Advance Payments for Goods, Services, and Other Items, 47175-47191 [2019-19197]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 84, Number 174 (Monday, September 9, 2019)]
[Proposed Rules]
[Pages 47175-47191]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-19197]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-104554-18]
RIN 1545-B078


Advance Payments for Goods, Services, and Other Items

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations regarding the 
timing of income inclusion under section 451 of the Internal Revenue 
Code (Code) of advance payments for goods, services, and certain other 
items. The proposed regulations reflect changes made by the Tax Cuts 
and Jobs Act. These proposed regulations affect taxpayers that use an 
accrual method of accounting and receive advance payments.

DATES: Written or electronic comments or a request for a public hearing 
must be received by November 8, 2019.

ADDRESSES: Submit electronic submissions via the Federal eRulemaking 
Portal at www.regulations.gov (indicate IRS and REG-104554-18) by 
following the online instructions for submitting comments. Once 
submitted to the Federal eRulemaking Portal, comments cannot be edited 
or withdrawn. The Department of the Treasury (Treasury Department) and 
the IRS will publish for public availability any comment received to 
its public docket, whether submitted electronically or in hard copy. 
Send hard copy submissions to Internal Revenue Service, CC:PA:LPD:PR 
(REG-104554-18), Room 5205, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to Courier's Desk, 
Internal Revenue Service,

[[Page 47176]]

CC:PA:LPD:PR (REG-104554-18), 1111 Constitution Avenue NW, Washington, 
DC 20224.

FOR FURTHER INFORMATION CONTACT: Concerning this proposed regulation, 
Peter E. Ford, (202) 317-7003; concerning submission of comments or a 
request for a public hearing, Regina L. Johnson, (202) 317-6901 (not 
toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Background

    This document contains proposed amendments to 26 CFR part 1 under 
section 451(c). On December 22, 2017, section 451(c) was amended by 
section 13221 of the Tax Cuts and Jobs Act, Public Law 115-97 (131 
Stat. 2054) (the Act), to provide that a taxpayer using an accrual 
method of accounting (accrual method taxpayer) with an applicable 
financial statement (AFS) may use the deferral method of accounting 
provided in section 451(c) for advance payments. These proposed 
regulations also provide a deferral method of accounting for taxpayers 
that do not have an AFS. Unless otherwise indicated, all references to 
section 451(c) in this preamble are to section 451(c), as amended by 
the Act.
    In general, section 451 provides that the amount of any item of 
gross income is included in gross income for the taxable year in which 
it is received by the taxpayer, unless, under the method of accounting 
used in computing taxable income, the amount is to be properly 
accounted for as of a different period. Under Sec.  1.451-1, accrual 
method taxpayers generally include items of income in gross income in 
the taxable year when all the events occur that fix the right to 
receive the income and the amount of the income can be determined with 
reasonable accuracy (the all events test). All the events that fix the 
right to receive income occur when (1) the required performance takes 
place, (2) payment is due, or (3) payment is made, whichever happens 
first. See Revenue Ruling 2003-10 (2003-1 CB 288); Revenue Ruling 84-31 
(1984-1 CB 127); Revenue Ruling 80-308 (1980-2 CB 162). Section 451(c) 
requires an accrual method taxpayer who receives an advance payment to 
include the amount thereof in income in the taxable year of receipt. 
Section 451(c) also generally codifies the current deferral method of 
accounting for certain advance payments for goods, services, and other 
specified items provided by the IRS under Revenue Procedure 2004-34 
(2004-22 IRB 991) by allowing accrual method taxpayers to elect to 
defer the inclusion of income associated with certain advance payments 
to the taxable year following the taxable year of receipt if such 
income also is deferred for AFS purposes.
    On April 12, 2018, the Treasury Department and the IRS issued 
Notice 2018-35 (2018-18 IRB 520) requesting, in part, comments on 
future guidance under section 451(c). The record of public comments 
received in response to Notice 2018-35 may be requested by sending an 
email to [email protected]. This document provides 
guidance on the application of section 451(c), taking into account 
comments that were received regarding section 451(c). The application 
of section 451(c) is addressed in separate guidance published in the 
same issue of the Federal Register as these proposed regulations.

Explanation of Provisions

    These proposed regulations describe and clarify the statutory 
requirements of section 451(c) by providing new Sec.  1.451-8.

1. Deferral Methods Under Sec.  1.451-8

A. AFS Deferral Method
    Consistent with section 451(c)(1)(A), these proposed regulations 
provide that an accrual method taxpayer with an AFS includes an advance 
payment in gross income in the taxable year of receipt unless the 
taxpayer uses the deferral method in section 451(c)(1)(B) and proposed 
Sec.  1.451-8(c) (AFS deferral method). A taxpayer using the AFS 
deferral method must have an AFS, as described in section 
451(b)(1)(A)(i) or (ii). These proposed regulations define the term AFS 
by reference to the definition of that term in proposed Sec.  1.451-
3(c)(1) (REG-104870-18). Under the AFS deferral method, a taxpayer with 
an AFS that receives an advance payment must include: (i) The advance 
payment in income in the taxable year of receipt, to the extent that it 
is included in revenue in its AFS, and (ii) the remaining amount of the 
advance payment in income in the next taxable year. The AFS deferral 
method provided in these proposed regulations closely follows the 
deferral method of Revenue Procedure 2004-34, as modified by Revenue 
Procedure 2011-14 (2011-4 IRB 330), and as modified and clarified by 
Revenue Procedure 2011-18 (2011-5 IRB 443), and Revenue Procedure 2013-
29 (2013-33 IRB 141) (Revenue Procedure deferral method). Because new 
section 451(c)(1)(B) was intended to generally codify the Revenue 
Procedure deferral method, the Treasury Department and the IRS believe 
that rules similar to the Revenue Procedure deferral method are 
necessary and appropriate for the proper application of section 451(c). 
See H.R. Rep. No. 115-466, at 429 (2017) (Conf. Rep.).

B. Non-AFS Deferral Method

    Section 451(c)(4)(A) generally defines an advance payment as any 
payment the full inclusion of which in gross income of the taxpayer for 
the year of receipt is a permissible method of accounting, any portion 
of which is included in revenue by the taxpayer in an AFS, and which is 
for goods, services, or other items identified by the Secretary. One 
commenter noted that the financial statement requirement within the 
definition of an advance payment means that the rule in Revenue 
Procedure 2004-34 that depended on determining when the advance payment 
was earned was not within the statutory text of section 451(c). The 
Treasury Department and the IRS have concluded that section 451(c) does 
not prohibit a deferral method that is otherwise permissible under 
Revenue Procedure 2004-34. See H.R. Rep. No. 115-466, at 429 (2017) 
(Conf. Rep.). See also, Joint Committee on Taxation, General 
Explanation of Public Law 115-97 (JCS-1-18) at 170-171 (Dec. 20, 2018). 
Revenue Procedure 2004-34 permitted non-AFS taxpayers to use the 
Revenue Procedure deferral method based on when the income is earned 
(earned standard). See section 5.02(3)(b) of Revenue Procedure 2004-34. 
The Revenue Procedure deferral method using the earned standard is a 
permissible method of accounting for non-AFS taxpayers and, therefore, 
these proposed regulations also provide a similar deferral method for 
non-AFS taxpayers in proposed Sec.  1.451-8(d) (non-AFS deferral 
method). Under the non-AFS deferral method, an accrual method taxpayer 
without an AFS that receives an advance payment must include: (i) The 
advance payment in income in the taxable year of receipt, to the extent 
that it is earned, and (ii) the remaining amount of the advance payment 
in income in the next taxable year.

2. Definition of Advance Payment

A. In General
    Section 451(c)(4)(A) generally defines advance payment as any 
payment (i) the full inclusion of which in gross income of the taxpayer 
for the taxable year of receipt is a permissible method of accounting, 
(ii) any portion of which is included in revenue by the taxpayer in an 
AFS (or such other financial statement as the Secretary may specify)

[[Page 47177]]

for a subsequent taxable year, and (iii) which is for goods, services, 
or such other items as may be identified by the Secretary.
    Proposed Sec.  1.451-8(b)(1)(i) clarifies that the definition of 
advance payment under the AFS and non-AFS deferral methods is 
consistent with the definition of advance payment in Revenue Procedure 
2004-34, which section 451(c) was meant to codify. See H.R. Rep. No. 
115-466, at 429 (2017) (Conf. Rep.). The Treasury Department and the 
IRS believe this definition of advance payment: (1) Is consistent with 
section 451(c), (2) minimizes additional tax compliance burden and 
cost, (3) provides clarity to taxpayers, and (4) uses rules which are 
familiar to both taxpayers and the IRS.
    Two commenters suggested that airline miles be explicitly included 
in the list of items for which an advance payment may be received. The 
commenters suggested that airline miles are a unique type of item, 
generally redeemed for air travel and non-travel rewards. The Treasury 
Department and the IRS decline to specifically include airline miles in 
the definition of advance payment because the use of the deferral 
method under these proposed regulations, to the extent airline miles 
are redeemable for goods or services, is already permissible. 
Therefore, these proposed regulations include examples to illustrate 
that, to the extent certain reward points are treated as separate 
performance obligations, they may be eligible for the deferral methods 
provided under these proposed regulations.
    Another commenter suggested that progress payments with respect to 
the sale of an interest in real property should be included in the 
definition of an advance payment. Revenue Procedure 2004-34 was 
intended to provide a simplified and consistent deferral period for the 
sale of goods, services, and other items. However, the definition of 
advance payment in Revenue Procedure 2004-34 does not include 
prepayments for interests in real property. These proposed regulations 
generally provide the same types of items in the definition of advance 
payment to those items provided in Revenue Procedure 2004-34. However, 
the Treasury Department and IRS will consider any comments received in 
determining whether it is appropriate to include additional types of 
items in the definition of advance payment.
B. Items Excluded From the Definition of an Advance Payment
    Section 451(c)(4)(B) provides that certain items, except as 
otherwise provided by the Secretary, are to be excluded from the 
definition of an advance payment. Pursuant to section 451(c)(4)(B), the 
term advance payment does not include rent; insurance premiums governed 
by subchapter L; payments with respect to financial instruments; 
payments with respect to certain warranty or guaranty contracts; 
payments subject to section 871(a), 881, 1441, or 1442; payments in 
property to which section 83 applies; and other payments identified by 
the Secretary.
    Several commenters requested that certain payments for certain 
types of goods be excluded from the definition of an advance payment 
under section 451(c)(4)(B). A commenter requested that certain pre-
delivery payments for the sale of high-value customer-configured 
equipment that will be delivered to customers at reasonably certain 
times not be included in the definition of advance payment. Another 
commenter requested that an exclusion be provided for goods for which 
(i) a taxpayer receives a payment in a taxable year with respect to a 
contract for the sale of goods not properly includible in such 
taxpayer's finished goods inventory, and (ii) on the last day of such 
taxable year the taxpayer does not have on hand (or available to it in 
such year through its normal source of supply) goods of a substantially 
similar kind and in a sufficient quantity to satisfy the contract 
during such contract year. This commenter suggested a narrowing of this 
exclusion could be done according to whether a good is commercially 
significant or of high-value. A commercially significant good has a 
useful life equal to or in excess of 10 years and it is developed, 
marketed, and sold to customers in the aerospace industry. Generally 
these goods require a significant amount of capital to produce and may 
require considerable time from development to delivery. Generally, for 
financial statement purposes, such manufacturers recognize revenue 
related to these goods when the product is completed and delivered to 
the customer and title and risk of loss have transferred to the 
customer.
    Proposed Sec.  1.451-8(b)(1)(ii) provides a list of items excluded 
from the definition of advance payment that is similar to Revenue 
Procedure 2004-34. An additional exclusion is provided for payments 
received in a taxable year earlier than the taxable year immediately 
preceding the taxable year of the contractual delivery date for a 
specified good, as defined in Sec.  1.451-8(b)(9). In response to the 
comments received, the Treasury Department and IRS have determined that 
an exclusion is appropriate for certain goods for which a taxpayer 
requires a customer to make an upfront payment under the contract if 
(i) the contracted delivery month and year of the good occurs at least 
two taxable years after an upfront payment, (ii) the taxpayer does not 
have the good or a substantially similar good on hand at the end of the 
year the upfront payment is received, and (iii) the taxpayer recognizes 
all of the revenue from the sale of the good in its AFS in the year of 
delivery.
    The Treasury Department and the IRS have employed the authority 
granted to the Secretary in section 451(c)(4)(B)(vii) to exclude 
certain payments, in a limited manner, that would otherwise constitute 
advance payments within the meaning of section 451(c)(4)(A), in 
response to the proposals described in comments already received. In 
order to fully consider other such potential exclusions, detailed 
comments that specifically address the following issues are requested:
    1. Does the authority granted to the Secretary by section 
451(c)(4)(B)(vii) to exclude certain payments from the definition of an 
advance payment under section 451(c) also permit an exception for those 
payments from the rules regarding the all events test under section 
451(b)?
    2. What significance, if any, should the time it takes to 
manufacture or create an item of property, or such item of property's 
useful life, be given in determining whether a pre-delivery payment for 
such item of property should be included in income as an advance 
payment?
    3. Does the authority granted to the Secretary by section 
451(c)(4)(B)(vii) authorize rules that change the timing of deductions 
or provide a safe harbor allowing specified categories of taxpayers to 
use methods of accounting for recognizing income other than an accrual 
method under section 451? Is there any particular authority under the 
Code that would allow changing the timing of deductions in this context 
under section 451 or another section of Subchapter E?
    4. Does the authority granted to the Secretary by section 
451(c)(4)(B)(vii) to exclude certain payments from the definition of an 
advance payment also authorize the imposition of conditions unrelated 
to an accrual method of accounting with respect to any such exclusions? 
For example, could the Secretary require that a taxpayer use an 
alternative method of accounting as a condition for excluding a type of 
payment from the definition of advance payment?
    5. Does the authority granted to the Secretary by section 
451(c)(4)(B)(vii) to

