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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 9941]
RIN 1545–BO68 and 1545–BO78

Taxable Year of Income Inclusion
Under an Accrual Method of
Accounting and Advance Payments for
Goods, Services, and Other Items
Internal Revenue Service (IRS),
Treasury.
ACTION: Final regulations.
AGENCY:

This document contains final
regulations regarding the timing of
income inclusion under an accrual
method of accounting, including the
treatment of advance payments for
goods, services, and certain other items.
The regulations reflect changes made by
the Tax Cuts and Jobs Act and affect
taxpayers that use an accrual method of
accounting and have an applicable
financial statement. These final
regulations also affect taxpayers that use
an accrual method of accounting and
receive advance payments.
DATES:
Effective Date: The regulations are
effective on December 30, 2021.
Applicability Dates: For dates of
applicability, see §§ 1.451–3(m), 1.451–
8(h), and 1.1275–2(l)(2).
FOR FURTHER INFORMATION CONTACT:
Concerning any provisions in § 1.451–3
within the jurisdiction of the Associate
Chief Counsel (Income Tax &
Accounting), Jo Lynn Ricks, (202) 317–
4615, Sean Dwyer, (202) 317–4853, or
Doug Kim, (202) 317–4794, and
concerning any provisions in § 1.451–8
within the jurisdiction of the Associate
Chief Counsel (Income Tax &
Accounting), Jo Lynn Ricks, (202) 317–
4615, or David Christensen, (202) 317–
4861; concerning any provisions in
§ 1.451–3 or § 1.451–8 within the
jurisdiction of the Associate Chief
Counsel (Financial Institutions &
Products), Deepan Patel, (202) 317–
3423, or Charles Culmer, (202) 317–
4528 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
SUMMARY:

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Background
This document contains amendments
to the Income Tax Regulations (26 CFR
part 1) under section 451(b) and (c) of
the Internal Revenue Code (Code).
On December 22, 2017, section 451(b)
and (c) were amended by section 13221
of Public Law 115–97 (131 Stat. 2054),
commonly referred to as the Tax Cuts
and Jobs Act (TCJA). Section 451(b) was

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amended to provide that, for a taxpayer
using an accrual method of accounting
(accrual method taxpayer), the all events
test for an item of gross income, or
portion thereof, is met no later than
when the item, or portion thereof, is
included in revenue for financial
accounting purposes on an applicable
financial statement (AFS). Section
451(c) was amended to provide that an
accrual method taxpayer may use the
deferral method of accounting provided
in section 451(c) for advance payments.
Unless otherwise indicated, all
references to section 451(b) and section
451(c) hereinafter are references to
section 451(b) and section 451(c), as
amended by the TCJA.
I. Section 451(b)
In general, section 451(a) 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 § 1.451–1(a),
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 (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. Revenue Ruling 2003–10, 2003–1
C.B. 288; Revenue Ruling 84–31, 1984–
1 C.B. 127; Revenue Ruling 80–308,
1980–2 C.B. 162.
Section 451(b)(1)(A) provides that, for
an accrual method taxpayer, the all
events test for an item of gross income,
or portion thereof, is met no later than
when the item, or portion thereof, is
included as revenue in an AFS (AFS
Income Inclusion Rule).
Section 451(b)(1)(B) lists exceptions
to the AFS Income Inclusion Rule. The
AFS Income Inclusion Rule does not
apply to taxpayers that do not have an
AFS for a taxable year or to any item of
gross income from a mortgage servicing
contract.
Section 451(b)(1)(C) codifies the all
events test, stating that the all events
test is met for any item of gross income
if all the events have occurred which fix
the right to receive such income and the
amount of such income can be
determined with reasonable accuracy.
Section 451(b)(2) provides that the
AFS Income Inclusion Rule does not
apply for any item of gross income the
recognition of which is determined

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using a special method of accounting,
‘‘other than any provision of part V of
subchapter P (except as provided in
clause (ii) of paragraph (1)(B)).’’
Section 451(b)(3) defines an AFS, as
referenced in section 451(b)(1)(A)(i), by
providing a hierarchical list of financial
statements.
Section 451(b)(4) provides that for
purposes of section 451(b), in the case
of a contract which contains multiple
performance obligations, the allocation
of the transaction price to each
performance obligation is equal to the
amount allocated to each performance
obligation for purposes of including
such item in revenue in the taxpayer’s
AFS.
Section 451(b)(5) provides that, if the
financial results of a taxpayer are
reported on the AFS for a group of
entities, the group’s financial statement
shall be treated as the AFS of the
taxpayer.
II. Section 451(c)
Section 451(c) provides special rules
for the treatment of advance payments.
Section 451(c)(1)(A) provides the
general rule requiring an accrual
method taxpayer to include an advance
payment in gross income in the taxable
year of receipt. However, section
451(c)(1)(B) permits a taxpayer to elect
to include any portion of the advance
payment in gross income in the taxable
year following the year of receipt to the
extent income is not included in
revenue in the AFS in the year of
receipt. Section 451(c)(1)(B) generally
codifies Revenue Procedure 2004–34,
2004–22 I.R.B. 991, which provided for
a similar deferral period.
Section 451(c)(2)(A) provides the
Secretary of the Treasury or his delegate
(Secretary) with the authority to provide
the time, form and manner for making
the election under section 451(c)(1)(B),
and the categories of advance payments
for which an election can be made.
Under section 451(c)(2)(B), the election
is effective for the taxable year that it is
first made and for all subsequent taxable
years, unless the taxpayer receives the
consent of the Secretary to revoke the
election. Section 451(c)(3) provides that
the deferral election does not apply to
advance payments received in the
taxable year that the taxpayer ceases to
exist.
Section 451(c)(4)(A) defines advance
payment for purposes of section 451(c).
Under section 451(c)(4)(A), the term
advance payment means any payment
that meets the following three
requirements: (1) The full inclusion of
the payment in gross income in the year
of receipt is a permissible method of
accounting; (2) any portion of the

