analysis regarding basis recovery with respect to the receipt of advance payments in the case of future sales of real property in the preceding section of this comment letter, SCI incorporates this analysis to the present section of the comment letter dealing with advance payments with respect to future sales of inventoriable goods.

In addition to the preceding argument regarding the recovery of basis, or as an alternative to this argument, SCI submits that sales of inventoriable goods should be entitled to a cost of goods sold offset in the event of an inclusion of advance payments in gross income for the following reasons.

2. The use of the phrase “item of gross income” in the definition of “receipt” in section 451(c) supports the allowance of a cost offset under section 451(c).

For a taxpayer electing the deferral method of accounting for advance payments with respect to sales of goods, section 451(c) provides that an advance payment that is deferred from gross income in the year in which the advance payment is received is required to be included in the taxpayer's gross income in the immediately succeeding taxable year. That requirement applies regardless of whether the taxpayer has earned the advance payment through the required performance of delivering the goods to the customer.

In connection with the foregoing rule, section 451(c) refers to the advance payment as an "item of gross income.” The reference to an “item of gross income” in section 451(c) occurs in the definition of "receipt” in section 451(c)(4)(C): “For purposes of this subsection, 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.” (Emphasis added.)

The use of the term “item of gross income” in section 451(c) necessarily carries with it the implication that in the case of a sale of goods, the cost of the goods that are sold must be taken into account in determining the amount of the “item of gross income.” In this regard, the term “item of gross income” is much more precise and specific than a mere general reference to “gross income” or “income” or “inclusion in gross income” or “inclusion in income.” The phrase “item of gross income” instead is a very technical and precise phrase that cannot be viewed as having been accidental. Thus, in applying the various rules in section 451(c), the operative amount in all of the rules should be viewed as being “an item of gross income.”

In the case of a sale of goods, the amount of the “item of gross income” that is associated with such a sale is the total sales revenue or gross receipts with respect to the sale reduced by the total amount of cost of goods sold associated with the sale. Thus, where a particular advance payment is subject to the elective deferral method under section 451(c), and where some portion of the advance payment is eligible for deferral to the taxable year following the year in which the advance payment is received, the amount of gross income that should be recognized in that following taxable year under section 451(c) is the total portion of the contract price that was received as an advance payment, and that was eligible for deferral, reduced by the amount of cost of goods sold that is properly associated with that deferred amount of contract price. Failure to take into account the amount of cost of goods sold in determining the amount by which the taxpayer's taxable income is increased under section 451(c) would result in an increase in the taxpayer's taxable income by an amount that is larger than the amount of gross income properly associated with the amount of the advance payment or portion of the advance payment that is subject to accelerated income inclusion under section 451(c).

3. The economic performance requirement does not provide a basis for denying a cost offset under section 451(c).

In the preamble to the proposed regulations under section 451(c), the Treasury and IRS contend that allowing a cost offset under section 451(c) for expected future costs would violate the economic performance requirement in section 461(h) of the Code. The preamble to the proposed regulations under section 451(c) begins its discussion of the reasons why the proposed regulations do not allow a cost offset under section 451 (c) as follows:

An allowance to account for future cost of goods sold, for future estimated costs, or other cost offset is inconsistent with sections 461(h) and, 471, 263A, and the accompanying regulations. Moreover, section 13221 does not change the timing rules provided in sections 461, 471, 263A and elsewhere that apply to liabilities.

84 Fed. Reg. at 47179.

This explanation in the preamble to the proposed regulations ignores the fact that the effect of allowing a cost offset against the amount of any portion of the contract price that is required to be accelerated into gross income pursuant to section 451(c) is not to accelerate a deduction, but instead the effect of the cost offset is merely to determine the proper amount of the item of gross income that is required to be accelerated into gross income. This is not the type of effect that the economic performance requirement was intended to prevent.

Moreover, the requirement under section 451(c) to include an amount in income at the time an advance payment is received (subject to elective one-year deferral) is itself a departure from the normal operation of the accrual method. Under the normal operation of the accrual method, in the case of a sale of goods, the amount of gross income that is associated with the goods ordered by a customer is not recognized until the goods are delivered to the customer. Since the effect of section 451(c) is clearly to depart from that normal operation of the accrual method with respect to the time of reporting gross income from the sale of goods, it is also clearly appropriate to depart from the normal operation of the accrual method as it applies to the cost offset element of the amount of gross income that is associated with the goods to be sold.