[[Page 47178]]

exclude certain payments from the definition of advance payment also 
authorize the imposition of a time limit on such exclusion? For 
example, could an exclusion under section 451(c)(4)(B)(vii) be limited 
to a specified number of years after which all remaining amounts would 
have to be recognized in income? If so, what would be an appropriate 
time limit?
    6. Does the authority granted to the Secretary by section 
451(c)(4)(B)(vii) allow deferral of income in an amount equal to the 
estimated future performance costs while requiring current recognition 
of estimated profits not in excess of the amounts of advance payments? 
If so, does the authority granted to the Secretary by section 
451(c)(4)(B)(vii) permit rules to account for the time value of money 
for any variances in estimated costs or profits?
    7. Would it be inappropriate to reduce the amount a C corporation 
would be permitted to defer for a given taxable year under a potential 
exclusion under section 451(c)(4)(B)(vii) by an amount equal to the 
excess of (i) distributions the C corporation made to its shareholders 
with respect to its stock, over (ii) the C corporation's taxable income 
for that taxable year?.

3. Advance Payment Acceleration Provisions

    Section 451(c)(3) provides that the deferral method does not apply 
to an advance payment received by the taxpayer during a taxable year if 
such taxpayer ceases to exist during (or with the close of) the taxable 
year. In contrast, Revenue Procedure 2004-34 provides more detailed 
acceleration rules.
    The Treasury Department and the IRS have determined that rules 
similar to the acceleration rules provided in Revenue Procedure 2004-34 
are appropriate for the proper application of the AFS and non-AFS 
deferral methods. The continued use of the deferral method for an 
advance payment is not appropriate and should be limited in certain 
situations, such as when the taxpayer ceases to exist, or when their 
obligation regarding the advance payment is satisfied or otherwise 
ends. Accordingly, proposed Sec.  1.451-8(c)(2) and (d)(6) provide 
rules to ensure the acceleration of an advance payment when a taxpayer 
either dies or ceases to exist, or when a taxpayer's obligation 
regarding an advance payment is satisfied or otherwise ends, except in 
certain circumstances. Consistent with Revenue Procedure 2004-34, the 
acceleration rules do not apply to a taxpayer that engages in a 
transaction to which section 381 applies or certain transactions in 
which section 351 applies in the taxable year in which an advance 
payment is received.
    Section 451(c) does not specifically address whether the deferral 
method may be used when an amount is earned in the taxable year, but 
deferred for AFS purposes. The deferral method under section 451(c) is 
an exception to the requirement to include an amount in income when it 
is received but is not an exception to the requirement to include an 
amount in income when it is earned under the all events test. 
Accordingly, consistent with Revenue Procedure 2004-34, these proposed 
regulations permit deferral of advance payments received to the extent, 
in the year of receipt, the amount is not included in revenue in the 
taxpayer's AFS, and is not otherwise earned in the taxable year of 
receipt. The amounts not included in gross income in the year of 
receipt must be included in gross income in the next taxable year.

4. Advance Payments and Financial Statement Adjustments

    Section 451(c) does not address the treatment of financial 
statement adjustments that cause amounts to not be included in income.
    Proposed Sec.  1.451-8(c)(3) and (d)(7) provide that a taxpayer 
that defers inclusion of all or a portion of an advance payment must 
include the remainder of the advance payment in gross income in the 
subsequent year, notwithstanding any write-down or adjustment for 
financial accounting purposes. This provision is consistent with a 
plain reading of section 451(c)(1)(B) and the rule in proposed Sec.  
1.451-3(j), which require that an item of income treated as deferred 
revenue in a taxpayer's AFS in one year and charged, in whole or part, 
to a capital account in a subsequent year, is included in revenue in 
the subsequent year.
    A financial accounting adjustment may occur after certain equity 
acquisitions. For example, after certain equity acquisitions, the 
acquiring entity may write-down or adjust the target's deferred revenue 
in the subsequent year under purchase accounting rules. Some taxpayers 
have asserted that a write-down or adjustment for financial accounting 
purposes results in a permanent exclusion of income for federal income 
tax purposes. Proposed Sec.  1.451-8(c)(3) and (d)(7) provide 
clarification for instances in which a taxpayer defers inclusion of an 
advance payment and is subsequently acquired in certain equity 
acquisitions. The Treasury Department and the IRS believe that 
financial statement write-downs or adjustments to deferred revenue 
should not be taken into account for federal income tax purposes when 
determining the proper amount to be included in income under the 
deferral method. This clarification ensures that a financial statement 
write-down or adjustment to deferred revenue does not result in a 
permanent exclusion of income for federal income tax purposes.

5. Short Taxable Years and the 92-Day Rule

    Section 451(c) does not provide rules relating to the treatment of 
short taxable years. Proposed Sec.  1.451-8(c)(4) and (d)(8) use the 
short taxable year rules of Revenue Procedure 2004-34 for the AFS and 
non-AFS deferral methods because a rule for short taxable years is 
necessary to properly implement the deferral method provided in section 
451(c)(1)(B).

6. Performance Obligations for AFS and Non-AFS Taxpayers

    Sections 451(b) and (c)(4)(D) require that taxpayers with contracts 
that contain multiple performance obligations must allocate transaction 
price, and therefore defer (or accelerate) income inclusion, consistent 
with the transaction price allocation used for AFS purposes. Proposed 
Sec.  1.451-3(c)(3) (REG-104870-18) defines the term performance 
obligation to mean a promise in a contract with a customer to transfer 
to the customer either a good or service (or a bundle of goods or 
services) that is distinct, or a series of distinct goods or services 
that are substantially the same and that have the same pattern of 
transfer to the customer. Proposed Sec.  1.451-8(b)(4) defines the term 
performance obligation by cross-reference to proposed Sec.  1.451-
3(c)(3) for purposes of the allocation rule provided in section 
451(c)(4)(D).
    Proposed Sec.  1.451-8(b)(7) defines the term transaction price by 
cross-reference to proposed Sec.  1.451-3(c)(6). Proposed Sec.  1.451-
3(c)(6) defines the term transaction price to mean the gross amount of 
consideration to which a taxpayer expects to be entitled for AFS 
purposes in exchange for transferring promised goods, services, or 
other property, including amounts referred to in proposed Sec.  1.451-
3(i). However, the term transaction price does not include certain 
items, such as amounts collected on behalf of third parties that are 
not otherwise income to the taxpayer, increases for consideration to 
which a taxpayer's entitlement is contingent on the occurrence or 
nonoccurrence of a future event, and reductions for amounts subject to 
section 461.

[[Page 47179]]

Proposed Sec.  1.451-3(c)(6)(ii) presumes that an amount included in 
the transaction price for AFS purposes is not contingent unless, upon 
examination of all of the facts and circumstances existing at the end 
of the taxable year, it can be established to the satisfaction of the 
Commissioner that the amount is contingent on the occurrence or 
nonoccurrence of a future event. Proposed Sec.  1.451-3(c)(6)(ii) also 
provides that certain amounts included in transaction price for AFS 
purposes, however, will not be treated as contingent on the occurrence 
or nonoccurrence of a future event.
    Comments are requested on allocation of the transaction price (i) 
to performance obligations that are not contractually based, (ii) for 
arrangements that include both income subject to section 451 and long-
term contracts subject to section 460, and (iii) when the income 
realization event for federal income tax purposes differs from the 
income realization event for AFS purposes.
    For non-AFS taxpayers, there is a continued need to provide an 
allocation method consistent with the objective criteria standard in 
Revenue Procedure 2004-34 because such taxpayers do not have an AFS and 
cannot use the transaction price allocation used for AFS purposes, as 
provided in section 451(b)(4). Therefore, proposed Sec.  1.451-8(d)(5) 
permits a non-AFS taxpayer to allocate the revenue of multiple 
obligations in a single contract based on how such obligations are 
separately priced or on any method that may be provided in guidance 
published in the IRB.

7. Accelerated Cost Offset

    Several commenters discussed the need for a regulatory exception to 
the existing statutory and regulatory timing rules that apply to 
liabilities (for example, deductions and offsets for rebates, refunds, 
and cost of goods sold (COGS) prior to when the liability for such 
items is incurred under section 461) when advance payments are required 
to be included in income under section 451(c) prior to the completion 
of the sale of goods or provision of services (accelerated cost 
offset). The commenters argued that not providing an accelerated cost 
offset in the regulations would cause a mismatch of income and expenses 
and result in the taxation of gross receipts.
    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. Section 13221 
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.
    The Conference Report also indicates that section 13221 of the Act 
is ``intended to override any deferral method provided by Treasury 
Regulation Sec.  1.451-5 for advance payments received for goods.'' 
H.R. Rep. No. 115-466, at 429 n 880 (2017) (Conf. Rep.). Section 1.451-
5 includes a deferral method that allows an accelerated cost offset 
when certain amounts are included in income prior to the sale of goods. 
See Sec.  1.451-5(c). Section 451(c) does not provide a cost offset, 
and the Conference Report does not provide any indication that Congress 
intended to preserve the cost offset rules permitted under Sec.  1.451-
5. See also, Joint Committee on Taxation, General Explanation of Public 
Law 115-97 (JCS-1-18) at 156-157 and 164-165 (December 20, 2018). Final 
regulations were published in the Federal Register (84 FR 33691) on 
July 15, 2019, that withdraw Sec.  1.451-5, consistent with the Act.
    The Treasury Department and the IRS believe that Congress 
intentionally simplified the rules for advance payments by limiting the 
deferral of advance payments for taxpayers with an AFS to a prescribed 
statutory method that: (1) Does not include an accelerated cost offset, 
(2) is consistent with Revenue Procedure 2004-34, and (3) overrides 
Sec.  1.451-5. See H.R. Rep. No. 115-466, at 429 (2017) (Conf. Rep.). 
Accordingly, the Treasury Department and the IRS decline to provide an 
accelerated cost offset in these proposed regulations. The Treasury 
Department and the IRS do not agree with the contention that changes to 
the timing of income under section 451 without an accelerated cost 
offset cause a taxation of gross receipts. Section 451(c) and these 
proposed regulations merely change the timing of income recognition, do 
not preclude any associated reduction or deduction for properly 
incurred liabilities, and are consistent with existing statutory and 
regulatory timing requirements that apply to liabilities.
    Several commenters proposed a cost offset mechanism for 
manufacturers of certain property and taxpayers with inventoriable 
goods in order to ensure matching of income and the associated 
expenses. Commenters made the following suggestions to alleviate the 
potential mismatch of the acceleration of income recognition with 
different timing rules for associated costs: (i) Permitting a taxpayer 
that uses a percentage of completion method for AFS purposes (book 
PCM), but not subject to section 460, to elect to use their AFS method 
for tax purposes; (ii) permitting a taxpayer that uses book PCM, but 
not subject to section 460, to elect to apply section 460 for federal 
income tax purposes; (iii) expanding the recurring item exception in 
section 461(h)(3) to permit a taxpayer to offset the portion of the 
advance payment included in income for the taxable year by the cost of 
goods sold related to this payment if the goods are completed and 
shipped to the customer within 8\1/2\ months of the end of the taxable 
year that the advance payment is included in income; or (iv) providing 
a cost offset for taxpayers that can demonstrate at the time of the 
purchase agreement that a net operating loss will remain unused for the 
5-year period after the taxable year the advance payment is received.
    The Treasury Department and the IRS continue to consider whether 
any such exceptions are an appropriate use of the Secretary's authority 
under section 461(h) or 460. To facilitate further consideration of 
such potential exceptions, detailed comments that specifically address 
the following issues are requested:
    1. Under what authority would it be appropriate for the Secretary 
to permit a taxpayer to use book PCM as its tax method? When inventory 
is involved, what limitations could be instituted to ensure that book 
PCM could not be used to recover costs related to inventoriable goods 
prior to the time when such costs could be recovered under sections 471 
and 263A? Under what specific authority would it be appropriate to 
permit a book PCM method to be used to recover costs related to 
inventoriable goods?
    2. Would elective use of book PCM for tax purposes provide an 
appropriate cost offset? Would such a method be characterized as one 
that reports contract revenue according to a taxpayer's book method, 
while accounting for costs, including nondeductible costs, as 
deductions under the Code? If not, how would such a method account for 
costs for federal income tax purposes?
    3. Rather than make book PCM elective, would it be appropriate for 
the definition of ``unique item'' for purposes of section 460 to be 
expanded?