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advance payment is included in revenue
in an AFS for a subsequent tax year; and
(3) the advance payment is for goods,
services, or such other items that the
Secretary has identified. Section
451(c)(4)(B) lists certain payments that
are excluded from the definition of
advance payment and gives the
Secretary the authority to identify other
payments to be excluded from the
definition. Section 451(c)(4)(C) provides
a special definition of the term ‘‘receipt’’
for purposes of the definition of advance
payment, and section 451(c)(4)(D) states
that rules similar to those for allocating
the transaction price among
performance obligations in section
451(b)(4) also apply for purposes of
section 451(c).
III. Prior Guidance
On April 12, 2018, the Department of
the Treasury (Treasury Department) and
the IRS issued Notice 2018–35, 2018–18
I.R.B. 520, providing interim guidance
on the treatment of advance payments
and requesting suggestions for future
guidance under section 451(b) and
section 451(c). On September 27, 2018,
the Treasury Department and the IRS
issued Notice 2018–80, 2018–42 I.R.B.
609, announcing that the Treasury
Department and the IRS intend to issue
proposed regulations providing that
accrued market discount is not
includible in income under section
451(b).
On September 9, 2019, the Treasury
Department and the IRS published
proposed regulations under section
451(b) (REG–104870–18, 84 FR 47191)
(proposed section 451(b) regulations)
and proposed regulations under section
451(c) (REG–104554–18, 84 FR 47175)
(proposed section 451(c) regulations),
referred to collectively hereinafter as the
‘‘proposed regulations.’’ The notices of
proposed rulemaking for section 451(b)
and (c) reflect consideration of the
comments received in response to
Notice 2018–35.
A public hearing on the proposed
regulations was held on December 10,
2019, at which two speakers provided
testimony. The Treasury Department
and the IRS received approximately ten
written comments responding to the
proposed regulations.
After the comment period for the
proposed regulations closed, the
Treasury Department and the IRS
received a comment letter regarding the
allocation of transaction price for
contracts that include both income
subject to section 451 and income
subject to a special method of
accounting provision, specifically,
section 460. In response to these
comments, in the Explanation of

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Provisions of a notice of proposed
rulemaking (REG–132766–18) that was
published on August 5, 2020 (85 FR
47508), the Treasury Department and
the IRS suggested allocation rules and
requested comments regarding the
application of section 451(b)(2) and (4)
to contracts with income that is
accounted for in part under proposed
§ 1.451–3 and in part under a special
method of accounting. No formal
comments were received regarding these
suggested rules.
Comments received before these
regulations were substantially
developed, including all comments
received on or before the deadline for
comments on November 8, 2019, were
carefully considered in developing these
regulations. Copies of the comments
received are available for public
inspection at http://
www.regulations.gov or upon request.
After consideration of the comments
received and the testimony at the public
hearing, this Treasury decision adopts
the proposed regulations as revised in
response to such comments and
testimony. The comments and the
revisions are discussed in the Summary
of Comments and Explanation of
Revisions section of this preamble.
Summary of Comments and
Explanation of Revisions
I. Overview
This Summary of Comments and
Explanation of Revisions section
summarizes the formal written
comments and some of the informal
commentary, both in writing and at
public events, addressing the proposed
regulations. Comments merely
summarizing or interpreting the
proposed regulations or recommending
statutory revisions generally are not
discussed in this preamble. Similarly,
comments outside the scope of this
rulemaking generally are not addressed
in this Summary of Comments and
Explanation of Revisions section.
II. Comments and Explanation of
Revisions Regarding the Proposed
Section 451(b) Regulations
A. Realization and Recognition
As noted in the preamble to the
proposed section 451(b) regulations,
footnote 872 of the Conference Report to
the TCJA states that section 451(b) was
not intended to revise the rules
associated with when an item is realized
for Federal income tax purposes and
does not require the recognition of
income in situations where the Federal
income tax realization event has not
taken place. See H.R. Rep. No. 115–466,
at 428 fn. 872 (2017) (Conf. Rep.). As

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also noted in the preamble to the
proposed section 451(b) regulations,
footnote 874 of the Conference Report
provides, by way of example, that the
timing rules of section 451(b) apply to
unbilled receivables for partially
performed services. Id. at 428 fn. 874.
Commenters provided little
commentary on footnote 874, except to
state that it is contrary to footnote 872.
Instead, the commenters presented two
views. First, some commenters
highlighted footnote 872 and cited case
law to support the claim that a
realization event is, and has always
been, a prerequisite for income
recognition. These commenters
acknowledged, however, that the case
law frames the issue not in terms of
‘‘realization’’ but rather in terms of
whether a seller has a fixed right to
income under the all events test.
Second, some commenters suggested
definitions of realization. However,
these recommended definitions differ,
particularly as to whether realization
applies to the provision of services. For
example, some commenters described
realization as applying to both contracts
for the provision of services and
contracts for the sale of goods, and
stated that realization occurs when the
taxpayer has a ‘‘fixed and unconditional
right to payment’’ under the contract.
One commenter reasoned that existing
judicial precedents require realization
without distinguishing between whether
the income is for the performance of
services or the sale of property. Another
commenter asserted that realization
means there has been a sale or
disposition under section 1001(a),
suggesting that realization applies only
to the sale of property. In sum, these
commenters suggested that the proposed
section 451(b) regulations do not give
effect to footnote 872 in the Conference
Report and ask that the final regulations
either explicitly define realization or
clarify when realization occurs in
certain circumstances, such as where a
taxpayer produces goods for customers
or where a taxpayer provides nonseverable services to customers.
The Treasury Department and the IRS
have considered these comments and
decline to define the term realization in
the final regulations. Congress did not
explicitly define realization in the
Conference Report. Some of the
suggested definitions of realization,
particularly the ones equating
realization with the all events test,
would nullify the AFS Income Inclusion
Rule entirely, which is clearly contrary
to Congress’ intent. Accordingly, it is
reasonable to conclude that Congress
intended a different concept of
realization that would give full effect to

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the statute. Further, the final regulations
do not clarify when realization occurs in
specific circumstances. Realization is a
factual determination that, while closely
aligned with the all events test, has
different meanings in different contexts.
Section 451 is a timing provision and
the amendments to section 451(b)(1)(A)
by TCJA were intended to modify the
timing of income to require an accrual
method taxpayer with an AFS to treat
the right to income as fixed, under the
all events test, no later than the time at
which the item (or portion thereof) is
taken into account in its AFS. The
statute thus reflects Congress’ intent to
incorporate timing concepts from the
financial reporting rules in the tax
timing rules for including items in gross
income. It does not seek to answer
whether the AFS income inclusion has
been realized. Accordingly, the focus of
the final regulations is on the
appropriate taxable year of AFS income
inclusion.