In addition, as will be discussed in detail in a later section of this comment letter, the allowance of a cost offset for expected future costs under former Treas. Reg. § 1.451-5 was clearly not viewed by the IRS and Treasury as representing a violation of the economic performance requirement, since the two provisions coexisted for over 33 years. As will be discussed later in connection with the discussion of former Treas. Reg. § 1.451-5, the rationale that was relied on for the conclusion that the cost offset under former Treas. Reg. § 1.451-5 was not inconsistent with the economic performance requirement should be equally applicable under section 451(c).

In addition, denying taxpayers the ability to claim a cost offset under section 451(c) would ordinarily have the effect that the taxpayer would be required to report an amount of gross income at the time of each advance payment income inclusion that would exceed the total amount of gross income on the contract that was associated with the portion of the total contract price being reported under section 451 (c) at that time. Correspondingly, if the taxpayer were denied a cost offset against the advance payment for the related amount of estimated future costs, the consequence would be that at the later time when the estimated future costs were actually incurred, the taxpayer would ordinarily be required to report those costs as losses with no associated revenue.

In the death care industry, the disparity in timing between the receipt of an advance payment and the related delivery of the goods to which the advance payment relates would in general be far longer than in any other industry (although, as noted earlier, in some cases certain manufacturers may have comparably lengthy time periods involved). In the death care industry, the length of that time disparity is typically so material that cemeteries and funeral providers will have difficulty operating under their present business model if they are required to pay tax on the gross amount of advance payments either in the year of receipt or in the succeeding taxable year, but are required to wait to obtain the benefit of the offsetting cost of goods sold until the goods are provided to the customer many years into the future. This pattern of reporting does not reflect the reality of the overall amount of gross income realized by the taxpayer on the contract as a whole, nor is it financially sustainable.

4. A cost offset under section 451(c) is supported by relevant case law

Over 50 years ago, the Supreme Court decided a series of three cases in which taxpayers using the accrual method of accounting were required to include the full amounts of advance payments in gross income at the time the advance payments were received, See Schlude v. Commissioner, 372 U.S. 128 (1963); American Automobile Association v. United States, 367 U.S. 687 (1961); and Automobile Club of Michigan v. Commissioner, 353 U.S. 180 (1957). However, all three of these cases involved advance payments for services to be performed in the future, rather than advance payments forgoes to be provided in the future.

The significant difference between advance payments for services and advance payments for goods is that it is clear that in the case of services, in contrast to the situation with respect to the sale of goods, the amount of the gross income from such services is not reduced by the costs of providing the services. Moreover, in Schlude, for example, the Court relied in part on the fact drat “the advance payments related to services which were to be performed only upon customers' demands without relation to fixed dates in the future,” and that the customers “could simply allow their rights under the contracts to lapse,” without receiving any services in exchange lor the advance payments. 372 U.S. at 135.

With respect to case law dealing with advance payments relating to the sale of goods, in Hagen Advertising Displays, Inc. v. Commissioner, 407 F.2d 1105 (6th Cir. 1969), the Sixth Circuit held that to the extent a manufacturer of advertising signs received advance payments for signs to be delivered in the future, “at least a portion of the advance payments constituted gross income in the year of their receipt, even though petitioner is an accrual-basis taxpayer.” Id. at 1109. On the issue of “what portion of the advance payments must be included in gross income in the year of receipt,” Id. at 1110, the court recognized that to determine the proper amount of gross income to be recognized, it would be necessary and appropriate for the taxpayer to reduce the total amount of the advance payments received by the cost of the signs that would be delivered in exchange for those advance payments, since the court agreed with the taxpayer's contention that “inclusion of the entire amount of the advances, without an allowance for related costs of goods sold, would constitute taxation of the return of capital.” Id.