[[Page 47180]]

    4. Section 460 requires use of the look-back method to compensate 
for improper acceleration or deferral of income under PCM. It also 
requires that all contract income be reported no later than the year 
following contract completion. Would elective use of a PCM under 
section 460 without these provisions invite abuse? If so, how could 
such abuse be prevented?

8. Section 451(c) Is a Method of Accounting

    Section 451(c)(2) provides that a taxpayer may elect deferral 
treatment of an advance payment governed by section 451(c), and such 
election shall be made at such time and manner and with respect to such 
categories of advance payments as specified by the Secretary. Section 
451(c)(2)(B) provides that the deferral method is treated as a method 
of accounting and the election is effective for taxable years with 
respect to which it is first made and for all subsequent taxable years, 
unless the taxpayer secures the consent of the Secretary to change to a 
different method of accounting.
    The use of the AFS or non-AFS deferral method is the adoption of, 
or a change in, a method of accounting under section 446. A taxpayer 
may change its method of accounting to use the deferral methods only 
with the consent of the Commissioner as required under section 446(e) 
and the corresponding regulations. The Treasury Department and the IRS 
intend to issue future guidance that will provide the procedures by 
which a taxpayer may change its method of accounting to use one of the 
deferral methods described in these proposed regulations. However, 
until further guidance for the treatment of advance payments is 
applicable, a taxpayer may continue to rely on Revenue Procedure 2004-
34, as described in Notice 2018-35.

Proposed Applicability Date

    Section 7805(b)(1)(A) and (B) of the Code generally provides that 
no temporary, proposed, or final regulation relating to the internal 
revenue laws may apply to any taxable period ending before the earliest 
of (A) the date on which such regulation is filed with the Federal 
Register, or (B) in the case of a final regulation, the date on which a 
proposed or temporary regulation to which the final regulation relates 
was filed with the Federal Register.
    These regulations are proposed to apply to taxable years beginning 
on or after the date the final regulations are published in the Federal 
Register. Until the date the Treasury decision adopting these 
regulations as final regulations is published in the Federal Register, 
a taxpayer may rely on these proposed regulations for taxable years 
beginning after December 31, 2017, provided that the taxpayer: (1) 
Applies all the applicable rules contained in these proposed 
regulations, and (2) consistently applies these proposed regulations to 
all advance payments. See section 7805(b)(7).

Statement of Availability of IRS Documents

    The IRS notice, revenue ruling, and revenue procedures cited in 
this preamble are published in the Internal Revenue Bulletin (or 
Cumulative Bulletin) and are available from the Superintendent of 
Documents, U.S. Government Publishing Office, Washington, DC 20402, or 
by visiting the IRS website at https://www.irs.gov.

Special Analysis

l. Regulatory Planning and Review

    Executive Orders 13771, 13563, and 12866 direct agencies to assess 
costs and benefits of available regulatory alternatives and, if 
regulation is necessary, to select regulatory approaches that maximize 
net benefits, including potential economic, environmental, public 
health and safety effects, distributive impacts, and equity. Executive 
Order 13563 emphasizes the importance of quantifying both costs and 
benefits, reducing costs, harmonizing rules, and promoting flexibility. 
The Executive Order 13771 designation for any final rule resulting from 
these proposed regulations will be informed by comments received. The 
preliminary Executive Order 13771 designation for this proposed rule is 
regulatory.
    The proposed regulations have been designated by the Office of 
Information and Regulatory Affairs (OIRA) as subject to review under 
Executive Order 12866 pursuant to the Memorandum of Agreement (MOA, 
April 11, 2018) between the Treasury Department and the Office of 
Management and Budget regarding review of tax regulations. The Office 
of Information and Regulatory Affairs has designated these proposed 
regulations as significant under section 1(b) of the MOA. Accordingly, 
OMB has reviewed these proposed regulations.
1. Background
    Under section 451(a) of the Internal Revenue Code, income is 
``recognized'' (that is, included in gross income for tax purposes) in 
the year in which it is received by the taxpayer, unless it is properly 
accounted for in a different period under the taxpayer's method of 
accounting. Because of this latter condition, the tax treatment of 
certain forms of income depends on the method of accounting a taxpayer 
is using. For taxpayers using the accrual method of accounting, income 
is generally recognized in the year in which all events have occurred 
that fix the right to receive that income and when the amount of income 
can be determined with reasonable accuracy (the ``all events test''). 
Receipt of payment by the business satisfies the all events test. 
However, recognition of certain payments for goods or services not yet 
provided may be deferred to the year following receipt of payment, to 
the extent that recognition is also deferred for on the taxpayer's 
Applicable Financial Statement (AFS). Such payments are referred to as 
``advance payments.''
    Prior to the December 22, 2017, enactment of, ``An Act to provide 
for reconciliation pursuant to titles II and V of the concurrent 
resolution on the budget for fiscal year 2018,'' Public Law 115-97, 131 
Stat. 2054 (2017), commonly referred to as the Tax Cuts and Jobs Act 
(TCJA), taxpayers were generally permitted to defer the tax on these 
advance payments; in other words, advance payments could be recognized 
in a later taxable year. Section 451(c), added by the TCJA, allows 
accrual-method taxpayers to elect to recognize as income only a portion 
of such an advance payment in the taxable year in which it is received, 
and then recognize the remainder in the following taxable year. Section 
451(c) essentially codifies the deferral method of accounting for 
advance payments that was permitted in Revenue Procedure 2004-34. 
(Joint Committee on Taxation, General Explanation of Public Law 115-97, 
(Washington, U.S. Government Publishing Office, December 2018), at 
167.) New section 451(c), the subject of the proposed regulations, 
deals with issues around how these advance payments are defined and the 
timing in which they need to be recognized in the business's income 
tax.
2. Need for the Proposed Regulations
    These proposed regulations provide certainty and clarity to 
taxpayers affected by statutory changes introduced in section 451(c). 
The Treasury Department and IRS have received questions and comments 
regarding the meaning of various provisions in section 451(c) and 
issues not explicitly addressed in the statute. The Treasury Department 
and the IRS have determined that such comments warrant the issuance of 
further guidance.

[[Page 47181]]

3. Overview of the Proposed Regulations
    The proposed regulations provide guidance regarding the new section 
451(c). The subsequent economic analysis covers proposed regulations 
to: (1) Describe and clarify the deferral rules for advance payments 
for taxpayers without an Applicable Financial Statement (AFS); (2) 
provide acceleration rules for taxpayers that cease to exist; (3) 
clarify the treatment of financial statement adjustments for taxpayers 
that have deferred advance payments; (4) provide rules relating to the 
treatment of short taxable years for taxpayers deferring advance 
payments; and (5) define and clarify the treatment of performance 
obligations.
4. Economic Analysis
A. Baseline
    The Treasury Department and the IRS have assessed the benefits and 
costs of the proposed regulations relative to a no-action baseline 
reflecting anticipated Federal income tax-related behavior in the 
absence of these proposed regulations. The following largely 
qualitative analysis describes the anticipated economic effects of the 
proposed regulation relative to this baseline.
B. Summary of Economic Effects
    The proposed regulations provide certainty and consistency in the 
application of section 451(c) by providing definitions and 
clarifications regarding the statute's terms and rules. An economically 
efficient tax system generally aims to treat income and expense derived 
from similar economic decisions consistently across taxpayers and 
across activities in order to reduce incentives for businesses to make 
choices based on tax rather than market incentives. In the absence of 
the guidance provided in these proposed regulations, the chances that 
different taxpayers might interpret the statute differently is 
exacerbated. For example, two similarly situated taxpayers might 
interpret the statutory provisions pertaining to the definition of 
advanced payments differently, with one taxpayer pursuing a project 
that another comparable taxpayer might decline because of a different 
interpretation of how the income may be treated under section 451(c). 
If this second taxpayer's activity is more profitable, an economic loss 
arises. An economic loss might also arise if all taxpayers have 
identical interpretations under the baseline of the tax treatment of 
particular income streams but are more conservative (or less 
conservative) regarding the interpretation than Congress intended for 
these income streams. In this case, guidance provides value by bringing 
economic decisions closer in line with the intents and purposes of the 
statute.
    Because the proposed regulations clarify the tax treatment of 
certain income streams, there is the possibility that investments or 
other business decisions may change as a result of these regulations. 
The Treasury Department and the IRS have not made projections of the 
change in investment patterns that might arise due to the discretionary 
aspects of the proposed regulations. The Treasury Department and the 
IRS have also not made projections of any change in compliance costs 
arising from the proposed regulations, relative to the baseline. The 
Treasury Department project that changes in investment patterns and 
compliance costs relative to the baseline may generally be small 
because the proposed regulations affect a relatively small number of 
entities and because they largely mirror the rules of Rev. Proc. 2004-
34.
    The economic consequences of these proposed regulations depend in 
part on their interaction with other sections of the Code, including 
section 460, which governs when costs can be recovered under the 
percentage of completion method, and section 461(h), which governs when 
costs incurred by a taxpayer satisfy the all events test, including a 
requirement for economic performance, and are thereby allowed as 
deductions for Federal income tax purposes. The economic analysis of 
the final regulations under section 451(c) may address the economic 
effects of regulatory guidance, if any, under sections 460 and 461(h) 
or other sections of the Code that interact with section 451(c), that 
is issued between the proposed and final regulations.
    The Treasury Department and the IRS project that approximately 
15,000 business entities may be affected by these regulations.
    The Treasury Department and the IRS solicit comments on this 
conclusion and particularly solicit comments that provide data, 
evidence, or models that would enhance the rigor by which the non-
revenue economic effects might be estimated for the final regulations.
C. Economic Analysis of Specific Provisions
    The Treasury Department and the IRS solicit comments on the 
economics of each of the items discussed subsequently and of any other 
items of the proposed regulations not discussed in this section. The 
Treasury Department and the IRS particularly solicit comments that 
provide data, other evidence, or models that could enhance the rigor of 
the process by which provisions might be developed for the final 
regulations.
i. Deferral Methods Under Section 451(c)
    The statute prescribes a particular deferral method for accrual-
method taxpayers that have an AFS (AFS taxpayers) but does not 
explicitly describe a deferral method to be used by taxpayers that do 
not have an AFS (non-AFS taxpayers). To remedy this gap, the proposed 
regulations describe and clarify that a method similar to the deferral 
method available to non-AFS taxpayers under Revenue Procedure 2004-34 
will be available to non-AFS taxpayers.
    The Treasury Department and the IRS considered and rejected a 
narrow interpretation of section 451(c) that would have precluded non-
AFS taxpayers from using a deferral method similar to that provided in 
Revenue Procedure 2004-34. Section 451(c) does not explicitly prohibit 
the use of such a method by non-AFS taxpayers, and the Treasury 
Department and IRS continue to have authority under the Code to 
prescribe a deferral method for such taxpayers. Precluding non-AFS 
taxpayers from using a deferral method similar to that of AFS taxpayers 
would treat AFS and non-AFS taxpayers quite differently regarding 
business decisions they might make that are otherwise similar. Such 
treatment would result in a less economically efficient tax system, 
which generally treats similar economic decisions similarly.
    The Treasury Department and the IRS solicit comments on this 
decision on the treatment of deferral by non-AFS taxpayers and 
particularly solicit comments that provide data, other evidence, or 
models that could enhance the rigor by which the final regulations over 
non-AFS deferral might be developed.
ii. Advance Payment Acceleration Provisions
    If a taxpayer ceases to exist by the close of a taxable year in 
which an advance payment has been received and deferred, then issues 
may arise as to when or whether the remaining amount of the payment 
will be recognized as taxable income because there may not be a 
succeeding taxable year in which such income can be recognized.
    Under the statute, if the taxpayer dies or ceases to exist by the 
close of the taxable year in which the advance payment was received, 
any remaining untaxed amounts of advance payments must be included in 
income in the year