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B. Scope of AFS Income Inclusion Rule
1. Proposed § 1.451–3(b): General Rule
The general AFS Income Inclusion
Rule in the proposed section 451(b)
regulations provides that, if a taxpayer
includes an item of gross income, or
portion thereof, in revenue in the
taxpayer’s AFS, the taxpayer must
include the item in gross income under
section 451(b). In addition to
commenting that the general rule in the
proposed section 451(b) regulations
potentially overrides the realization
requirement, contrary to footnote 872 of
the Conference Report, commenters
suggested that the rule is overbroad and
could cause taxpayers to incur a tax
liability without having the money to
pay the liability.
The Treasury Department and the IRS
note that the potential to incur a tax
liability without having the money to
pay the liability is inherent in the
accrual method. However, the Treasury
Department and the IRS acknowledge
that the proposed AFS Income Inclusion
Rule could exacerbate this situation and
that the proposed rule could result in
inclusions that would be inconsistent
with footnote 872 of the Conference
Report. Accordingly, the final
regulations provide that, under the AFS
Income Inclusion Rule, the all events
test under § 1.451–1(a) for any item of
gross income, or portion thereof, is met
no later than when that item, or portion
thereof, is ‘‘taken into account as AFS
revenue.’’ In determining when an item
of gross income is ‘‘taken into account
as AFS revenue,’’ AFS revenue is
reduced by amounts that the taxpayer
does not have an enforceable right to

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recover if the customer were to
terminate the contract on the last day of
the taxable year. The determination of
whether the taxpayer has an enforceable
right to recover amounts of AFS revenue
is governed by the terms of the contract
and applicable Federal, state, or
international law, and includes amounts
recoverable in equity and liquidated
damages.
The revised rule is designed to
reconcile the intended preservation of
the realization concept, consistent with
footnote 872 of the Conference Report,
with the intended scope of section
451(b), as illustrated in footnote 874 of
the Conference Report. The revised rule
is also consistent with concepts
illustrated in Example 4 in the Joint
Committee on Taxation, General
Explanation of Public Law 115–97 (JCS–
1–18) at 163 (Dec. 20, 2018) (Blue Book).
In the example, the taxpayer enters into
a contract with a customer for a
customized piece of machinery. Under
the contract, the taxpayer will not
invoice the customer until the item is
delivered to the customer, the customer
accepts the machinery, and title to the
machinery has transferred to the
customer. The contract specifically
provides that, if the customer withdraws
from the agreement, the taxpayer has an
enforceable right to payment as the
work is performed, even if the contract
is not completed. The taxpayer does not
complete the machinery in year one but
includes an amount in revenue in its
AFS in year one. Example 4 concludes
that, under the AFS Income Inclusion
Rule, the taxpayer is required to
recognize the amount in year one. The
revised AFS Income Inclusion Rule in
the final regulations incorporates the
key elements reflected in Example 4.
To reduce any additional compliance
burdens, the final regulations provide
an alternative method to determine
when an item of gross income is treated
as ‘‘taken into account as AFS revenue’’
under the AFS Income Inclusion Rule.
Under the ‘‘alternative AFS revenue
method’’, the taxpayer does not reduce
AFS revenue by amounts that the
taxpayer lacks an enforceable right to
recover if the customer were to
terminate the contract on the last day of
the taxable year. The alternative AFS
revenue method is a method of
accounting that applies to all items of
gross income in the trade or business
that are subject to the AFS income
inclusion rule. Taxpayers using the
alternative AFS revenue method may
also use the AFS cost offset method
provided in the final regulations.
Under the final regulations two
additional adjustments to AFS revenue
are made in determining whether an

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item of gross income is treated as ‘‘taken
into account as AFS revenue.’’ These
adjustments apply both under the AFS
Income Inclusion Rule and under the
alternative AFS revenue method. First,
if the transaction price, as defined in
§ 1.451–3(a)(14), was increased because
a significant financing component is
deemed to exist under the standards the
taxpayer uses to prepare its AFS, then
any AFS revenue attributable to such
increase is disregarded. In such
situations, total AFS revenue taken into
account over the term of the contract
exceeds the stated consideration in the
contract and such excess is, for AFS
purposes, offset by a corresponding
interest expense. Because such excess is
generally not imputed income for
Federal income tax purposes and a
deduction for the AFS interest expense
is generally not imputed for Federal
income tax purposes, it is necessary to
adjust AFS revenue to prevent the
improper acceleration, or overreporting,
of gross income. If situations arise in
which imputed income and imputed
deductions are also required for Federal
income tax purposes, an adjustment to
AFS revenue is still appropriate as the
amount and timing of the imputed
income would be outside the scope of
section 451 and the regulations
thereunder. Second, to the extent that
AFS revenue reflects a reduction for (1)
amounts that are cost of goods sold or
liabilities that are required to be
accounted for under other provisions of
the Code, such as section 461, including
liabilities for allowances, rebates,
chargebacks, rewards issued in credit
card and other transactions and other
reward programs, and refunds (for
example, estimated returns based on
historic practice), regardless of when
any such amount is incurred (Liability
Amounts); or (2) amounts anticipated to
be in dispute or anticipated to be
uncollectable, the taxpayer must
increase AFS revenue by such amounts.
The Treasury Department and the IRS
have determined that adjustments for
such amounts are necessary to prevent
the taxpayer from effectively taking
such amounts into account for Federal
income tax purposes in a taxable year
prior to the taxable year in which they
are otherwise permitted to be taken into
account under other provisions of the
Code. Additionally, if AFS revenue is
not adjusted for Liability Amounts in
the taxable year that such amounts are
otherwise permitted to be taken into
account, then a taxpayer may obtain an
improper double benefit by taking such
amounts into account to reduce taxable
income under another provision of the
Code while also deferring an equal