Nevertheless, since the “[t]axpayer has made no attempt to estimate the cost of goods sold of the signs for which advances were received,” and “[s]ince it is clear that taxpayer, not the Commissioner, must bear the burden of reporting in the proper tax year amounts which it claims are costs of goods sold, taxpayer cannot complain in this petition for review of the consequences of its failure to do so.” It is notable that Hagen was decided six years after the last of the three Supreme Court decisions on the taxation of advance payments, and that Hagen relied on those decisions in rejecting the taxpayer's attempt to defer the advance payments. Thus, Hagen provides strong support for the conclusion that when a taxpayer is required to include an advance payment relating to the sale of goods in determining taxable income prior to the delivery of the goods, the taxpayer should be permitted to take the estimated future cost of those goods into account in determining the amount of the required gross income inclusion relating to the advance payment.

5. The allowance of a cost offset in former Treas. Reg. § 1.451-5 supports the allowance of a cost offset under section 451(e).

It is also noteworthy under section 451(c) that the former provision of the regulations dealing with the deferral of advance payments relating to the sale of goods that was in effect before the enactment of section 451(c), namely, former Treas. Reg. § 1.451-5, clearly provided for an offset against advance payments for the cost of the goods to which the advance payments related for cases where income recognition relating to the advance payments was required at a time before the time when the goods to which the advance payments related were provided to the customer. These regulations were issued in response to court decisions, such as those that were discussed in the preceding subsection of this comment letter, in which the tax treatment of advance payments for the future performance of services or the future sale of goods was addressed.

The background for these regulations also includes the fact that, in September of 1969. President Nixon appointed a task force, the President's Task Force on Business Taxation, which issued a report in September of 1970 making recommendations for changes in several areas. One of these recommendations was that there should be an increased conformity between tax and financial accounting. See, e.g., John S. Nolan, The Merit in Conformity of Tax to Financial Accounting, Taxes, December, 1972, at 761. The treatment of advance payments was one area where the tax and financial accounting treatments had begun to diverge as a result of the court decisions in this area.

As a result, regulations were issued under section 451 that were designed to permit taxpayers to defer for tax purposes the reporting of advance payments for the sale of goods to be delivered in a later taxable year until the taxable year in which the goods were delivered to the customer. However, because this policy was intended to be consistent with the call for greater conformity between tax and financial reporting mentioned above, the approach the IRS and Treasury adopted to implement this deferral policy was conditioned on financial conformity in the treatment of the advance payments.

Thus, the general rule in former Treas. Reg. § 1.451-5(b)(1)(ii), which permitted taxpayers using an accrual method of accounting that received advance payments for the sale of goods in a later taxable year than the year in which the advance payments were received to defer the reporting of the advance payments for tax purposes to the year in which the amounts would be properly accruable for tax purposes, which would ordinarily have been the year in which the goods to which the advance payments related were delivered to the customer, conditioned the availability of this tax deferral on the requirement that the advance payments must be included in gross receipts for tax purposes no later than the year in which the advance payments were included in gross receipts for financial reporting purposes. Since generally accepted accounting principles at that time required advance payments to be deferred for financial reporting purposes until the goods to which the advance payments related were delivered to the intended customer, the practical effect of this general rule in the regulations was to permit tax deferral until the goods were delivered to the customer.

However, the IRS and Treasury also concluded that, in a situation where a taxpayer received advance payments that exceeded the expected cost of the goods to be delivered in a future taxable year, so that the taxpayer was assured, at the time it received the advance payments, that it would earn a profit on the sale of the goods, there should be a time limit on the length of the deferral period before the assured profit was recognized in gross income. The approach the IRS and Treasury adopted to implement this policy was reflected in former Treas. Reg. § 1.451-5(c), which provided special rules for the treatment of advance payments that related to goods that were included in the taxpayer's inventory.