[[Page 47182]]

they were received. The proposed regulations extend this payment 
``acceleration'' rule to situations in which a performance obligation 
is satisfied or otherwise ends in the taxable year of receipt or in a 
succeeding short taxable year, a treatment that is consistent with a 
similar rule in Revenue Procedure 2004-34.
    The Treasury Department and the IRS considered not modifying or 
expanding the acceleration rule contained in section 451(c), but 
rejected this alternative because of the remaining amount may never be 
picked up into income risking a permanent exclusion of the amount from 
taxable income. The possibility of a permanent exclusion of income 
provides incentives for taxpayers to structure payments in ways that 
avoid tax liability, thus reducing Federal tax revenue without 
providing an accompanying general economic benefit. The proposed 
regulations treat the expanded set of accelerated transactions 
consistently with similar types of transactions based on the timing and 
structure of the payments involved.
    The Treasury Department and the IRS solicit comments on the 
proposed regulation's treatment of acceleration and particularly 
solicit comments that provide data, other evidence, or models that 
would enhance the rigor by which the treatment of acceleration might be 
developed for the final regulations.
iii. Advance Payments and Financial Statement Adjustments
    Under the statute, if a taxpayer counts an advance payment as an 
item of deferred revenue, under certain conditions (for example, 
certain acquisitions of one corporation by another), the taxpayer may 
be required by its system of accounting to adjust that item on the 
balance sheet in a subsequent year. The item would then not be included 
in current earnings or AFS revenues. In this case, taxpayers might 
argue that they can exclude the amount deferred from taxable income 
because it is never ``earned'' nor included in revenue under their AFS. 
If this argument is upheld, taxpayers could convert an income 
``deferral'' amount into an income ``exemption'' amount. To address 
this issue and avoid this possibility, the proposed regulations specify 
that such financial statement adjustments are to be treated as 
``revenue.''
    The Treasury Department and the IRS considered not providing 
clarity on the treatment of financial statement write-downs, but 
rejected that approach, because it would have risked an inappropriate 
permanent exclusion of income. The possibility of a permanent exclusion 
of income provides incentives for taxpayers to structure payments in 
ways that avoid tax liability, thus reducing Federal tax revenue 
without providing an accompanying general economic benefit.
    The Treasury Department and the IRS solicit comments on these 
proposed regulations and particularly solicits comments that provide 
data, other evidence, and models that would enhance the rigor by which 
the final regulations dealing with financial statement adjustments 
might be developed.
iv. Short Taxable Years and the 92-Day Rule
    Section 451(c) does not provide a rule relating to the treatment of 
short taxable years. In the absence of such a rule, it will be unclear 
to taxpayers how they should implement the deferral method provided in 
section 451(c) in the case of a short taxable year. To address this 
issue, the proposed regulations provide rules relating to the treatment 
of short taxable years for advance payments that are generally 
consistent with Revenue Procedure 2004-34. The Treasury Department and 
the IRS considered and rejected not providing short taxable year rules 
because such a decision would have created significant confusion among 
taxpayers, increased administrative costs for the IRS, and increased 
compliance costs for taxpayers.
    The Treasury Department and the IRS solicit comments on these 
proposed regulations and particularly solicit comments that would 
provide data, other evidence, and models that would enhance the rigor 
by the treatment of short taxable years might be developed for the 
final regulations.
v. Performance Obligations for Non-AFS Taxpayers
    A performance obligation is a contractual arrangement with a 
customer to provide a good, service or a series of goods or services 
that are basically the same and have a routine pattern of transfer. The 
statute requires that taxpayers with contracts that include multiple 
performance obligations to allocate the transaction price to each 
performance obligation in the same manner that revenue is allocated in 
the taxpayer's AFS. The statute does not, however, specify the 
allocation rules to be used by non-AFS taxpayers.
    To address this issue, the proposed regulations provide allocation 
rules for non-AFS taxpayers consistent with a similar rule in Revenue 
Procedure 2004-34. That rule specifies that the transaction price be 
allocated in a manner that is based on payments the taxpayer regularly 
receives for an item or items it regularly sells or provides 
separately. The Treasury Department and the IRS considered not 
providing allocation rules for non-AFS taxpayers but rejected such an 
approach because it would have treated similarly situated taxpayers 
quite differently, and would have led to increased administrative costs 
for the IRS and increased compliance costs for taxpayers. While the 
allocation rules for AFS taxpayers and non-AFS taxpayers under the 
proposed regulations do differ, the chosen solution provides a rule 
upon which non-AFS taxpayers can rely, while minimizing the differences 
between AFS and non-AFS taxpayers in this regard within the constraints 
imposed by the statute.
    The Treasury Department and the IRS solicit comments on these 
proposed regulations and particularly solicit comments that would 
provide data, other evidence, and models that would enhance the rigor 
by which final regulations affecting the treatment of performance 
obligations taxable for non-AFS taxpayers might be developed for the 
final regulations.

II. Paperwork Reduction Act

    These proposed regulations do not impose any additional information 
collection requirements in the form of reporting, recordkeeping 
requirements or third-party disclosure requirements related to tax 
compliance. However, because the deferral methods described in proposed 
Sec. Sec.  1.451-8(c) and (d) are methods of accounting, a portion of 
affected taxpayers would be required to request the consent of the 
Commissioner for a change in their method of accounting under section 
446(e) and the accompanying regulations. The IRS expects that these 
taxpayers will request this consent by filing Form 3115, Application 
for Change in Accounting Method (Parts I, II, IV and Schedule B). 
Filing of Form 3115 and statements attached thereto (for taxpayers who 
are required to do so or who elect to do so as a result of the proposed 
regulations) is the sole collection of information requirement imposed 
by the statute and the proposed regulations. See subsequent paragraphs 
for a description of taxpayers who would be required to change the 
method of accounting under the statute and the proposed regulations.
    For purposes of the Paperwork Reduction Act, the reporting burden 
associated with the collection of

[[Page 47183]]

information with respect to section 451(c) will be reflected in the 
Paperwork Reduction Act submissions for IRS Form 3115 (OMB control 
numbers 1545-0074 for individual filers, 1545-0123 for business filers, 
and 1545-2070 for all other types of filers). The IRS may provide 
streamlined method change procedures which could permit the filing of a 
statement in lieu of filing a Form 3115, or, in certain cases, no 
notification (see, for example, the revenue procedure accompanying 
these proposed regulations).
    The Treasury Department and the IRS anticipate that these proposed 
regulations would require an accrual method taxpayer that receives an 
advance payment and chooses to make an election to use the deferral 
method described in proposed Sec.  1.451-8(c) or (d) to file a Form 
3115 to change the method of accounting to comply with these proposed 
regulations. See proposed Sec.  1.451-8(e). The Treasury Department and 
IRS estimate that 20,000-40,000 taxpayers will be required to file a 
Form 3115 in order to change to the deferral method described in 
proposed Sec.  1.451-8(c).\a\ The Treasury Department and the IRS 
anticipate a certain number of accrual method taxpayers without an AFS 
that receive advance payments may choose to use the non-AFS deferral 
method described in proposed Sec.  1.451-8(d). The Treasury Department 
and IRS plan to provide streamlined procedures for taxpayers to change 
to the methods of accounting described in proposed Sec.  1.451-8(c) and 
(d). See the revenue procedure accompanying these proposed regulations.
---------------------------------------------------------------------------

    \a\ This estimate is based on data from the Compliance Data 
Warehouse of accrual-method taxpayers (includes C corporations, S 
corporations, partnerships, and sole proprietorships) with an AFS 
that E-filed schedule M-3 during 2012-2016. Schedule M-3 is used to 
report a net income (loss) reconciliation but not all taxpayers who 
should file an M-3 do so. The rules for filing the M-3 differ based 
on taxpayer status. For example, for C corporations, in general only 
those with assets of $10 million or more file an M-3 schedule with 
their Form 1120.
---------------------------------------------------------------------------

    For a taxpayer with an AFS that uses the deferral method in 
proposed Sec.  1.451-8(c), a change in the taxpayer's revenue 
recognition policies for financial accounting purposes requires the 
taxpayer to seek the consent of the Commissioner under section 446(e) 
to use the method for federal income tax purposes. See proposed Sec.  
1.451-8(e). It is anticipated that the reporting burden associated with 
the collection of information for a statement in lieu of the Form 3115 
would be reflected in the Paperwork Reduction Act Submission associated 
with Revenue Procedure 2018-31, 2018-22 IRB 637 (or successor) (OMB 
control number 1545-1551). See the revenue procedure accompanying these 
proposed regulations.
    In 2018, the IRS released and invited comment on a draft of Form 
3115 in order to give members of the public the opportunity to benefit 
from certain specific provisions made to the Code. The IRS received no 
comments on the forms during the comment period. Consequently, the IRS 
made the forms available in January 2019 for use by the public. The IRS 
notes that Form 3115 applies to changes of accounting methods generally 
and is therefore broader than section 451(c).
    The current status of the Paperwork Reduction Act submissions 
related to the information collections in the proposed regulations is 
provided in the accompanying table. The overall burden estimates 
provided for the OMB control numbers below are aggregate amounts that 
relate to the entire package of forms associated with the applicable 
OMB control number and will in the future include, but not isolate, the 
estimated burden of the tax forms that will be created or revised as a 
result of the information collections in the proposed regulations. 
These numbers are therefore unrelated to the future calculations needed 
to assess the burden imposed by the proposed regulations. These burdens 
have been reported for other regulations that rely on the same OMB 
control numbers to conduct information collections under the Paperwork 
Reduction Act, and the Treasury Department and the IRS urge readers to 
recognize that these numbers are duplicates and to guard against 
overcounting the burden that the regulations that cite these OMB 
control numbers impose. No burden estimates specific to the forms 
affected by the proposed regulations are currently available. The 
Treasury Department and the IRS have not estimated the burden, 
including that of any new information collections, related to the 
requirements under the proposed regulations. For the OMB control 
numbers discussed above, the Treasury Department and the IRS estimate 
PRA burdens on a taxpayer-type basis rather than a provision-specific 
basis. Those estimates capture both changes made by the Act and those 
that arise out of discretionary authority exercised in the proposed 
regulations (when final) and other regulations that affect the 
compliance burden for that form.
    The Treasury Department and the IRS request comments on all aspects 
of information collection burdens related to the proposed regulations, 
including estimates for how much time it would take to comply with the 
paperwork burdens described above for each relevant form and ways for 
the IRS to minimize the paperwork burden. In addition, when available, 
drafts of IRS forms are posted for comment at https://apps.irs.gov/app/picklist/list/draftTaxForms.htm. IRS forms are available at https://www.irs.gov/forms-instructions. Forms will not be finalized until after 
they have been approved by OMB under the PRA.

