This article summarizes key accounting method areas for businesses to focus on in 2022. The topics addressed include high-dollar items affecting a wide array of industries such as revenue recognition timing, small business simplified methods and lease accounting income and expenses.
New automatic change procedures to comply with the final revenue recognition regulations
The Tax Cuts and Jobs Act of 2017 (TCJA) amended the revenue recognition timing rules to add a fourth prong to the “all events” test. Accordingly, under the new standard, income is recognized at the earliest of when it is received, due, earned or recognized in the financial statements.
The final regulations issued pursuant to the TCJA refer to this as the “AFS income inclusion rule,” and it generally applies to an accrual basis taxpayer with an applicable financial statement (AFS) such as a certified, audited financial statement issued under Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).
The procedures to comply with the final regulations are lengthy (70 pages), complex and contain multiple method changes, options and terms and conditions to consider. This discussion addresses common issues related to the new AFS income inclusion rule only. Affected taxpayers that have not implemented the final revenue recognition regulations, or have taken a position contrary to the rules, should act quickly to review their methods of accounting and file any necessary accounting method changes (Form 3115) because the final rules are now mandatory for all covered income items, with the exception of certain “specified fees.”
Notably, the automatic change to comply with the AFS income inclusion rule is particularly time sensitive because this change is only available temporarily (i.e., for tax years 2021 through 2023). Thereafter, the change must be made under the more onerous and costly nonautomatic change procedures. Taxpayers should review revenue recognition methods, which can be a time-consuming process depending on the number and type of revenue streams, customer contracts and variations in terms and conditions (e.g., performance obligations, revenue offsets, contingency provisions).
Common exposure items to be aware of include improperly deferring income from overlooked liabilities, misapplication of the “enforceable right” standard, impermissible use of the now-repealed “two-year” deferral method for advance payments and long-term contracts accounted for using noncompliant book percentage of completion methods. In particular, the issue of overlooked liabilities is common for taxpayers that make a tax revenue recognition method change in connection with implementing the new revenue recognition financial standard under ASC 606. Under ASC 606, the adjustment to financial statement revenue is determined based on
revenue. Conversely, the AFS income inclusion rule used to determine taxable income applies to
gross
income, without any offset for costs other than the limited exception provided for sales of certain goods under the optional cost offset method. Consequently, taxpayers need to carefully analyze AFS income and addback liabilities and cost offsets in accordance with the AFS income inclusion rule. Additionally, issues have arisen in connection with applying the new “enforceable right” standard that are discussed further below.
IRS raises issues with the enforceable right standard
As noted above, under the amended “all events test,” an item of income is recognized at the earliest of when it is due, received, earned or reported in the AFS. Significantly, the final revenue recognition regulations provide that income “reported in the AFS” does not include amounts the taxpayer does not have an “enforceable right” to recover if the customer were to terminate the contract at the end of the tax year (regardless of whether the customer actually terminates the contract).
IRS officials at a recent ABA tax conference noted that the enforceable right standard may not cover common situations, such as the three scenarios noted below:
State tax refund claims – The enforceable right standard appears inapplicable because the tax authority is not the taxpayer’s customer and there is no contract between the parties. This situation raises the issue of whether a taxpayer might be required to include the refund in income (e.g., because it was reported in the AFS) even though the amount is not realized as of year-end (e.g., because the government has not approved the refund), which appears contrary to the TCJA.
Volume purchase discounts received by a purchaser – According to the IRS, the enforceable right standard may be inapplicable to discount income received by a purchaser from a vendor because the discount is a purchase price adjustment rather than a revenue item, and the party paying the discount is a vendor and not a customer of the purchaser. Consequently, guidance might be necessary to address the treatment of this income (e.g., where discount income is included in the AFS but the contract may be terminated before the discount is earned).
Insurance policy renewal commissions received by insurance agent from insurance company – The IRS noted this type of arrangement falls outside the traditional customer relationship contemplated under the enforceable right standard and questioned whether the enforceable right standard was properly applied in an example in the final regulations. Under the facts in the example, the taxpayer (insurance agent) receives a renewal commission from the insurance company if a policy is renewed. The example concludes that the taxpayer does not have an enforceable right to a renewal commission for a particular policy because the carrier could cancel the policy prior to renewal.
The IRS indicated that it plans to study situations not addressed in the enforceable right standard rules and will consider providing a broadly defined definition of the term “customer.” The IRS also requested input from commentators to assist it in formulating additional guidance addressing more fact patterns that may be eligible for the enforceable right exception.
New lease accounting standard
Taxpayers required to adopt the new financial standard for lease accounting under ASC 842 in 2022 (e.g., privately held businesses) may need to devote considerable tax resources to address the tax implications of the standard.
Under ASC 842, book lease accounting changed significantly in areas such as lease classification, lease acquisition costs, lease termination payments and sale/leaseback transactions. In particular, the new standard substantially modified the treatment of operating leases by a lessee. Under the new standard, the lessee is required to account for these leases on the balance sheet as right of use (ROU) assets with an offsetting liability, rather than as “true” leases (rent expense) under the previous accounting principles.