Under these rules, if a taxpayer received advance payments that exceeded the cost of the goods to which the advance payments related (referred to in the regulations as "substantial advance payments"), the taxpayer was only able to defer the reporting of the advance payments for tax purposes to the second taxable year following the taxable year in which the substantial advance payments were received. However, to be consistent with the policy that only the expected amount of profit on the sale, rather than the total amount of the advance payment, would be included in the taxpayer's gross income at the end of the two-year deferral period, former Treas. Reg. § 1.451-5(c)(1)(ii) provided that in cases where a taxpayer was required to accelerate the recognition of substantial advance payments relating to the sale of inventoriable goods, compared to the time when the goods were delivered to the customer, the taxpayer was also required to take into account a cost offset against the advance payments at the time the advance payments were recognized for tax purposes:

[T]he taxpayer must take into account in such taxable year the costs and expenditures included in inventory at the end of such year with respect to such goods (or substantially similar goods) on hand or, if no such goods are on hand by the last day of such . . . taxable year, the estimated cost of goods necessary to satisfy the agreement.

This provision in former Treas. Reg. § 1.451-5(c)(1)(ii) is obviously highly relevant to the Issue of whether a similar cost offset is appropriate under section 451(c). In this regard it is particularly notable that this cost offset under former Treas. Reg. § 1.451-5(c)(1)(ii) was not limited to costs that had already been incurred at the time the advance payments were required to be recognized for tax purposes, but also included estimated future costs in those cases where the costs related to the advance payments had not yet been incurred at that time. The proposed version of former Treas. Reg. § 1.451-5 was issued on August 7, 1970, Accounting for Advance Payments, 35 Fed. Reg. 12612 (August 7, 1970), only a little more than a year after the Sixth Circuit's Hagen decision, which was discussed in the preceding subsection of this opinion.

This cost offset provision in former Treas. Reg. § 1.451-5(c)(1)(ii) undoubtedly reflected the discussion in the Sixth Circuit's Hagen decision to the effect that when taxpayers are required to recognize advance payments for the sale of goods for tax purposes prior to the time when the taxpayer delivers the goods to the customer the taxpayer should be permitted to claim an offset against the amount of the advance payments for the estimated cost of the goods to which the advance payments relate. Thus, the cost offset provision in former Treas. Reg. § 1.451-5(c)(1)(ii) did not represent administrative generosity to taxpayers on the part of the IRS and Treasury, but instead simply represented an acknowledgment and recognition by the IRS and Treasury of what was required in order to avoid taxing the taxpayer on a return of capital, as discussed in the Hagen case. Accordingly, the cost offset provision in former Treas. Reg. § 1.451-5(c)(1)(h) provides strong support for the position that a similar cost offset, encompassing not only costs already incurred but also estimated future costs, should also be permitted under section 451(c).

As noted earlier, the IRS and Treasury contend in the preambles to the proposed regulations that permitting a cost offset for estimated future costs would violate the economic performance requirement under the all-events test as it relates to deductions, costs, and liabilities. However, it is clear that the IRS and Treasury previously both explicitly and implicitly rejected that position by reason of the fact that the IRS and Treasury continued to permit an offset for estimated future costs under former Treas, Reg. § 1.451-5(c)(1)(h) (prior to the enactment of section 451(b) and section 451(c)) for over thirty years after the enactment of the economic performance requirement in 1984.

Subsequent to the enactment of section 461(h), the terms of former Treas. Reg. § 1.451-5(c)(1)(ii) were never modified as a result of the enactment of the economic performance requirement in section 461(h) in 1984. Former Treas. Reg. § 1.451-5 was originally issued in final form in 1971, T.D. 7103, Accounting for Advance Payments, 36 Fed. Reg. 5495 (March 24, 1971), and, as noted above, the provision concerning the inclusion of a cost offset for estimated future costs was contained in the original 1971 version of this regulation.

After section 461(h) was enacted in 1984, former Treas. Reg. § 1.451-5 was allowed to remain in effect for over 33 years, until the enactment of section 451(c) in December of 2017, with no change to the provision permitting a cost offset for estimated future costs, even though former Treas. Reg. § 1.451-5 was amended twice during the period of time after the enactment of section 461(h) in other ways. T.D. 8067, Accounting for Long-Term Contracts. 51 Fed. Reg. 376 (Jan. 6, 1986); T.D. 8929, Accounting for Long-Term Contracts. 66 Fed. Reg. 2219 (Jan. 11, 2001), Moreover, when proposed regulations under section 461(h) were issued in 1990, IA-258-84, Economic Performance Requirement. 55 Fed. Reg. 23235 (June 7, 1990), followed by final regulations on this subject in 1992, T.D. 8408, Economic Performance Requirement, 57 Fed. Reg. 12411 (April 10, 1992), there was no reference in the preambles to either the proposed regulations or the final regulations to any perceived need to make any change to former Treas. Reg. § 1.451-5 to take account of the enactment of the economic performance requirement.