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amount of gross income to a later year
under § 1.451–3. The AFS revenue
adjustments in the final regulations do
not preclude a taxpayer from accounting
for trading stamps and premium
coupons under § 1.451–4. However, the
Treasury Department and the IRS are
still evaluating whether the rules in
§ 1.451–4 should be modified or
clarified in light of certain financial
reporting changes under ASC 606.
On a separate issue relating to the
scope of the AFS Income Inclusion
Rule, taxpayers questioned, in light of
the realization discussion in footnote
872, whether the AFS Income Inclusion
Rule applies to the sale of goods. Since
Example 4 of the Blue Book involves the
sale of goods, it is reasonable to
conclude that Congress intended for the
AFS Income Inclusion Rule, as revised,
to extend to contracts for the sale of
goods. Accordingly, as with the
proposed section 451(b) regulations, the
final regulations provide that the AFS
Income Inclusion Rule applies to
contracts for the sale of goods.
2. Proposed § 1.451–3(b): Cost Offset for
AFS Income Inclusions
Proposed § 1.451–3(b) does not
provide for a cost offset when an
amount is included under the AFS
Income Inclusion Rule. The preamble to
the proposed section 451(b) regulations
discusses reasons for not providing a
cost offset, including the potential for
income distortions and Congressional
intent that a cost offset not be provided.
The preamble to the proposed section
451(b) regulations requests comments
on this issue.
Multiple commenters proposed
allowing an offset for the cost of goods
sold (COGS) when income is included
under the AFS Income Inclusion Rule.
Commenters pointed out that the term
‘‘item of gross income’’ generally means
total sales net of COGS. See, for
example, § 1.61–3(a). Commenters also
described situations where income
might be distorted by inclusions in early
years of a multi-year contract with the
costs being allowed in later years
without income to offset. Commenters
expressed concern that, in these
situations, or more generally, the AFS
Income Inclusion Rule might operate as
a tax on gross receipts.
One commenter suggested that the
statute uses the AFS as a backstop to
timing recognition of revenue because
the AFS provides a good standard by
which to determine when a taxpayer
receives an economic benefit. The
commenter acknowledged that there has
been a policy interest in achieving
greater book-tax conformity in a variety
of areas. The commenter recommended

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that, if the final regulations use the AFS
to measure the receipt of an economic
benefit, then the final regulations also
should reflect the AFS standards that
require certain items of income be
reported ‘‘net’’ of offsetting items.
Commenters also noted that, for AFS
purposes, credit card issuers generally
report interchange fees net of estimated
reward costs and report credit card late
fees net of estimated uncollectable
amounts. Commenters explained that
reward costs and uncollectable credit
card late fees ‘‘are so closely aligned
with the realization of income that AFS
standards require those items to be
presented separately in the revenue
section of the income statement but
concurrently as to timing.’’ One
commenter expressed concern that not
reducing interchange fees by estimated
reward costs and credit card late fees by
estimated uncollectable amounts in
determining the amount of income
recognized under the AFS Income
Inclusion Rule would result in the
inclusion of more income for Federal
income tax purposes than was reported
on the AFS.
Accordingly, commenters
recommended that the final regulations
provide that the all events test and the
economic performance requirement
under section 461 should be deemed to
be met for items that are ‘‘closely
aligned’’ with income amounts
recognized under the AFS Income
Inclusion Rule. Commenters explained
that section 461 should be deemed to be
met for items such as estimated reward
costs and estimated uncollectable late
fees to the extent these items are
reported on the revenue section of the
AFS as a reduction to amounts subject
to the AFS Income Inclusion Rule. One
commenter further explained that this
treatment would be consistent with the
clear reflection of income doctrine of
section 446. Alternatively, one
commenter recommended modifying
the definition of transaction price under
proposed § 1.451–3(c)(6) to reduce
interchange fees by the amount of
reward costs that satisfy section 461 and
credit card late fees by amounts that are
considered uncollectable for AFS
purposes.
The Treasury Department and the IRS
have considered these comments and
have determined that a cost offset based
on estimates of future costs would be
inappropriate. As discussed in the
preamble to the proposed section 451(b)
regulations, allowing a cost offset based
on estimated costs would be
inconsistent with sections 461, 263A,
and 471, and the regulations under
those sections of the Code. In addition,
a cost offset based on estimated costs

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813

would increase the possibility of income
distortions as the costs of goods would
effectively be recovered, through
income deferral, prior to the taxable
year in which the cost was actually
incurred.
However, the Treasury Department
and the IRS agree with comments
suggesting that taxpayers should be
afforded the flexibility of applying an
offset for costs incurred against AFS
income inclusions from the future sale
of inventory, the ‘‘AFS cost offset
method.’’ Accordingly, a taxpayer that
uses the AFS cost offset method
determines the amount of gross income
includible for a year prior to the year in
which ownership of inventory transfers
to the customer by reducing the amount
of revenue it would otherwise be
required to include under the AFS
Income Inclusion Rule for the taxable
year (AFS inventory inclusion amount)
by the cost of goods related to the item
of inventory for the taxable year, the
‘‘cost of goods in progress offset.’’ The
net result is the amount that is required
to be included in gross income for that
year under the AFS Income Inclusion
Rule. The deferred revenue, that is, the
revenue that was reduced by the cost of
goods in progress offset for a taxable
year prior to the taxable year that
ownership of the item of inventory is
transferred to the customer, is generally
taken into account in the taxable year in
which ownership of the item of
inventory is transferred to the customer.
The final regulations provide that the
cost of goods in progress offset for each
item of inventory for the taxable year is
calculated as (1) the cost of goods
incurred through the last day of the
taxable year, (2) reduced by the
cumulative cost of goods in progress
offset amounts attributable to the items
of inventory that were taken into
account in prior taxable years, if any.
However, the cost of goods in progress
offset cannot reduce the AFS inventory
inclusion amount for the item of
inventory below zero. Further, the cost
of goods in progress offset attributable to
one item of inventory cannot reduce the
AFS inventory inclusion amount
attributable to a separate item of
inventory. Any cost of goods that were
not used to offset AFS inventory
inclusion amounts because they were
subject to limitation are considered
when the taxpayer determines the cost
of goods in progress offset for that item
of inventory in a subsequent taxable
year.
The cost of goods in progress offset is
determined by reference to the costs and
expenditures related to each item of
inventory produced or acquired for
resale, which costs have been incurred