[[Page 47184]]

[GRAPHIC] [TIFF OMITTED] TP09SE19.001

III. Regulatory Flexibility Act

    It is hereby certified that these proposed regulations will not 
have a significant economic impact on a substantial number of small 
entities within the meaning of section 601(6) of the Regulatory 
Flexibility Act (5 U.S.C. chapter 6).
    The Treasury Department and the IRS have estimated the number of 
business entities that may be affected by the statute and these 
proposed regulations. The statute and proposed regulations affect only 
those business entities that use an accrual method of accounting.
    Regarding the accrual method of accounting, the Treasury Department 
and the IRS estimate that approximately 9 percent of business entities 
with gross receipts of $25 million or less used an accrual method of 
accounting in taxable year 2016. Furthermore, section 13102 of TCJA 
modified section 448 to expand the number of taxpayers eligible to use 
the cash method. In general, C corporations and partnerships with a C 
corporation partner are now permitted to use the cash receipts and 
disbursements method of accounting if average annual gross receipts are 
$25 million or less (up from $5 million or less in 2016). The Treasury 
Department and the IRS project that in future years, the number of 
entities with gross receipts not greater than $25 million that will be 
using the accrual method will be less than 9 percent of all entities 
with gross receipts not greater than $25 million.

[[Page 47185]]



----------------------------------------------------------------------------------------------------------------
                                                                       Number of returns (taxable year 2016)
                                                                                    (thousands)
                                                                 -----------------------------------------------
                             Entity                                                    Method of accounting
                                                                    All returns  -------------------------------
                                                                                      Accrual          Cash
----------------------------------------------------------------------------------------------------------------
C Corporations:
    Gross Receipts >$25 mil.....................................              30              28               2
    Gross Receipts [lE]$25 mil..................................           1,567             700             867
                                                                 -----------------------------------------------
        Total...................................................           1,597             728             869
S Corporations:
    Gross Receipts >$25 mil.....................................              41              34               7
    Gross Receipts [lE]$25 mil..................................           4,551           1,140           3,411
                                                                 -----------------------------------------------
        Total...................................................           4,592           1,174           3,418
Partnerships:
    Gross Receipts >$25 mil.....................................              20              17               3
    Gross Receipts [lE]$25 mil..................................           3,743             860           2,883
                                                                 -----------------------------------------------
        Total...................................................           3,763             877           2,886
Sole Proprietors and LLCs:
    Gross Receipts >$25 mil.....................................               1               1               0
    Gross Receipts [lE]$25 mil..................................          25,524             358          25,166
                                                                 -----------------------------------------------
        Total...................................................          25,525             359          25,166
All Entities:
    Gross Receipts >$25 mil.....................................              92              80              12
    Gross Receipts [lE]$25 mil..................................          35,385           3,058          32,327
                                                                 -----------------------------------------------
        Total...................................................          35,477           3,138          32,339
----------------------------------------------------------------------------------------------------------------
Source: Statistics of Income data. Cash accounting includes cash, other, and unknown.

    Regarding the applicable financial statement, the Treasury 
Department and the IRS estimate that 235,000-250,000 entities with 
gross receipts of $25 million or less had an audited income statement 
in taxable year 2016. This is an upper bound estimate of entities that 
may be affected by these proposed regulations because small entities 
are less likely to have a financial statement that falls within the 
definition of AFS in proposed Sec.  1.451-3(c)(1) (which generally 
refers to certified audited financial statements in accordance with 
GAAP or IFRS). An AFS is generally a financial statement that is 
certified as being prepared in accordance with GAAP or IFRS that is 
issued for credit purposes, reporting to shareholders, or other non-tax 
purpose. The smaller the entity, the less likely that it will engage a 
CPA firm to audit their financial statements. An AFS does not include 
financial statements that have only been compiled or reviewed by a CPA 
firm, which are more affordable for small entities, as these types of 
statements are not certified as prepared in accordance with GAAP or 
IFRS.
    Affected taxpayers would be required to file Form 3115. As an 
indicator of whether a taxpayer is likely to have to file a Form 3115, 
the Treasury Department and the IRS estimated the number of businesses 
that used the accrual method of accounting, had a financial statement, 
and indicated they had unearned or deferred income. Approximately 
15,000 businesses with gross receipts of $25 million or less fit this 
category. This is an upper bound estimate of the number of taxpayers 
relying of Revenue Procedure 2004-34 that will need to file a Form 3115 
since some reporting of unearned or deferred income may just have 
deferral for financial reporting and not tax reporting reasons.
    These proposed rules will not have a significant economic impact on 
small entities affected because the costs to comply with these proposed 
regulations are not significant. An entity is required to file a Form 
3115 (Parts I, II, IV and Schedule B) to change its method of 
accounting in order to use the deferral method described in proposed 
Sec.  1.451-8(c) or (d). The Treasury Department and IRS plan to 
provide streamlined procedures for taxpayers to change to the methods 
of accounting described in proposed Sec.  1.451-8(c)1 and (d). See the 
revenue procedure accompanying these proposed regulations. As noted in 
this revenue procedure, the estimated cumulative annual reporting and/
or recordkeeping burden for the statutory method changes described 
under OMB control number 1545-1551, before publication of the revenue 
procedure, is 27,336 respondents, and a total annual reporting and/or 
recordkeeping burden of 30,580 hours. The estimated annual burden per 
respondent/recordkeeper under OMB control number 1545-1551 before 
publication of this revenue procedure varies from \1/6\ hour to 8\1/2\ 
hours, depending on individual circumstances, with an estimated average 
of 1\1/4\ hours. The estimated cumulative annual reporting and/or 
recordkeeping burden for the method changes described under OMB control 
number 1545-1551 after that revenue procedure is accounted for is 
27,346 respondents, and a total annual reporting and/or recordkeeping 
burden is 31,479 hours, leaving the average reporting and recordkeeping 
burden essentially unchanged. These burdens are essentially unaffected 
by these proposed regulations.
    Notwithstanding this certification that the proposed rule would not 
have a significant economic impact on a substantial number of small 
entities, the Treasury Department and the IRS invite comments from the 
public about the impact of this proposed rule on small entities.
    Pursuant to section 7805(f), these regulations will be submitted to 
the Chief Counsel for Advocacy of the Small Business Administration for 
comment on their impact on small business.

IV. Unfunded Mandates Reform Act

    Section 202 of the Unfunded Mandates Reform Act of 1995 requires 
that agencies assess anticipated costs and benefits and take certain 
other

[[Page 47186]]

actions before issuing a final rule that includes any Federal mandate 
that may result in expenditures in any one year by a state, local, or 
tribal government, in the aggregate, or by the private sector, of $100 
million in 1995 dollars, updated annually for inflation. In 2018, that 
threshold is approximately $150 million. This rule does not include any 
Federal mandate that may result in expenditures by state, local, or 
tribal governments, or by the private sector in excess of that 
threshold.

V. Executive Order 13132: Federalism

    Executive Order 13132 (entitled ``Federalism'') prohibits an agency 
from publishing any rule that has federalism implications if the rule 
either imposes substantial, direct compliance costs on state and local 
governments, and is not required by statute, or preempts state law, 
unless the agency meets the consultation and funding requirements of 
section 6 of the Executive Order. This rule does not have federalism 
implications and does not impose substantial direct compliance costs on 
state and local governments or preempt state law within the meaning of 
the Executive Order.

Comments and Requests for a Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any comments that are submitted timely 
to the IRS as prescribed in this preamble under the ADDRESSES heading. 
The Treasury Department and the IRS request comments on all aspects of 
the proposed regulations. All comments will be available at https://www.regulations.gov or upon request. A public hearing will be scheduled 
if requested in writing by any person that timely submits written 
comments. If a public hearing is scheduled, notice of the date, time, 
and place for the public hearing will be published in the Federal 
Register.

Effect on Other Documents

    When finalized, these proposed regulations will obsolete Revenue 
Procedure 2004-34, Revenue Procedure 2011-18, Revenue Procedure 2013-29 
and Notice 2018-35.

Drafting Information

    The principal author of these proposed regulations is Peter E. 
Ford, IRS Office of the Associate Chief Counsel (Income Tax and 
Accounting). However, other personnel from the Treasury Department and 
the IRS participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *
    Sections 26 U.S.C. 451(c)(2)(A), (3), (4)(A)(iii), (4)(B)(vii);

0
Par. 2. Section 1.451-8 is added to read as follows:


Sec.  1.451-8  Advance payments for goods, services, and certain other 
items.

    (a) In general. Except as provided in paragraph (c) or (d) of this 
section, an accrual method taxpayer shall include an advance payment in 
gross income no later than in the taxable year in which the taxpayer 
receives the advance payment as provided under Sec.  1.451-1(a).
    (b) Definitions. Except as otherwise provided in this section, the 
following definitions apply for purposes of this section:
    (1) Advance payment--(i) In general. An advance payment is a 
payment received by a taxpayer if:
    (A) The full inclusion of the payment in the gross income of the 
taxpayer for the taxable year of receipt is a permissible method of 
accounting, without regard to this section;
    (B) Any portion of the payment is included in revenue by the 
taxpayer in an applicable financial statement for a subsequent taxable 
year;
    (C) The payment is for:
    (1) Services;
    (2) The sale of goods;
    (3) The use, including by license or lease, of intellectual 
property, including copyrights, patents, trademarks, service marks, 
trade names, and similar intangible property rights, such as franchise 
rights and arena naming rights;
    (4) The occupancy or use of property if the occupancy or use is 
ancillary to the provision of services, for example, advance payments 
for the use of rooms or other quarters in a hotel, booth space at a 
trade show, campsite space at a mobile home park, and recreational or 
banquet facilities, or other uses of property, so long as the use is 
ancillary to the provision of services to the property user;
    (5) The sale, lease, or license of computer software;
    (6) Guaranty or warranty contracts ancillary to an item or items 
described in paragraph (b)(1)(i)(C)(1), (2), (3), (4), or (5) of this 
section;
    (7) Subscriptions in tangible or intangible format. Subscriptions 
for which an election under section 455 is in effect is not included in 
this paragraph (b)(1)(i)(C)(7);
    (8) Memberships in an organization. Memberships for which an 
election under section 456 is in effect are not included in this 
paragraph (b)(1)(i)(C)(8);
    (9) An eligible gift card sale;
    (10) Any other payment specified by the Secretary in other guidance 
published in the Internal Revenue Bulletin (see Sec.  601.601(d)(2)); 
or
    (11) Any combination of items described in paragraphs 
(b)(1)(i)(C)(1) through (10) of this section.
    (ii) Exclusions from the definition of advance payment. An advance 
payment does not include:
    (A) Rent, except for amounts paid with respect to an item or items 
described in paragraph (b)(1)(i)(C)(3), (4) or (5) of this section;
    (B) Insurance premiums, to the extent the inclusion of those 
premiums is governed by subchapter L;
    (C) Payments with respect to financial instruments (for example, 
debt instruments, deposits, letters of credit, notional principal 
contracts, options, forward contracts, futures contracts, foreign 
currency contracts, credit card agreements (including rewards or 
loyalty points under such agreements), financial derivatives, or 
similar items), including purported prepayments of interest;
    (D) Payments with respect to service warranty contracts for which 
the taxpayer uses the accounting method provided in Revenue Procedure 
97-38 (1997-2 CB 479);
    (E) Payments with respect to warranty and guaranty contracts under 
which a third party is the primary obligor;
    (F) Payments subject to section 871(a), 881, 1441, or 1442;
    (G) Payments in property to which section 83 applies; and
    (H) Payments received in a taxable year earlier than the taxable 
year immediately preceding the taxable year of the contractual delivery 
date for a specified good.
    (2) Applicable financial statement. Applicable financial statement 
has the same meaning as provided in proposed Sec.  1.451-3(c)(1).
    (3) Eligible gift card sale. Eligible gift card sale means the sale 
of a gift card or gift certificate if:
    (i) The taxpayer is primarily liable to the customer, or holder of 
the gift card,