In addition, one of the provisions that was added to the regulations under section 461 as part of the changes that were made to the regulations relating to section 461(h) can be read as encompassing the inclusion of estimated future costs in the cost offset under former Treas. Reg. § 1.451-5. That provision is Treas. Reg. § 1.461-1(a)(2)(iii)(C), in a subsection of the regulations headed “Alternative timing rules," which reads as follows:

Section 461 and the regulations thereunder do not apply to any amount allowable under a provision of the Code as a deduction for a reserve for estimated expenses.

Based on the text of this provision, it would appear that this provision should apply to the inclusion of estimated future costs in the cost offset under former Treas. Reg. § 1.451-5. The reference in this provision in Treas. Reg. § 1.461-1(a)(2)(iii)(C) to “any amount allowable under a provision of the Code” should encompass an amount that is allowable pursuant to a regulation that is issued under a provision of the Code, and former Treas. Reg. § 1.451-5 is unquestionably a regulation issued under section 451 of the Code. In addition, the reference in this provision in Treas. Reg. § 1.461-1(a)(2)(iii)(C) to “a deduction for a reserve for estimated expenses” should encompass the allowance of a cost offset for estimated future costs under former Treas. Reg. § 1.451-5.

In addition, in accounting method changes, private letter rulings, and field service advices issued subsequent to the enactment of section 461(h), the IRS has continued to either reference or specifically permit the allowance of an offset for the estimated cost of goods sold of goods in respect of which a substantial advance payment has been received by a taxpayer. See, e.g., FSA 1847 (Jul. 12, 1996); FSA 2306 (Mar. 25, 1998); PLR 9231002. Thus, the argument by the IRS and Treasury in the preamble to the proposed regulations that permitting a cost offset under section 451(c) for estimated future costs would violate the economic performance requirement is clearly refuted by the longstanding continued allowance of a cost offset for estimated future costs under former Treas. Reg. § 1.451-5, despite the enactment of the economic performance requirement.

The position expressed in the preamble to the effect that providing for a cost offset under section 451(c) would violate the economic performance requirement completely misconstrues the history of the economic performance provisions. Those provisions were enacted for a completely different reason than would be applicable in the case of section 451(b) and section 451(c).

Section 461(h) was enacted in 1984 to address the problem that existed under prior law where a taxpayer, by contract or by operation of law, became obligated to perform acts in the future that were of a fixed nature, but the cost of these acts was somewhat uncertain because the acts would not be performed on a fixed date in the near future. Given that the all-events test as it previously existed would be satisfied in the foregoing circumstances, if the taxpayer could reasonably estimate the cost of the future acts the taxpayer was obligated to perform, and the amount of the taxpayer's deduction would not be limited to the present value of the cost of performing those acts in the distant future, the Treasury proposed to Congress and Congress enacted in 1984 a provision to delay those deductions. Section 461(h) accomplished this goal by adding a third prong to the all-events test-the economic performance requirement — that basically deferred the deduction for future acts until the acts were performed by the taxpayer.

That additional requirement was intended to apply to expenditures of a type that satisfied the all-events test under the previous rules, but that would be subject to a prolonged delay in payment. It was never the intention of the Treasury to apply the economic performance requirement to deductions that were never subject to the all-events test as its existed prior to the enactment of section 461(h).

Accordingly, section 461(h) was not intended to apply, for example, to trading stamps that were accounted for under Treas. Reg. § 1.451-4, to future development costs that were obligated to be paid by developers of undeveloped land that sold subdivided lots to customers prior to development of the lots, or to the cost of goods sold offset that was permitted by Treas. Reg. § 1.451-5(c). The intention was that these types of expenses would continue to be deductible without regard to the economic performance requirement, in light of the fact that they were deductible without satisfying the all-events test as it existed prior to the enactment of section 461 (h). In those types of circumstances, Treasury thought it would be inappropriate to apply section 461(h) to expenses that were never subject to the all-events test to begin with.