Although the tax lease accounting rules remain unchanged and, as in the past, do not follow book treatment, significant effort may be required to address the tax implications of the new financial accounting standard.
Taxpayers impacted in 2022 by the lease accounting standard should consider the following action steps:
Review book and tax lease methods, which can require extensive lead time, depending on the volume and complexity of lease agreements, general ledger accounts and items affected and data availability. In particular, taxpayers that implemented new lease accounting systems and processes will need to ensure that these new enhancements capture the information needed to maintain the historical tax methods and calculations.
Where the tax treatment does not follow the book lease accounting standard, taxpayers will need to create new or revise existing book/tax adjustments for various lease-related income and expenses such as rent, interest, depreciation, amortization, lease acquisition costs and sale/leaseback transactions.
Determine whether method changes (Form 3115) are required for noncompliant or non-optimal lease accounting methods. Fortunately, automatic changes are available for many common lease-related items such as lease classification changes, tenant improvement costs, lease acquisition expenses, lease termination payments, rent income and expenses under section 467 rent agreements and rent income subject to the new AFS income inclusion rule discussed above.
New procedures for small business taxpayer simplified method changes
The TCJA increased the gross receipts threshold for favorable small business simplified accounting methods, including the cash overall method, inventory accounting and uniform capitalization (UNICAP) method exceptions and the exemption from PCM for certain “small” construction contracts. The expanded eligibility provided in the TCJA and the final regulations issued thereunder resulted in wide adoption of these small business simplified methods by taxpayers looking to save cash and simplify their tax compliance.
Procedures issued to implement the final small business taxpayer regulations favorably add automatic changes to accommodate common situations, such as permitting taxpayers with inventory to automatically change to or from the cash and accrual overall methods.
Significantly, the procedures also facilitate taxpayers needing to make frequent automatic changes to or from the small business simplified methods by providing a permanent waiver of the eligibility rule that prohibits a taxpayer from making the same automatic change within five tax years. However, the waiver is subject to a key restriction that requires the taxpayer to change from the small business taxpayer method(s) in the first year it becomes a “former small business taxpayer” and is disqualified from using the small business simplified methods (e.g., taxpayer exceeds the gross receipts threshold or becomes a tax shelter). Consequently, small business taxpayers using the simplified method(s) will need to carefully monitor their gross receipts levels and tax shelter status and be prepared to file Form 3115 timely if they require the waiver to make an automatic change to a different permissible method. Conversely, changes that fail to satisfy the eligibility rules must generally be made under the more onerous and costly nonautomatic method change procedures.
A pass-through entity that is typically profitable but expects to incur a net operating loss for 2022 (e.g., due to COVID, inflation or supply chain issues) should consider making an election to use the prior year’s (2021) taxable income to avoid disqualification as a syndicate (tax shelter) and remain qualified for the favorable small business taxpayer methods. Under the final regulations, the election is made on an annual basis (not permanently), thus providing added flexibility for pass-through entities to benefit from the favorable small business simplified methods.
Additionally, a former small business taxpayer required to implement a UNICAP method change should allow sufficient time to comply with the final UNICAP rules, which may require significant effort, particularly for producers with intricate or complex book inventory accounting practices (e.g., numerous standard cost calculations, significant uncapitalized direct costs or variances, intercompany inventory transactions).
Updated list of automatic method changes issued
The IRS recently issued an updated list of automatic accounting method changes that replaces the existing list and includes numerous modifications. Taxpayers filing automatic accounting method change applications (Form 3115) for 2022 are required to use the updated procedures.
The new list incorporates recent guidance issued to implement legislative amendments (e.g., TCJA, Coronavirus Aid, Relief and Economic Security (CARES) Act), comply with final regulations under the TCJA for items such as the revenue recognition timing provisions and small business taxpayer simplified methods discussed above, and make various depreciation changes (bonus, qualified improvement property, 30-year alternative depreciation system (ADS) life for residential rental property placed in service by an electing real property trade or business, certain late or revoked depreciation elections, ADS depreciation changes for a controlled foreign corporation (CFC) under global intangible low-taxed income (GILTI) rules).
Other significant modifications include deleting obsolete provisions (e.g., temporary transition relief to implement depreciation changes and to revoke or make late elections), prohibiting automatic changes for section 174 research and experimental expenditures and software development costs subject to the capitalization provisions under the TCJA, and providing important clarification in certain situations regarding the automatic change eligibility rule that precludes filing an automatic change if the same item was changed within the five prior tax years. See the separate article above for an update on the TCJA amendments to section 174 research and experimental expenditures.
Because many taxpayers will need to file automatic method changes in 2022 (e.g., to comply with TCJA final regulations or in connection with ASC 842 lease accounting standard adoptions discussed above), taxpayers and their advisors should be aware of the new guidance and ensure that 3115 filings comply with the updated procedures.
For more information on this topic, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.
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