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under section 461 and have been
capitalized and included in inventory
under sections 471 and 263A or any
other applicable provision of the Code
at the end of the year. However, the cost
of goods in progress offset does not
reduce the costs that are capitalized to
the item of inventory produced or
acquired for resale by the taxpayer
under the contract. That is, while the
cost of goods in progress offset reduces
the AFS inventory inclusion amount, it
does not affect how and when costs are
capitalized to inventory under sections
471 and 263A or any other applicable
provision of the Code or when those
capitalized costs will be recovered.
Instead, the cost of goods in progress
offset serves only to reduce or ‘‘offset’’
any AFS income inclusion amounts for
the item of inventory and defer such
amounts to the taxable year in which
ownership of the item of inventory is
transferred to the customer.
The costs of goods comprising the
cost of goods in progress offset must be
determined by applying the inventory
accounting methods used by the
taxpayer for Federal income tax
purposes. A taxpayer must calculate its
cost of goods in progress offset by
reference to all costs that the taxpayer
has permissibly capitalized and
allocated to items of inventory under its
inventory method, but may not consider
costs that are not properly capitalized
under such method.
In the taxable year in which
ownership of the item of inventory is
transferred to the customer, any revenue
deferred by way of a prior year cost
offset is included in gross income in the
year of the transfer along with any
additional revenue that is otherwise
required to be included in gross income
under the AFS Income Inclusion Rule
for such year. Although no cost offset is
permitted in such year, the taxpayer
would recover costs capitalized and
allocated to the item of inventory
transferred as cost of goods sold in such
year in accordance with sections 471
and 263A or any other applicable
provision of the Code. However, if in a
taxable year prior to the taxable year in
which ownership of the item of
inventory is transferred to the customer,
either (A) the taxpayer dies or ceases to
exist in a transaction other than a
transaction to which section 381(a)
applies, or (B) the taxpayer’s obligation
to the customer with respect to the item
of inventory ends other than in a
transaction to which 381(a) applies or
certain section 351(a) transactions
between members of the same
consolidated group, then all payments
received for the item of inventory that
were not previously included in gross

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income as a result of the application of
the cost offset rules are required to be
included in gross income in such year.
The Treasury Department and the IRS
adopted this approach in the final
regulations because the AFS cost offset
method provides options for taxpayers.
All taxpayers that are required to
account for income from the sale of
inventory under the AFS income
inclusion rule and that report AFS
revenue in a taxable year prior to the
taxable year in which ownership of the
item of inventory is transferred to the
customer will generally be required to
accelerate income inclusions under
such rule. However, taxpayers have the
option of using the AFS cost offset
method to reduce the amount of income
they are required to accelerate under
such rule. The AFS cost offset allows
taxpayers to reasonably match income
inclusions and incurred cost of goods,
and more clearly reflects income.
The final regulations adopt a cost of
goods sold offset based on incurred
costs because the approach is consistent
with § 1.61–3 and more objective than a
cost of goods sold offset based on
projected future costs. In addition, the
AFS cost offset method provides a
degree of parity for sellers of goods with
service providers who deduct costs as
incurred without capitalizing the costs
to inventory. A cost offset based on
projected future cost of goods sold was
rejected because it is inconsistent with
sections 461(h), 263A and 471, and the
regulations under those sections of the
Code. Further, Congress rejected the
deferral method for advance payments
in former § 1.451–5(c), which contained
a cost of goods sold offset for estimated
future costs. See Conf. Rep. at 429 fn.
880.
The AFS cost offset method is a
method of accounting that applies to all
items of income eligible for the AFS cost
offset method in the trade or business.
The method applies to items at the trade
or business level so that taxpayers can
choose to apply the method only to
trades or businesses where the burden
of determining costs incurred relative to
the related reduction in AFS income
inclusion amount warrants the adoption
of the method. If a taxpayer uses the
AFS cost offset method for a trade or
business it must use the method for all
eligible items in that trade or business.
Further, if a taxpayer uses the AFS cost
offset method, it must also use the
advance payment cost offset method in
§ 1.451–8(e). The advance payment cost
offset method is discussed later in this
preamble. Special coordination rules
exist for taxpayers that use the AFS cost
offset method and the advance payment
cost offset method and that have income

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from the sale of an item of inventory
that is required to be accounted for
under both §§ 1.451–3 and 1.451–8
because certain payments received for
such item meet the definition of an
advance payment under § 1.451–8(a)(1).
See § 1.451–3(c)(1) for such
coordination rules.
The AFS cost offset method reduces
the amount of income from the sale of
an item of inventory that is required to
be accelerated under the AFS Income
Inclusion Rule by an amount of incurred
cost of goods related to the item.
However, the offsets to interchange fees
and credit card late fees recommended
by the commenters are based on
estimated reward costs and
uncollectable late fees rather than
incurred costs of goods. Accordingly,
the final regulations do not allow a cost
offset for interchange fees, credit card
late fees, and similar items of revenue
that are subject to the AFS Income
Inclusion Rule and reported net of
estimated future amounts for AFS
purposes.
3. Proposed § 1.451–3(c)(4) and (c)(6)(ii):
Revenue, Transaction Price and
Increases in Consideration
Proposed § 1.451–3(c)(4) provides
that, for the AFS Income Inclusion Rule,
revenue means all transaction price
amounts includible in gross income
under section 61 of the Code. Proposed
§ 1.451–3(c)(6) provides that the
transaction price is the gross amount of
consideration to which a taxpayer
expects to be entitled for AFS purposes
in exchange for transferring goods,
services, or other property, but not
including, among other things,
‘‘increases in consideration’’ to which a
taxpayer’s entitlement is contingent on
the occurrence or nonoccurrence of a
future event for the period in which the
amount is contingent.
Commenters expressed confusion
about the phrase ‘‘increases in
consideration’’ because the definition of
transaction price otherwise refers to
‘‘amounts’’ and does not distinguish
between increases and decreases.
Commenters asserted that there is no
reason to treat ‘‘increases’’ in
consideration different from other
consideration because all consideration
is not realized until the taxpayer has a
fixed right to payment. Commenters
concluded that any portion of the
contract price subject to a contractual
contingency, for example, a future
performance, is excluded from the
transaction price until the contingency
is satisfied. In addition, one commenter
noted that it is unclear when there is a
contingent ‘‘increase’’ in consideration,