Consequently, since, prior to the enactment of section 451(c), it was clear that a cost offset encompassing both actual costs and expected future costs was permitted under former Treas. Reg. § 1.451-5(c)(1)(ii) with respect to advance payments relating to the sale of goods, and since that provision in the regulations reflected an acceptance by the IRS and Treasury of the judicial position on the need for a cost offset that was expressed in the Sixth Circuit's Hagen decision, it is reasonable to conclude that a cost offset under section 451(c) encompassing both actual costs and expected future costs survives in the case of advance payments relating to the sale of goods.

The conclusion that the allowance of a cost offset under former Treas. Reg. § 1.451-5 supports the allowance of a cost offset under section 451(c) is not affected by the recent withdrawal of former Treas. Reg. § 1.451-5. Since that regulation is now superseded by section 451(c), there is no continuing need for those regulations. However, that withdrawal in no way invalidates the analysis that the presence of a cost offset in former Treas. Reg. § 1.451-5 supports the propriety of permitting a cost of goods sold offset against any income inclusions that result from taxing advance payments prior to the completion and delivery of the goods to which the advance payments relate.

Moreover, as will be discussed in subsequent sections of this comment letter, there is nothing in the text or legislative history of section 451(c) that suggests that there was any intention to overrule the understanding under prior law that any rule that requires the reporting for tax purposes of advance payments relating to the sale of goods prior to the time when the goods are delivered to the customer should be accompanied by a cost offset against the advance payments for the estimated future costs that the taxpayer will be required to incur with respect to the goods to which the advance payments relate. Moreover, as discussed in the preceding section of this comment letter, the use of the phrase “item of gross income” in section 451(c) to refer to the effect on taxable income of the operation of section 451(c) makes clear that retention of the cost offset for purposes of section 451(c) was in fact very much intended,

6. The lack of a cost offset for advance payments for sales of goods in Rev. Proc. 2004-34 does not support denying a cost offset under section 451(c).

In explaining the decision not to permit a cost offset against revenue that is required to be accelerated under section 451(c), the preamble to the proposed regulations under section 451(c) places considerable reliance on the fact that since Rev. Proc. 2004-34, in contrast to former Treas. Reg. § 1.451-5, did not provide for any cost offset against advance payments, even in cases where taxpayers used Rev. Proc. 2004-34, rather than Treas. Reg. § 1.451-5, with respect to advance payments relating to the sale of goods, as a result, no cost offset was intended in section 451(c):

Section 13221 [of the TCJA] changes the timing of income for advance payments for goods and generally codifies Revenue Procedure 2004-34. See H.R. Rep. No. 115-466, at 429 (2017) (Conf. Rep.). Revenue Procedure 2004-34 does not include an accelerated cost offset when amounts are included in income prior to the sale of goods or provision of services.

84 Fed. Reg. at 47179.

The foregoing quotation from the preamble to the proposed regulations under section 451(c) cites the Conference Report discussion relating to section 451(c), which specifically referred to an intention to codify Rev. Proc. 2004-34 in section 451(c). This reference to Rev. Proc. 2004-34 in the Conference Report will be discussed in more detail in the next section of this comment letter.

Rev. Proc. 2004-34 was a successor to Rev. Proc. 70-21 and Rev. Proc. 71-21, which were issued during the same time period as Treas. Reg. § 1.451-5. Rev. Proc. 70-21 and Rev. Proc. 71-21 provided a limited one-year deferral period for advance payments relating to the performance of services. These revenue procedures did not provide any cost offset with respect to this category of advance payments. When Rev. Proc. 2004-34 was issued as a replacement for Rev. Proc. 71-21, the scope of the revenue procedure was expanded to include advance payments with respect to the sale of goods, but Rev. Proc. 2004-34 did not provide any cost offset in the case of advance payments for the sale of goods.