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for the value of the card until redemption or expiration; and
    (ii) The gift card is redeemable by the taxpayer or by any other 
entity that is legally obligated to the taxpayer to accept the gift 
card from a customer as payment for items listed in paragraphs 
(b)(1)(i)(C)(1) through (11) of this section.
    (4) Performance obligation. Performance obligation has the same 
meaning as provided in proposed Sec.  1.451-3(c)(3).
    (5) Received. 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.
    (6) Revenue. Revenue has the same meaning as provided in proposed 
Sec.  1.451-3(c)(4) and is determined under the rules provided in 
proposed Sec.  1.451-3.
    (7) Transaction price. Transaction price has the same meaning as 
provided in proposed Sec.  1.451-3(c)(6).
    (8) Contractual delivery date. Contractual delivery date means the 
month and year of delivery listed in the written contract to the 
transaction.
    (9) Specified good. A specified good means a good for which:
    (i) During the taxable year a payment is received, the taxpayer 
does not have on hand (or available to it in such year through its 
normal source of supply) goods of a substantially similar kind and in a 
sufficient quantity to satisfy the contract to transfer the good to the 
customer; and
    (ii) All the revenue from the sale of the good is recognized in the 
taxpayer's AFS in the year of delivery.
    (c) Deferral method for taxpayers with an applicable financial 
statement (AFS)--
    (1) In general. An accrual method taxpayer with an AFS that 
receives an advance payment may elect the deferral method described in 
this paragraph (c) if the taxpayer is able to determine the extent to 
which advance payments are included in revenue in its AFS in the 
taxable year received, including a short taxable year (if applicable). 
A taxpayer that uses the deferral method must:
    (i) Include the advance payment, or any portion thereof, in gross 
income in the taxable year of receipt to the extent included in revenue 
in its AFS; and
    (ii) Include the remaining portion of such advance payment in gross 
income in the taxable year following the taxable year in which such 
payment is received.
    (2) Acceleration of advance payments--(i) In general. A taxpayer 
that uses the deferral method described in this paragraph (c) must 
include in gross income for the taxable year of receipt or, if 
applicable, for a short taxable year described in paragraph (c)(4) of 
this section, all advance payments not previously included in gross 
income:
    (A) If, in that taxable year, the taxpayer either dies or ceases to 
exist in a transaction other than a transaction to which section 381(a) 
applies; or
    (B) If, and to the extent that, in that taxable year, the 
taxpayer's obligation with respect to the advance payments is satisfied 
or otherwise ends other than in:
    (1) A transaction to which section 381(a) applies; or
    (2) A section 351(a) transfer that is part of a section 351 
transaction in which:
    (i) Substantially all assets of the trade or business (including 
advance payments) are transferred;
    (ii) The transferee adopts or uses the deferral method in the year 
of transfer; and
    (iii) The transferee and the transferor are members of the same 
consolidated group, as defined in Sec.  1.1502-1(h).

    (ii) Example. Ceasing to exist. A is a calendar year taxpayer 
and is in the business of selling and licensing computer software 
(off the shelf, fully customized, and semi-customized) and providing 
customer support. On July 1, 2018, A enters into a 2-year software 
maintenance contract and receives an advance payment. Under the 
contract, A will provide software updates if it develops an update 
within the contract period, as well as online and telephone customer 
support. A ceases to exist on December 1, 2018, in a transaction 
that does not involve a section 351(a) transfer described in 
paragraph (c)(2)(i)(B)(2) of this section and is not a transaction 
to which section 381(a) applies. For federal income tax purposes, A 
must include the entire advance payment in gross income in its 2018 
taxable year.

    (3) Financial statement adjustments--(i) In general. 
Notwithstanding section 451(c)(4)(A)(ii), if a taxpayer treats an 
advance payment as an item of deferred revenue in its AFS and writes-
down or adjusts that item, or portion thereof, to an equity account 
(for example, retained earnings) or otherwise writes-down or adjusts 
that item of deferred revenue in a subsequent taxable year, revenue for 
that subsequent taxable year includes that item, or portion thereof, 
that is written down or adjusted.

    (ii) Examples--(A) Example 1. On May 1, 2018, A, a corporation 
that files its federal income tax return on a calendar year basis, 
received $100 as an advance payment for a 2-year contract to provide 
services. For financial accounting purposes, A recorded $100 as a 
deferred revenue liability in its AFS, expecting to report \1/4\ of 
the advance payment in revenue in its AFS for 2018, \1/2\ for 2019, 
and \1/4\ for 2020. On August 31, 2018, C, an unrelated corporation 
that files its federal income tax return on a calendar year basis, 
acquired all of the stock of A, and A joined C's consolidated group. 
A's short taxable year ended on August 31, 2018, and, as of that 
date, A had included only \1/4\ ($25) of the advance payment in 
revenue in its AFS. On September 1, 2018, after the stock 
acquisition, and in accordance with purchase accounting rules, C 
wrote down A's deferred revenue liability to its fair value of $10 
as of the date of the acquisition. The $10 will be included in 
revenue on A's AFS in accordance with the method of accounting A 
uses for financial accounting purposes. For federal income tax 
purposes, A uses the deferral method. For federal income tax 
purposes, A must take \1/4\ ($25) of the advance payment into income 
for its short taxable year ending August 31, 2018, and the remainder 
of the advance payment ($75) ($65 write down + $10 future financial 
statement revenue) must be included in income for A's next 
succeeding taxable year.
    (B) Example 2. On May 1, 2018, B, a corporation that files its 
federal income tax return on a calendar year basis, received $100 
advance payment for a contract to be performed in 2018, 2019, and 
2020. On August 31, 2018, D, a corporation that is not consolidated 
for federal income tax purposes, acquired all of the stock of B. 
Before the stock acquisition, on its AFS for 2018, B included $40 of 
the advance payment in revenue, and $60 as a deferred revenue 
liability. On September 1, 2018, after the stock acquisition and in 
accordance with purchase accounting rules, D wrote down its $60 
deferred revenue liability to $10 (its fair value) as of the date of 
the acquisition. After the acquisition, B does not include in 
revenue any of the $10 deferred revenue liability in its 2018 AFS. B 
does include $5 in revenue in 2019, and $5 in revenue in 2020. For 
federal income tax purposes, B uses the deferral method. For federal 
income tax purposes, B must take $40 of the advance payment into 
income in 2018, and the remainder of the advance payment ($60) ($50 
write down + $10 future financial statement revenue) must be 
included in income for B's next succeeding taxable year, 2019.

    (4) Short taxable year rule--(i) In general. If the taxpayer's next 
succeeding taxable year is a short taxable year, other than a taxable 
year in which the taxpayer dies or ceases to exist in a transaction 
other than a transaction to which section 381(a) applies, and the short 
taxable year consists of 92 days or less, a taxpayer using the deferral 
method must include the portion of the advance payment not included in 
the taxable year of receipt in gross income for the short taxable year 
to the extent included in revenue in an AFS. Any amount of the advance 
payment not included in the taxable year of receipt and the short 
taxable year must be included in gross income for the taxable year 
immediately following the short taxable year.

    (ii) Example. A is a calendar year taxpayer and is in the 
business of selling and licensing

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computer software (off the shelf, fully customized, and semi-
customized) and providing customer support. On July 1, 2018, A 
receives an advance payment for a 2-year software maintenance 
contract. Under the contract, A will provide software updates if it 
develops an update within the contract period, as well as online and 
telephone customer support. A changes its taxable period to a fiscal 
year ending March 31 so that A has a short taxable year beginning 
January 1, 2019, and ending March 31, 2019. In its AFS, A includes 
\1/4\ of the payment in revenue for the taxable year ending December 
31, 2018; \1/6\ in revenue for the short taxable year ending March 
31, 2019; \1/4\ in revenue for the taxable year ending March 31, 
2020; and \1/4\ in revenue for the taxable year ending March 31, 
2021. Because the taxable year ending March 31, 2019, is 92 days or 
less, A must include \1/4\ of the payment in gross income for the 
taxable year ending December 31, 2018, \1/6\ in gross income for the 
short taxable year ending March 31, 2019, and the remaining amount 
in gross income for the taxable year ending March 31, 2020.

    (5) Financial statement conformity requirement. A taxpayer that 
uses the deferral method under this paragraph (c) must use the same 
financial statement that is used to apply the rules in section 451(b) 
and the accompanying regulations when applying the deferral method 
provided in section 451(c) and these regulations.
    (6) Allocation of transaction price. A taxpayer using the deferral 
method under this paragraph (c) must use the allocation rules provided 
in proposed Sec.  1.451-3(g).
    (7) Rules relating to eligible gift card sales. For purposes of 
paragraphs (b)(1)(i)(B) and (c)(1) of this section, if an eligible gift 
card is redeemable by an entity described in paragraph (b)(3)(ii) of 
this section whose financial results are not included in the taxpayer's 
AFS, a payment will be treated as included by the taxpayer in revenue 
in its AFS to the extent the gift card is redeemed by the entity during 
the taxable year.
    (8) Examples. The following examples illustrate the rules of this 
paragraph (c). In each example in paragraphs (c)(8)(i) through (xxv) of 
this section, the taxpayer uses an accrual method of accounting for 
federal income tax purposes and files its returns on a calendar year 
basis. Except as stated otherwise, the taxpayer in each example has an 
AFS.

    (i) Example 1. Services. On November 1, 2018, A, in the business 
of giving dancing lessons, receives an advance payment for a 1-year 
contract commencing on that date and providing for up to 48 
individual, 1-hour lessons. A provides eight lessons in 2018 and 
another 35 lessons in 2019. In its AFS, A includes \1/6\ of the 
payment in revenue for 2018, and \5/6\ of the payment in revenue for 
2019. A uses the deferral method. For federal income tax purposes, A 
must include \1/6\ of the payment in gross income for 2018, and the 
remaining \5/6\ of the payment in gross income for 2019.
    (ii) Example 2. Services. Assume the same facts as in Example 1 
in paragraph (c)(8)(i) of this section, except that the advance 
payment is received for a 3-year contract under which up to 96 
lessons are provided. A provides eight lessons in 2018, 48 lessons 
in 2019, and 40 lessons in 2020. In its AFS, A includes \1/12\ of 
the payment in revenue for 2018, \1/2\ of the payment in revenue for 
2019, and \5/12\ of the payment in gross revenue for 2020. For 
federal income tax purposes, A must include \1/12\ of the payment in 
gross income for 2018, and the remaining \11/12\ of the payment in 
gross income for 2019.
    (iii) Example 3. Goods and Services. On June 1, 2018, B, a 
landscape architecture firm, receives an advance payment for goods 
and services that, under the terms of the agreement, must be 
provided by December 2019. On December 31, 2018, B estimates that 
\3/4\ of the work under the agreement has been completed. In its 
AFS, B includes \3/4\ of the payment in revenue for 2018 and \1/4\ 
of the payment in revenue for 2019. B uses the deferral method. For 
federal income tax purposes, B must include \3/4\ of the payment in 
gross income for 2018, and the remaining \1/4\ of the payment in 
gross income for 2019, regardless of whether B completes the job in 
2019.
    (iv) Example 4. Repair Contracts. On July 1, 2018, C, in the 
business of selling and repairing television sets, receives an 
advance payment for a 2-year contract under which C agrees to repair 
or replace, or authorizes a representative to repair or replace, 
certain parts in the customer's television set if those parts fail 
to function properly. In its AFS, C includes \1/4\ of the payment in 
revenue for 2018, \1/2\ of the payment in revenue for 2019, and \1/
4\ of the payment in revenue for 2020. C uses the deferral method. 
For federal income tax purposes, C must include \1/4\ of the payment 
in gross income for 2018 and the remaining \3/4\ of the payment in 
gross income for 2019.
    (v) Example 5. Online website Design. D, in the business of 
building and designing websites, receives advance payments that 
oblige D to build and design various websites. D tracks each request 
for a website with unique identifying numbers. On July 20, 2018, D 
receives online payments for 2 websites. One of the website requests 
is submitted and processed on September 1, 2018, and the other is 
submitted and processed on February 1, 2020. In its AFS, D includes 
the payment for the September 1, 2018, website in revenue for 2018 
and the payment for the February 1, 2020, website in revenue for 
2020. D uses the deferral method. For federal income tax purposes, D 
must include the payment for the September 1, 2018, website in gross 
income for 2018 and the payment for the February 1, 2020, website in 
gross income for 2019.
    (vi) Example 6. Gift Cards. E, a hair styling salon, receives 
advance payments for gift cards that may later be redeemed at the 
salon for hair styling services or hair care products at the face 
value of the gift card. The gift cards look like standard credit 
cards, and each gift card has a magnetic strip that, in connection 
with E's computer system, identifies the available balance. The gift 
cards may not be redeemed for cash and have no expiration date. In 
its AFS, E includes advance payments for gift cards in revenue when 
redeemed. E is not able to determine the extent to which advance 
payments are included in revenue in its AFS for the taxable year of 
receipt and therefore does not meet this requirement of paragraph 
(c)(1) of this section. Therefore, E may not use the deferral method 
for these advance payments.
    (vii) Example 7. Gift Cards. Assume the same facts as in Example 
6 in paragraph (c)(8)(vi) of this section, except that the gift 
cards have an expiration date 12 months from the date of sale, E 
does not accept expired gift cards, and E includes unredeemed gift 
cards in revenue in its AFS for the taxable year in which the cards 
expire. Because E tracks the sale date and the expiration date of 
the gift cards for purposes of its AFS, E is able to determine the 
extent to which advance payments are included in revenue for the 
taxable year of receipt. Therefore, E meets this requirement of 
paragraph (c)(1) of this section and may use the deferral method for 
these advance payments.
    (viii) Example 8. Online Subscriptions. G is in the business of 
compiling and providing business information for a particular 
industry in an online format accessible over the internet. On 
September 1, 2018, G receives an advance payment from a subscriber 
for 1 year of access to its online database, beginning on that date. 
In its AFS, G includes \1/3\ of the payment in revenue for 2018 and 
the remaining \2/3\ in revenue for 2019. G uses the deferral method. 
For federal income tax purposes, G must include \1/3\ of the payment 
in gross income for 2018 and the remaining \2/3\ of the payment in 
gross income for 2019.
    (ix) Example 9. Membership Fees. On December 1, 2018, H, in the 
business of operating a chain of ``shopping club'' retail stores, 
receives advance payments for membership fees. Upon payment of the 
fee, a member is allowed access for a 1-year period to H's stores, 
which offer discounted merchandise and services. In its AFS, H 
includes \1/12\ of the payment in revenue for 2018 and \11/12\ of 
the payment in revenue for 2019. H uses the deferral method. For 
federal income tax purposes, H must include \1/12\ of the payment in 
gross income for 2018, and the remaining \11/12\ of the payment in 
gross income for 2019.
    (x) Example 10. Cruise. In 2018, I, in the business of operating 
tours, receives payments from customers for a 10-day cruise that 
will take place in April 2019. Under the agreement, I charters a 
cruise ship, hires a crew and a tour guide, and arranges for 
entertainment and shore trips for the customers. In its AFS, I 
includes the payments in revenue for 2019. I uses the deferral 
method. For federal income tax purposes, I must include the payments 
in gross income for 2019.
    (xi) Example 11. Travel agent services. On November 1, 2018, J, 
a travel agent, receives payment from a customer for an airline 
flight that will take place in April 2019. J purchases and delivers 
the airline ticket to the customer