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and taxpayers could revise the contract
terms to meet this requirement.
The Treasury Department and the IRS
agree with these comments. The term
‘‘increases in consideration’’ was meant
to signal income items that are subject
to a condition precedent, such as bonus
payments that require complete
performance before the taxpayer is
entitled to the bonus payment. The final
regulations have been revised to remove
the reference to ‘‘increases in
consideration’’ entirely. The concept is
now subsumed by the general rule that,
to determine when an item of gross
income is ‘‘taken into account as AFS
revenue’’ under the AFS Income
Inclusion Rule, AFS revenue is reduced
by amounts that the taxpayer does not
have an enforceable right to recover if
the customer were to terminate the
contract at the end of the taxable year.
If an amount is contingent due to a
condition precedent, such as with some
bonus payments, and the taxpayer
would not have an enforceable right to
recover such amount if the customer
were to terminate the contract at the end
of the taxable year, the AFS Income
Inclusion Rule does not require the
taxpayer to include such amount in
gross income in the current year.
4. Proposed § 1.451–3(c)(6)(ii):
Rebuttable Presumption
Proposed § 1.451–3(c)(6)(ii) provides a
rebuttable presumption that amounts
included in revenue in an AFS are
presumed to not be contingent on the
occurrence or nonoccurrence of a future
event unless, upon examination of all
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.
Commenters requested that the final
regulations remove the rebuttable
presumption regarding contingent
consideration. Commenters reasoned
that the rebuttable presumption imposes
a higher standard of proof upon
taxpayers than is ordinarily required to
establish that consideration is
contingent. Additionally, commenters
noted that basing the presumption on
the treatment of the consideration for
financial reporting purposes is not
sensible because the financial
accounting rules do not make the
conclusion dependent on whether the
consideration is or is not contingent on
the occurrence or non-occurrence of a
future event. Rather, under the
Financial Accounting Standards Board
(FASB) and International Accounting
Standards Board, Accounting Standards
Codification (ASC) Topic 606 and

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International Financial Reporting
Standards (IFRS) 15, Revenue from
Contracts with Customers (collectively,
ASC 606), the recognition of contingent
consideration is based on a
determination of the likely outcome of
the contingency. Accordingly,
commenters recommended that the final
regulations eliminate the presumption
in favor of noncontingency.
As noted earlier, the final regulations
have been revised to remove the
reference to ‘‘contingent consideration’’
entirely. The concept is now subsumed
by the general rule that, to determine
when an item of gross income is ‘‘taken
into account as AFS revenue’’ under the
AFS Income Inclusion Rule, AFS
revenue is reduced by amounts that the
taxpayer does not have an enforceable
right to recover if the customer
terminates the contract at the end of the
taxable year. Given this change, the final
regulations remove the rebuttable
presumption that a taxpayer has an
enforceable right to amounts included
in AFS revenue.
5. Proposed § 1.451–3(c)(6)(ii):
Enforceable Right to Payment
Commenters requested that the final
regulations clarify or remove the rule in
proposed § 1.451–3(c)(6)(ii) that treats
amounts for which the taxpayer has an
‘‘enforceable right to payment’’ for
performance completed to date as not
contingent on the occurrence or
nonoccurrence of a future event. First,
commenters reasoned that the rule is
ambiguous, resulting in controversies
with exam. Second, commenters
asserted that, assuming the phrase
‘‘enforceable right to payment’’ is based
on the financial statement rules in ASC
606, this standard effectively overrides
the tax realization requirement requiring
a fixed, unconditional right to payment.
Further, commenters reasoned that the
rule is inconsistent with the exception
for increases in consideration to which
a taxpayer’s entitlement is contingent on
the occurrence or nonoccurrence of a
future event.
The Treasury Department and the IRS
agree with these comments. As
discussed earlier, the final regulations
modify the general AFS Income
Inclusion Rule by reducing the AFS
revenue that is accelerated and included
in gross income. Under the AFS Income
Inclusion Rule, to determine when the
item of gross income is ‘‘taken into
account as AFS revenue,’’ AFS revenue
is reduced by amounts that the taxpayer
does not have an ‘‘enforceable right’’ to
recover if the customer were to
terminate the contract on the last day of
the taxable year. The term ‘‘enforceable
right’’ is specifically defined in § 1.451–

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815

3(a)(9) as any right that a taxpayer has
under the terms of a contract or under
applicable federal, state, or international
law, including rights to amounts
recoverable in equity or liquidated
damages.
6. Proposed § 1.451–3(c)(6)(iii):
Reductions for Amounts Subject to
Section 461 and Disputed Income
Proposed § 1.451–3(c)(6)(iii) provides
that the ‘‘transaction price’’ does not
include reductions for amounts subject
to section 461, including amounts
anticipated to be in dispute, returns,
and rewards issued in credit card
transactions. One commenter
recommended that the final regulations
clarify that rewards issued in credit card
transactions are subject to section 461
and do not reduce original issue
discount (OID) income in any
circumstance, regardless of the structure
of the credit card program. The
commenter requested this clarification
because taxpayers have taken different
positions on the treatment of these
rewards while the IRS has taken the
position that rewards do not reduce OID
income. The commenter stated that the
better approach is to treat these rewards
as liabilities under section 461. The
commenter further explained that
treating these rewards as amounts
subject to section 461 in all
circumstances would create uniformity
among credit card issuers, reduce
controversy between taxpayers and the
IRS, and ease the compliance burden on
taxpayers by eliminating the need for a
facts and circumstances analysis of each
credit card program. The Treasury
Department and the IRS agree with the
commenter and have modified the final
regulations in § 1.451–3(b)(2)(i)(A)(1) to
clarify that rewards issued in a credit
card transaction are items subject to
section 461.
Commenters also questioned whether
the AFS Income Inclusion Rule modifies
the treatment of income amounts subject
to an actual dispute or a clerical error
(disputed income amounts). The AFS
Income Inclusion Rule does not modify
the treatment of disputed income
amounts. The principles set forth in
Revenue Ruling 2003–10, 2003–1 C.B.
288, continue to apply. For example, an
accrual method taxpayer does not
accrue gross income in the taxable year
of sale if, during the year of sale, the
customer disputes its liability to the
taxpayer. In addition, if an accrual
method taxpayer overbills a customer
due to a clerical mistake, and the
customer disputes the liability in the
subsequent taxable year, the taxpayer
must accrue gross income in the taxable
year of sale for the correct amount.