However, Announcement 2004-48, which was issued at the same time as Rev. Proc. 2004-34 to explain some of the decisions that were reflected in Rev. Proc. 2004-34, included a discussion of the reasons why the decision had been made not to permit a cost offset in the case of advance payments for the sale of goods under Rev. Proc. 2004-34. This discussion included the following:

The final revenue procedure is designed to simplify the various issues that have arisen under Rev. Proc. 71-21. After careful consideration, the Service has determined that a special COGS rule is inconsistent with that simplification. Taxpayers that receive advance payments for goods and qualify to use the deferral method in § 1.451-5 may use that method, including the rule for COGS included in the regulation.

(Emphasis added.)

This passage from Announcement 2004-48 made clear that the decision not to permit a cost offset under Rev. Proc. 2004-34 in connection with advance payments relating to the sale of goods was based on the rationale that permitting a cost offset in those circumstances would be inconsistent with the simplification Rev. Proc. 2004-34 was intended to achieve, and also made clear that a cost offset remained available under former Treas. Reg. § 1.451-5. Thus, the lack of any cost offset provision in Rev. Proc. 2004-34 was based solely on administrative considerations relating to the desire for simplification and therefore should not be viewed as support for denying a cost offset under section 451(c) in the case of advance payments relating to the sale of goods.

7. Statements in the Conference Report on the relationship between section 451(c) and Rev. Proc. 2004-34 do not support denying a cost offset in the case of advance payments relating to the sale of goods.

The section of the Conference Report on the TCJA dealing with section 451(c) includes the following statement regarding the relationship between section 451(c) and Rev. Proc. 2004-34:

The provision . . . codifies the current deferral method of accounting for advance payments for goods, services, and other specified items provided by the IRS under Revenue Procedure 2004-34.

H.R. Rep. No. 115-466 at 429.

If the foregoing statement in the Conference Report were read in isolation, this statement might be viewed as suggesting that section 451(c) was intended to be identical in every aspect of its operation to Rev. Proc. 2004-34, and, under this interpretation, for example, the denial of a cost offset in the case of advance payments for the sale of goods would be carried over from Rev. Proc. 2004-34 to section 451(c). However, the statement in the Conference Report quoted above is followed immediately by an additional statement that makes clear that the first statement was not intended to imply the wholesale importation of the rules in Rev. Proc. 2004-34:

That is, the provision allows accrual method taxpayers to elect to defer the inclusion of income associated with certain advance payments to the end of the tax year following the tax year of receipt if such income also is deferred for financial statement purposes.

The foregoing statement makes clear that it was only limited aspects of the rules in Rev. Proc. 2004-34 that were codified in section 451(c), namely, the one-year deferral period provided in Rev. Proc. 2004-34, and the requirement that amounts must be deferred for financial reporting purposes in order to be eligible for deferral for tax purposes under section 451(c). This second sentence in the Conference Report does not suggest that these two aspects of Rev. Proc. 2004-34 are merely examples of aspects of Rev. Proc. 2004-34 that were codified in section 451(c), but rather that these two aspects of Rev. Proc. 2004-34 represent the totality of the rules in Rev. Proc. 2004-34 that were codified in section 451(c).

An additional extremely important aspect of the second statement relating to section 451(c) quoted above from the Conference Report is the way this statement describes the amounts that are eligible for deferral under section 451(c): “defer the inclusion of income associated with certain advance payments.” (Emphasis added.) It is extremely significant that this statement does not refer to deferring the inclusion of the total amount of advance payments, but instead refers to deferring the inclusion of "income associated with certain advance payments.” (Emphasis added.)

Thus, the amount that is deferred under section 451(c) is not the total amount of the advance payment but rather the amount of income associated with the advance payment. This aspect of this statement is consistent with the fact, noted earlier, that the definition of “receipt” in section 451(c) refers to the time when an item of gross income is received, not the time when an advance payment is received

Moreover, a footnote to the second statement in the Conference Report quoted above reads as follows: “Thus, the provision is intended to override any deferral method provided by Treasury Regulation section 1.451-5 for advance payments received for goods.” This footnote is entirely consistent with the conclusion that the intended codification of Rev. Proc. 2004-34 was limited to the one-year deferral period and the financial conformity requirement in Rev. Proc. 2004-34, since Treas. Reg. § 1.451-5 provided a much more generous deferral period than Rev. Proc. 2004-34.