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on November 14, 2018. J retains a portion of the customer's payment 
(the excess of the customer's payment over the cost of the airline 
ticket) as its commission. Because J is not required to provide any 
services after the ticket is delivered to the customer, J earns its 
commission when the airline ticket is delivered. The customer may 
cancel the flight and receive a refund from J only to the extent the 
airline itself provides refunds. In its AFS, J includes its 
commission in revenue for 2019. The commission is not an advance 
payment because the payment is not earned by J, in whole or in part, 
in a subsequent taxable year. Thus, J may not use the deferral 
method for this payment.
    (xii) Example 12. Broadcasting Rights. K, a professional sports 
franchise, is a member of a sports league that enters into contracts 
with television networks for the right to broadcast games to be 
played between teams in the league. The money received by the sports 
league under the contracts is divided equally among the member 
teams. The league entered into a 3-year broadcasting contract 
beginning October 1, 2018. K receives three equal installment 
payments on October 1 of each contract year, beginning in 2018. In 
its AFS, K includes \1/4\ of the first installment payment in 
revenue for 2018 and \3/4\ in revenue for 2019; K includes \1/4\ of 
the second installment in revenue for 2019 and \3/4\ in revenue for 
2020; K includes \1/4\ of the third installment in revenue for 2020 
and \3/4\ in revenue for 2021. K uses the deferral method. Each 
installment payment constitutes an advance payment under paragraph 
(b)(1) of this section. For federal income tax purposes, K must 
include \1/4\ of the first installment payment in gross income for 
2018 and \3/4\ in gross income for 2019; \1/4\ of the second 
installment in gross income for 2019 and \3/4\ in gross income for 
2020; and \1/4\ of the third installment in gross income for 2020 
and \3/4\ in gross income for 2021.
    (xiii) Example 13. Insurance Claims Administration. L is in the 
business of negotiating, placing, and servicing insurance coverage 
and administering claims for insurance companies. On December 1, 
2018, L enters into a contract with an insurance company to provide 
property and casualty claims administration services for a 4-year 
period beginning January 1, 2019. Pursuant to the contract, the 
insurance company makes four equal annual payments to L; each 
payment relates to a year of service and is made during the month 
prior to the service year (for example, L is paid on December 1, 
2018, for the service year beginning January 1, 2019). In its AFS, L 
includes the first payment in revenue for 2019; the second payment 
in revenue for 2020; the third payment in revenue for 2021; and the 
fourth payment in revenue for 2022. L uses the deferral method. Each 
annual payment constitutes an advance payment under paragraph (b)(1) 
of this section. For federal income tax purposes, L must include the 
first payment in gross income for 2019; the second payment in gross 
income for 2020; the third payment in gross income for 2021; and the 
fourth payment in gross income for 2022.
    (xiv) Example 14. Internet Services. M is a cable internet 
service provider that enters into contracts with subscribers to 
provide internet services for a monthly fee (paid prior to the 
service month). For those subscribers who do not own a compatible 
modem, M provides a rental cable modem for an additional monthly 
charge (also paid prior to the service month). Pursuant to the 
contract, M will replace or repair the cable modem if it proves 
defective during the contract period. In December 2018, M receives 
payments from subscribers for January 2019 internet service and 
cable modem use. In its AFS, M includes the entire amount of these 
payments in revenue for 2019. M uses the deferral method. Because a 
subscriber's use of a cable modem is ancillary to the provision of 
internet services by M, and because the cable modem warranty is 
ancillary to the use of the cable modem, the payments are advance 
payments. For federal income tax purposes, M must include the 
advance payments in gross income for 2019.
    (xv) Example 15. License Agreement. On January 1, 2019, N enters 
into, and receives advance payments pursuant to, a 5-year license 
agreement for the use of N's trademark. Under the contract, the 
licensee pays N both the first-year (2019) license fee and the 
fifth-year (2023) license fee upon commencement of the agreement. 
The fees for the second, third, and fourth years are payable on 
January 1 of each license year. The contract provides the customer 
with access to N's trademark throughout the term of the agreement. 
In its AFS, N includes the fees in revenue for the respective 
license year. N uses the deferral method. For federal income tax 
purposes, N must include the first-year license fee in gross income 
for 2019, the second-year and the fifth-year license fee in gross 
income for 2020, the third-year license fee in gross income for 
2021, and the fourth-year license fee in gross income for 2022.
    (xvi) Example 16. Computer Software Subscription. On July 1, 
2018, O, in the business of licensing computer software (off the 
shelf, fully customized, and semi-customized) and providing customer 
support, receives an advance payment for a 2-year ``software 
subscription contract'' under which O will provide software updates 
if it develops an update within the contract period, as well as 
online and telephone customer support. In its AFS, O includes \1/4\ 
of the payment in revenue for 2018, \1/2\ in revenue for 2019, and 
the remaining \1/4\ in revenue for 2020, regardless of when O 
provides updates or customer support. O uses the deferral method. 
For federal income tax purposes, O must include \1/4\ of the payment 
in gross income for 2018 and \3/4\ in gross income for 2019.
    (xvii) Example 17. Performance Obligation. P is in the business 
of licensing computer software (off the shelf, fully customized, and 
semi-customized) and providing customer support. On July 1, 2018, P 
receives an advance payment of $100 for a 2-year software 
subscription that includes a 1-year ``software maintenance 
contract'' under which P will provide integral software updates 
within the contract period, as well as a ``customer support 
agreement'' for online and telephone customer support. In its AFS, P 
allocates $80 of the payment to the subscription agreement and $20 
to the customer support agreement. With respect to the $80 allocable 
to the subscription agreement, P includes \1/4\ ($20) in revenue for 
2018, \1/2\ ($40) in revenue for 2019, and the remaining \1/4\ ($20) 
in revenue for 2020. With respect to the $20 allocable to the 
customer support agreement, P includes \1/2\ ($10) in revenue for 
2018, and the remaining \1/2\ ($10) in revenue for 2019 regardless 
of when P provides the customer support. For federal income tax 
purposes, P must include $30 in gross income for 2018 ($20 allocable 
to the subscription agreement and $10 allocable to the customer 
support agreement) and the remaining $70 in gross income for 2019.
    (xviii) Example 18. Gift Cards Administered by Another. Q 
corporation operates department stores. U corporation, V 
corporation, and W corporation are wholly owned domestic 
subsidiaries of Q that file a consolidated federal income tax return 
with Q. X corporation is a controlled foreign subsidiary of Q that 
is prohibited from filing a consolidated return with Q. U sells 
Brand A goods, V sells Brand B goods, X sells Brand C goods, and Z 
is an unrelated entity that sells Brand D goods. W administers a 
gift card program for the Q consolidated group, X, and Z. Pursuant 
to the underlying agreements, W issues gift cards that are 
redeemable for goods or services offered by U, V, X, and Z. In 
addition, U, V, X, and Z sell gift cards to customers on behalf of W 
and remit amounts received to W. The agreements provide that W is 
primarily liable to the customer for the value of the gift card 
until redemption, and U, V, X, and Z are obligated to accept the 
gift card as payment for goods or services. When a customer 
purchases goods or services with a gift card at U, V, X, or Z, W 
reimburses that entity for the sales price of the goods or services 
purchased with the gift card, up to the total gift card value. In 
2018, W sells gift cards with a total value of $900,000, and, at the 
end of 2018, the unredeemed balance of the gift cards is $100,000. 
In the consolidated group's AFS, the group includes revenue from the 
sale of a gift card when the gift card is redeemed. W tracks sales 
and redemptions of gift cards electronically, is able to determine 
the extent to which advance payments are included in revenue in its 
consolidated AFS for the taxable year of receipt, and meets the 
requirements of paragraph (c)(1) of this section. The payments W 
receives from the sale of gift cards are advance payments because 
they are payments for eligible gift cards. Thus, W is eligible to 
use the deferral method. At the end of 2018, W includes $800,000 in 
income in its consolidated AFS. Under the deferral method, W must 
include $800,000 of the payments from gift card sales in gross 
income in 2018 and the remaining $100,000 of the payments in gross 
income in 2019.
    (xix) Example 19. Gift Cards of Affiliates. R is a Subchapter S 
corporation that operates an affiliated restaurant corporation and 
manages other affiliated restaurants. These other restaurants are 
owned by other Subchapter S corporations, partnerships, and limited 
liability companies. R has a partnership interest or an equity 
interest in some of the restaurants. R administers a gift