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Lastly, if a taxpayer ships excess
quantities of goods and the customer
does not dispute the shipment and
agrees to pay for the excess quantities of
goods, the taxpayer accrues gross
income in the amount of the agreed
payment in the taxable year of the sale.
In response to these comments, the
final regulations clarify that, under the
AFS Income Inclusion Rule, to the
extent that AFS revenue was reduced
for amounts anticipated to be in dispute
or anticipated to be uncollectable, AFS
revenue is increased by such amounts.
Accordingly, although ASC 606 reduces
the transaction price for anticipated
disputes to determine the amount of
revenue to include on an AFS, see ASC
606–10–32–6, AFS revenue is increased
for amounts anticipated to be in dispute
or anticipated to be uncollectable,
because those amounts are included in
gross income until they are actually
disputed.
C. Proposed § 1.451–3(c)(5): Special
Method of Accounting
Proposed § 1.451–3(c)(5) provides a
non-exhaustive list of examples of
special methods of accounting to which
the AFS Income Inclusion Rule
generally does not apply. Commenters
requested that the final regulations
include the methods of accounting for
notional principal contracts under
§ 1.446–3 and the timing rules for
stripped bonds under section 1286 as
examples of special methods of
accounting. The Treasury Department
and the IRS adopt these comments in
the final regulations and have added
additional special methods for
clarification purposes. The list of
special methods of accounting remains
non-exhaustive.

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D. Proposed § 1.451–3(d): Exceptions to
the AFS Income Inclusion Rule
Proposed § 1.451–3(d) describes the
exceptions to the AFS Income Inclusion
Rule. The proposed rule clarifies that
the AFS Income Inclusion Rule does not
apply unless all of the taxpayer’s entire
taxable year is covered by an AFS. In
addition, the AFS Income Inclusion
Rule does not cover items of income in
connection with a mortgage servicing
contract. A commenter requested that an
exception be added for any amount that
has not yet been realized for Federal
income tax purposes. As discussed
earlier, the Treasury Department and the
IRS decline to adopt this suggestion
because providing rules on realization is
beyond the scope of these final
regulations.

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E. Proposed § 1.451–3(g): Contracts With
Multiple Performance Obligations
1. Proposed § 1.451–3(g): Allocation of
Transaction Price to Contracts With
Multiple Performance Obligations
Subject to Section 451(b)
Proposed § 1.451–3(g) provides that if
a taxpayer’s contract with a customer
has multiple performance obligations
subject to section 451(b), transaction
price is allocated to performance
obligations as transaction price is
allocated to performance obligations in
the taxpayer’s AFS.
The final regulations clarify that each
performance obligation yields an item of
gross income that must be accounted for
separately under the AFS Income
Inclusion Rule. When a contract
contains multiple performance
obligations, to determine the amount of
gross income allocated to each
performance obligation, the transaction
price determined under the taxpayer’s
applicable accounting principles, is
allocated to each corresponding item of
gross income in accordance with how
the transaction price is allocated to each
performance obligation for AFS
purposes. If the accounting standards
used to prepare the AFS identify a
single performance obligation that
yields more than one corresponding
item of gross income, the portion of the
transaction price amount that is
allocated to the single performance
obligation for AFS purposes must be
further allocated among the
corresponding items of gross income
using any reasonable method.
The final regulations simplify the
definition of transaction price. The final
regulations define the term transaction
price to mean the total amount of
consideration to which a taxpayer is, or
expects to be, entitled from all
performance obligations under a
contract. The transaction price is
determined under the standards the
taxpayer uses to prepare its AFS.
Accordingly, adjustments to the
transaction price that were reflected in
the transaction price definition in the
proposed regulations have, to the extent
relevant under these final regulations,
been moved to operative rules to ensure
clarity. See § 1.451–3(b)(2) and (d)(3).
In addition, the final regulations
clarify how the transaction price should
be allocated to the extent the transaction
price includes a reduction for liabilities,
amounts anticipated to be in dispute or
anticipated to be uncollectable, or a
significant financing component that is
deemed to exist under the standards the
taxpayer uses to prepare its AFS. The
final regulations clarify that the
taxpayer must determine the specific

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performance obligation to which such
reduction relates and increase the
transaction price allocable to the
corresponding item of gross income by
the amount of the reduction (specific
identification approach). If it is
impracticable from the taxpayer’s
records to use the specific identification
approach, the final regulations allow
taxpayers to use any reasonable method
to allocate the amount to the items of
gross income in the contract. The final
regulations also provide that a pro-rata
allocation of this amount across all
items of gross income under the contract
based on the relative transaction price
amounts allocated to the items for AFS
purposes is a reasonable method.
Similarly, the final regulations clarify
how the transaction price should be
allocated if the transaction price was
increased because a significant
financing component is deemed to exist
under the standards the taxpayer uses to
prepare its AFS. In this situation, the
taxpayer must determine the specific
performance obligation to which such
amount relates and decrease the
transaction price amount allocable to
the corresponding item of gross income
by such amount (the ‘‘specific
identification approach’’). If it is
impracticable from the taxpayer’s
records to use the specific identification
approach, the taxpayer may use any
reasonable method to allocate such
amount to the items of gross income in
the contract. The final regulations
provide that a pro-rata allocation of
such amount across all items of gross
income under the contract based on the
relative transaction price amounts
allocated to the items for AFS purposes
is a reasonable method.
2. Proposed § 1.451–3(g): Contracts With
Income Subject to § 1.451–3 and Income
Subject to a Special Method of
Accounting
In the proposed regulations, the
Treasury Department and the IRS
requested comments on the allocation of
the transaction price for contracts that
include both income subject to section
451 and income subject to a special
method of accounting provision,
specifically, section 460. A commenter
to the proposed regulations suggested
that the allocation provisions under
section 460 and the regulations
thereunder, and not section 451(b)(4),
should control the amount of gross
income from a long-term contract that is
accounted for under section 460. The
commenter noted that using this
approach is appropriate in light of
section 451(b)(2), which reflects
Congress’s intent to not disturb the
treatment of amounts for which the