In this regard, it is significant that this footnote in the Conference Report referring to former Treas. Reg. § 1.451-5 was appended to the second sentence in the Conference Report relating to former Rev. Proc. 2004-34, rather than to the first sentence. That is, the footnote is appended to the sentence in the Conference Report that explains the meaning of the description of section 451(c) as representing a “codification” of Rev. Proc. 2004-34 as consisting of the one-year deferral period and the financial conformity requirement. As a result, the meaning of this footnote is that the one-year deferral period in section 451(c) overrules the more generous deferral period that was provided by former Treas. Reg. § 1.451-5.

Moreover, the statutory text of section 451(c) itself says nothing about a repeal or overruling of Treas. Reg. § 1.451-5. Accordingly, reading the footnote as having any implications about any issues on which the provisions of section 451(c) are not explicitly inconsistent with the provisions of Treas. Reg. § 1.451-5 would represent giving inappropriate weight to the footnote.

8. The contrast between the definition of "receipt” in section 451(c) and the definition of “received” in Rev. Proc. 2004-34 provides further support for the conclusion that section 451(c) was not intended to codify every aspect of Rev. Proc. 2004-34.

In further support of the conclusion that section 451(c) was not intended to codify all aspects of Rev.Proc. 2004-34, it is notable that the definition of “receipt” in section 451(c) differs in one significant respect from the definition of “received” in Rev. Proc. 2004-34. As noted earlier, section 451(c)(4)(C) defines “receipt” as follows: “For purposes of this subsection, 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,” (Emphasis added.)

As noted earlier, it is significant that this definition of “receipt” defines receipt in terms of the lime when “an Hem of gross income is received by the taxpayer.” (Emphasis added.) In contrast, section 4.04 of Rev. Proc. 2004-34 defined “received” as follows: “Income is 'received' by the taxpayer if it is actually or constructively received, or if it is due and payable to the taxpayer.” (Emphasis added.)

Thus, the definition of “received” in Rev. Proc. 2004-34 used the very general term “income” to refer to the amount that was received, whereas the definition of “receipt” in section 451(c) uses the much more precise and specific term “an item of gross income” to refer to the amount that is received. This contrast between the definition of “receipt” in section 451(c) and the definition of “received” in Rev. Proc. 2004-34 makes clear that it was a very conscious and deliberate choice to use the precise and technical phrase “an item of gross income” in the definition of “receipt” in section 451(c), rather than the much more general term “income” that had been used in the definition of “received” in Rev. Proc. 2004-34. Thus, the use of the phrase “an item of gross income” in the definition of “receipt” in section 451(c) should be given effect, and giving effect to the use of this term requires allowing a cost offset in determining the amount of gross income that is deferred under section 451(c).

For the reasons discussed above, SCI submits that a cost offset should be allowed under section 451(c), and this cost offset should include the estimated amount of future costs that it will be necessary for SCI to incur relating to the income inclusion. SCI requests that this conclusion be incorporated into the final regulations that are issued under section 451(c).

Conclusion

As discussed in the introduction to these comments, these proposed regulations have the potential to produce dire financial consequences that are nearly unique to members of the death care industry. In contrast to other industries, the death care industry is confronted with the problem that revenue is being accelerated for financial reporting purposes under ASC 606 to an earlier point in time, rather than being required to change to the over-time method of recognizing revenue for financial reporting purposes. Moreover, in comparison to other industries, the death care industry faces an enormous potential time gap between the accelerated recognition of revenue under sections 451(b) and (c) and the allowance of the deduction of costs for tax purposes. If the realization requirement and cost offset issues are not resolved in a manner that is favorable to taxpayers in general, then consideration should be given to creating a special exception for the death care industry. That approach was adopted in the proposed regulations under section 451(c) in creating a specified goods exception for certain industries, and SCI could envision such an exception for the death care industry in light of the significantly adverse effect that these proposed regulations have on the death care industry,

Representatives of SCI would be pleased to answer any questions you may have and to discuss the problems faced by it and other members of the death care industry in light of the proposed regulations.

Respectfully submitted,

Sarah E. Adams
Vice President Tax
Service Corporation International
Houston, TX