[[Page 47190]]

card program for participating restaurants. Each participating 
restaurant operates under a different trade name. Under the gift 
card program, R and each of the participating restaurants sell gift 
cards, which are issued with R's brand name and are redeemable at 
all participating restaurants. Participating restaurants sell the 
gift cards to customers and remit the proceeds to R, R is primarily 
liable to the customer for the value of the gift card until 
redemption, and the participating restaurants are obligated under an 
agreement with R to accept the gift card as payment for food, 
beverages, taxes, and gratuities. When a customer uses a gift card 
to make a purchase at a participating restaurant, R is obligated to 
reimburse that restaurant for the amount of the purchase, up to the 
total gift card value. In R's AFS, R includes revenue from the sale 
of a gift card when a gift card is redeemed at a participating 
restaurant. R tracks sales and redemptions of gift cards 
electronically, is able to determine the extent to which advance 
payments are included in revenue in its AFS for the taxable year of 
receipt, and meets the requirements of paragraph (c)(1) of this 
section. The payments R receives from the sale of gift cards are 
advance payments because they are payments for eligible gift card 
sales. Thus, for federal income tax purposes, R is eligible to use 
the deferral method. In the taxable year of receipt, R must include 
the advance payment in income to the extent included in its AFS, and 
must include any remaining amount in income in the taxable year 
following the taxable year of receipt.
    (xx) Example 20. Gift Cards for Domestic and International 
Hotels. S is a corporation that operates for the benefit of its 
franchisee members, who own and operate domestic and international 
individual member hotels. S collects membership fees from the member 
hotels in exchange for providing a wide variety of management 
support services, which include making reservations for customers at 
the various member hotels. S also administers a gift card program 
for its members by selling gift cards that may be redeemed for hotel 
rooms and food or beverages provided by any member hotel. The 
agreements underlying the gift card program provide that S is 
entitled to the proceeds from the sale of the gift cards, must 
reimburse the member hotel for the value of a gift card redeemed, 
and until redemption remains primarily liable to the customer for 
the value of the card. In S's AFS, S includes payments from the sale 
of a gift card when the card is redeemed. S tracks sales and 
redemptions of gift cards electronically, is able to determine the 
extent to which advance payments are included in revenue in its AFS 
for the taxable year of receipt, and meets the requirements of 
paragraph (c)(1) of this section. The payments S receives from the 
sale of gift cards are advance payments because they are payments 
for eligible gift card sales. Thus, for federal income tax purposes, 
S is eligible to use the deferral method. In the taxable year of 
receipt, S must include in income the advance payment to the extent 
included in its AFS, and must include any remaining amount in income 
in the taxable year following the taxable year of receipt.
    (xxi) Example 21. Discount Voucher. On December 10, 2018, T, in 
the business of selling home appliances, sells a washing machine for 
$500. As part of the sale, T gives the customer a 40 percent 
discount voucher for any future purchases of T's goods up to $100 in 
the next 60 days. In its AFS, T treats the discount voucher as a 
separate performance obligation and allocates $30 of the $500 sales 
price to the discount voucher. T includes $12 of the amount 
allocated to the discount voucher in revenue for 2018 and includes 
$18 of the discount voucher in revenue for 2019. T uses the deferral 
method. For federal income tax purposes, T must include the $12 
allocable to the discount voucher in gross income in 2018 and the 
remaining $18 allocated to the discount voucher in gross income in 
2019.
    (xxii) Example 22. Rewards. On December 31, 2018, U, in the 
business of selling consumer electronics, sells a new TV for $1,000 
and gives the customer 50 reward points. Each reward point is 
redeemable for a $1 discount on any future purchase of U's products. 
The reward points are not redeemable for cash and have a 2-year 
expiration date. U tracks each customer's reward points and does not 
sell reward points separately. In its AFS, U treats the rewards 
points as a separate performance obligation and allocates $45 of the 
$1,000 sales price to the rewards points. U does not include any of 
the amount allocated to the reward points in revenue for 2018. U 
includes $25 of the reward points in revenue for 2019 and $20 of the 
reward points in revenue for 2020. U uses the deferral method. For 
federal income tax purposes, U does not include any amount of the 
reward points in gross income in 2018, and includes the entire $45 
allocated to the reward points in gross income in 2019.
    (xxiii) Example 23. Credit Card Rewards. V, a wholly owned 
credit card company, issues credit cards. V also has a loyalty 
program in which cardholders earn reward points for the use of its 
credit card to make purchases. Each reward point is redeemable for a 
$1 on any future purchases. V may not use the deferral method 
because payments under credit card agreements including rewards for 
credit card purchases are excluded from the definition of an advance 
payment under paragraph (b)(1)(ii)(C) of this section.
    (xxiv) Example 24. Airline Reward Miles. On January 1, 2018, W, 
in the business of transporting passengers on airplanes, sells a 
customer a $700 airline ticket to fly roundtrip in 2018. As part of 
the purchase, the customer also receives 7,000 points (air miles) 
from W to be used for future air travel. In its AFS, W allocates 
$665 to the roundtrip airfare and $35 to the air miles. In its AFS, 
the $665 allocated to the airfare is included in Year 1 when the 
customer takes the roundtrip flight. The $35 allocated to the air 
miles is deferred and included in Year 3 when the customer redeems 
the air miles. W uses the deferral method described in paragraph (c) 
of this section. For federal income tax purposes, the $665 is 
included in gross income in Year 1 and the $35 allocated to the air 
miles is included in gross income in Year 2.
    (xxv) Example 25. Chargebacks. Taxpayer X, a manufacturer of 
pharmaceuticals, is a calendar-year accrual method taxpayer with an 
AFS. In addition to billing the wholesaler for the sale of the 
pharmaceuticals at the wholesale acquisition cost under the 
contract, X generally credits or pays wholesalers a chargeback of 
40% of the wholesale acquisition cost for sales made by those 
wholesalers to qualifying customers. In 2018, X enters into a 
contract to sell 1,000 units to W, a wholesaler, for $10 per unit, 
totaling $10,000 (1,000 x $10 = $10,000). The contract also provides 
that X will issue a 40% chargeback for sales by W to certain 
qualifying customers. X delivers 600 units to W on December 31, 
2018, and bills W $6,000 under the contract. For AFS purposes, X 
adjusts its revenue by 40% for all sales to W for anticipated 
chargebacks. As such, in its 2018 AFS, X reports $3,600 ($6,000-
$2,400 = $3,600) of revenue from the contract with W, decreasing 
revenue by $2,400 (40% x $6,000 = $2,400) for anticipated chargeback 
claims. For federal income tax purposes, under proposed Sec.  1.451-
3(c)(4), X's 2018 revenue is $6,000 because revenue is not reduced 
for anticipated chargebacks. Because no portion of the $6,000 is 
included in revenue on an AFS in a subsequent taxable year (that is, 
on an AFS after 2018), none of the $6,000 is an advance payment 
under paragraph (b)(1)(i) of this section.

    (d) Deferral method for taxpayers without an AFS (non-AFS deferral 
method)--(1) In general. Only a taxpayer described in paragraph (d)(2) 
of this section may elect to use the non-AFS deferral method described 
in paragraph (d)(4) of this section.
    (2) Taxpayers eligible to use the non-AFS deferral method. A 
taxpayer is eligible to use the non-AFS deferral method if the taxpayer 
does not have an applicable financial statement as defined in proposed 
Sec.  1.451-3(c)(1) and is able to determine the extent to which 
advance payments are earned in the taxable year of receipt, or a short 
taxable year, if applicable.
    (3) Advance payment. For purposes of the non-AFS deferral method, 
in applying paragraph (b)(1)(i)(B) of this section, an advance payment 
is any portion of the payment received that is earned by the taxpayer, 
in whole or in part, in a subsequent taxable year.
    (4) Deferral of advance payments based on when payment is earned--
(i) In general. The non-AFS deferral method described in this paragraph 
(d) is a permissible method of accounting that may be used only by a 
taxpayer described in paragraph (d)(2) of this section. Under the non-
AFS deferral method of accounting, a taxpayer includes the advance 
payment in gross income for the taxable year of receipt, including, if 
applicable, a short taxable year described in paragraph (d)(8) of this 
section, to the extent that it is earned in that taxable year and 
includes

[[Page 47191]]

the remaining portion of the advance payment in gross income in the 
next succeeding taxable year.
    (ii) When payment is earned. A payment is earned when the all 
events test described in Sec.  1.451-1(a) is met, without regard to 
when the amount is received, as defined under paragraph (b)(5) of this 
section, by the taxpayer. If a taxpayer is unable to determine the 
extent to which a payment is earned in the taxable year of receipt, the 
taxpayer may determine that amount:
    (A) On a statistical basis if adequate data are available to the 
taxpayer;
    (B) On a straight line ratable basis over the term of the agreement 
if the taxpayer receives advance payments under a fixed term agreement 
and if it is not unreasonable to anticipate at the end of the taxable 
year of receipt that the advance payment will be earned ratably over 
the term of the agreement; or
    (C) By the use of any other basis that in the opinion of the 
Commissioner results in a clear reflection of income.
    (5) Contracts with multiple obligations--(i) In general. If a 
taxpayer receives a payment that is attributable to more than one item 
described in paragraph (b)(1)(i)(C) of this section, the taxpayer must 
allocate the payment to such items in a manner that is based on 
objective criteria.
    (ii) Objective criteria. A taxpayer's allocation method with 
respect to a payment described in paragraph (d)(5)(i) of this section 
is based on objective criteria if the allocation method is based on 
payments the taxpayer regularly receives for an item or items it 
regularly sells or provides separately or any method that may be 
provided in guidance published in the Internal Revenue Bulletin (see 
Sec.  601.601(d) of this chapter).
    (6) Acceleration of advance payments. For purposes of this 
paragraph (d), the acceleration rules provided in paragraph (c)(2) of 
this section apply to a taxpayer that uses the non-AFS deferral method.
    (7) Advance payments in certain acquisitions and other financial 
statement adjustments. For purposes of this paragraph (d), the rules 
provided in paragraph (c)(3) of this section apply to a taxpayer that 
uses the non-AFS deferral method.
    (8) Short taxable year rule. For purposes of this paragraph (d), 
the short taxable year rule provided in paragraph (c)(4) of this 
section applies to a taxpayer that uses the non-AFS deferral method.
    (9) Eligible gift card sale. For purposes of paragraphs 
(b)(1)(i)(B) and (d)(4) of this section, if an eligible gift card is 
redeemable by an entity described in paragraph (b)(3)(ii), including an 
entity whose financial results are not included in the taxpayer's 
financial statement, a payment will be treated as earned by the 
taxpayer to the extent the gift card is redeemed by the entity during 
the taxable year.
    (10) Examples. The rules of this paragraph (d) are illustrated by 
the examples in paragraphs (d)(10)(i) and (ii). In each of these 
examples, the taxpayer uses the non-AFS deferral method described in 
this paragraph (d).

    (i) Example 1. A, a video arcade operator, receives payments in 
2018 for game tokens that are used by customers to play the video 
games offered by A. The tokens cannot be redeemed for cash. The 
tokens are imprinted with the name of the video arcade, but they are 
not individually marked for identification. A completed a study on a 
statistical basis, based on adequate data available to A, and 
concluded that for payments received in the current year, x percent 
of tokens are expected to be used in the current year, y percent of 
tokens are expected to be used in the next year, and the remaining z 
percent of tokens are expected to never be used. Based on the study, 
A treats as earned for 2018 x percent (for tokens expected to be 
used in that year) as well as z percent (for tokens that are 
expected to never be used). Using the study, A determines the extent 
to which advance payments are earned in the taxable year of receipt. 
A may determine the extent to which a payment is earned in the 
taxable year of receipt on a statistical basis provided that any 
portion that is not included in the taxable year of receipt is 
included in the next succeeding taxable year. Thus, for federal 
income tax purposes, A must include x percent and z percent of the 
advance payments in gross income for 2018 and y percent of the 
advance payments in gross income for 2019.
    (ii) Example 2. B is in the business of providing internet 
services. On September 1, 2018, B receives an advance payment from a 
customer for a 2-year term for access to its internet services, 
beginning on that date. B does not have an AFS. B is unable to 
determine the extent to which the payment is earned in the taxable 
year of receipt. For federal income tax purposes, B may determine 
the extent to which the payment is earned in the year of receipt on 
a straight line ratable basis over the term of the agreement if it 
is not unreasonable to anticipate at the end of the taxable year of 
receipt that the advance payment will be earned ratably over the 
term of the agreement.

    (e) Method of accounting. The use of the deferral method under 
paragraph (c) of this section or the non-AFS deferral method under 
paragraph (d) of this section is the adoption of, or a change in, a 
method of accounting under section 446 of the Internal Revenue Code or 
the accompanying regulations. In addition, a change in the manner of 
recognizing advance payments in revenue in an AFS that changes or could 
change the timing of the inclusion of income for federal income tax 
purposes is a change in method of accounting under section 446 and the 
accompanying regulations. A taxpayer may change its method of 
accounting to use the methods described in paragraphs (c) or (d) of 
this section, or change its manner of recognizing advance payments in 
revenue in an AFS only with the consent of the Commissioner as required 
under section 446(e) and the corresponding regulations.
    (f) Applicability date. The rules of this section are applicable 
for taxable years beginning on or after the date of publication of the 
Treasury decision adopting these rules as final regulations in the 
Federal Register. Until the date the Treasury decision adopting these 
regulations as final regulations is published in the Federal Register, 
a taxpayer may rely on these proposed regulations for taxable years 
beginning after December 31, 2017, provided that the taxpayer applies 
all the applicable rules contained in these proposed regulations, and 
consistently applies these proposed regulations to all advance 
payments. See section 7805(b)(7).

Kirsten Wielobob,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2019-19197 Filed 9-5-19; 4:15 pm]
BILLING CODE 4830-01-P