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Federal Register / Vol. 86, No. 3 / Wednesday, January 6, 2021 / Rules and Regulations
taxpayer uses a special method of
accounting.
The Treasury Department and the IRS
believe that a rule is necessary to
address the application of section
451(b)(2) and (4) to contracts with
income that is accounted for in part
under § 1.451–3 and in part under a
special method of accounting and
suggested rules for public comment in
the preamble of a separate notice of
proposed rulemaking published in the
Federal Register on August 5, 2020 (85
FR 47508). The suggested rules
provided that if an accrual method
taxpayer with an AFS has a contract
with a customer that includes one or
more items of gross income subject to a
special method of accounting (as
defined in proposed § 1.451–3(c)(5)) and
one or more items of gross income
subject to section 451, the allocation
rules under section 451(b)(4) do not
apply to determine the amount of each
item of gross income that is accounted
for under the special method of
accounting provision. Rather, the
taxpayer first allocates the transaction
price to the item(s) of gross income
subject to a special method of
accounting (as determined under the
special method of accounting). The
remainder of the transaction price, the
‘‘residual amount’’, is then allocated to
the items of gross income that are
subject to § 1.451–3. To the extent the
contract contains more than one item of
gross income that is subject to section
451, the residual amount would be
allocated to each such item in
proportion to the amounts allocated to
the corresponding performance
obligations for AFS purposes. The
Treasury Department and the IRS
requested comments on these suggested
allocation rules. However, no formal
comments were received regarding these
suggested rules.
The final regulations largely adopt the
rules suggested in the preamble to the
separate notice of proposed rulemaking
published in the Federal Register on
August 5, 2020 (85 FR 47508).
Accordingly, the final regulations
provide that the transaction price
allocation rule in § 1.451–3(d)(1) does
not apply to determine the amount of
each item of gross income that is subject
to a special method of accounting.
Rather, the final regulations provide that
the transaction price is first allocated to
items of gross income subject to a
special method of accounting, as
determined under the special method of
accounting. For this purpose, a special
method of accounting has the meaning
set forth in § 1.451–3(a)(13), except as
otherwise provided in guidance

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F. Proposed § 1.451–3(i): Special
Ordering Rule for Certain Items of
Income for Debt Instruments

discount in certain private label credit
card transactions.
Commenters requested that the final
regulations provide that promotional
discount, which also is sometimes
labeled merchant discount, is not a
specified fee. Promotional discount
arises when a credit card issuer charges
a fee to a merchant as compensation for
accepting a below market interest rate
on a credit card balance during a
promotional period. Commenters
explained that promotional discount is
generally included in income over a
promotional or similar period on a
taxpayer’s AFS and, despite possible
alternative labeling, is, in substance, an
adjustment to the yield of a debt
instrument for AFS purposes. The
Treasury Department and the IRS agree
that any fee that adjusts the yield of a
debt instrument for AFS purposes over
the life of the instrument or another
period should not be a specified fee.
Therefore, the final regulations do not
include the phrase ‘‘over the life of the
instrument’’ in the definition of a
specified fee but add the phrase ‘‘spread
over a period of time’’ to clarify the
definition. Thus, a fee that adjusts the
yield of a debt instrument over a
promotional or similar period for AFS
purposes, such as promotional discount,
is not a specified fee under the final
regulations.
One commenter agreed that section
451(b) was not intended to affect the
application of the general OID timing
rules to OID other than for certain fees
that are not treated as discount for AFS
purposes, including the specified credit
card fees. Accordingly, the commenter
agreed with the rules in proposed
§ 1.451–3(i) and the inclusion of the
general OID timing rules as a special
method of accounting. Except as
provided in the preceding paragraph,
the definition of specified fees in the
proposed regulations is adopted in the
final regulations.

Under proposed § 1.451–3(i), if a fee
is not treated by a taxpayer as discount
or as an adjustment to the yield of a debt
instrument over the life of the
instrument (such as points) in its AFS,
and the fee otherwise would be treated
as creating or increasing OID for Federal
income tax purposes (specified fee),
then the rules in the proposed
regulations under section 451(b) apply
before the rules in sections 1271
through 1275 and the corresponding
regulations. Proposed § 1.451–3(i)(2)
provides three examples of specified
fees: Credit card late fees, credit card
cash advance fees, and interchange fees
(specified credit card fees). Interchange
fees are sometimes labeled merchant

G. Proposed § 1.451–3(k): Cumulative
Rule for Multi-Year Contracts
The proposed regulations provide that
for a multi-year contract, a taxpayer
must take into account the cumulative
amounts included in income in prior
taxable years on the contract in order to
determine the amount to be included for
the taxable years remaining in the
contract. The proposed regulations
contain two examples that illustrate this
rule.
The final regulations clarify that if the
item of gross income from a multi-year
contract is from the sale of an item of
inventory and the taxpayer uses the AFS
cost offset method, the taxpayer must
first determine the ‘‘AFS inventory

published in the Internal Revenue
Bulletin (see § 601.601(d)).
To determine the transaction price
allocated to items of gross income
subject to a special method of
accounting, the taxpayer must first
adjust the AFS transaction price by the
amounts described in the final
paragraph of part II.B.1 of this Summary
of Comments and Explanation of
Revisions. Accordingly, if the AFS
transaction price includes a reduction
for cost of goods sold, liabilities,
amounts expected to be in dispute or
anticipated to be uncollectible, or a
significant financing component that
exists under the standards the taxpayer
uses to prepare its AFS, the taxpayer
must increase the transaction price
amount by the amount of such
reduction. If the AFS transaction price
has been increased because a significant
financing component exists under the
standards the taxpayer uses to prepare
its AFS, the taxpayer must decrease the
transaction price amount by the amount
of such increase.
After the taxpayer makes the
adjustments to the transaction price
described earlier, the taxpayer first
allocates such amount to the item(s) of
gross income subject to a special
method of accounting, and then
allocates the remainder (residual
amount) to the item(s) of gross income
that are subject to § 1.451–3. If the
contract, contains more than one item of
gross income that is subject to § 1.451–
3, the taxpayer allocates the residual
amount to these items in proportion to
the amounts allocated to the
corresponding performance obligations
for AFS purposes or as otherwise
provided in guidance published in the
Internal Revenue Bulletin (see
§ 601.601(d)).

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inclusion amount’’ for the taxable year.
The taxpayer determines the AFS
inventory inclusion amount for the
taxable year by first taking the greater of:
(1) The cumulative amount of revenue
from the item of inventory that satisfies
the all events test under § 1.451–1(a)
through the last day of the taxable year,
less the portion of any advance payment
received that is deferred to a subsequent
taxable year under § 1.451–8, if
applicable, or (2) the cumulative
amount of revenue from the item of
inventory that is treated as taken into
account as AFS revenue through the last
day of the taxable year and identifies the
larger of the two amounts or if the two
amounts are equal, the equal amount.
The taxpayer then reduces such amount
by the prior year AFS inventory
inclusion amount for that item of
inventory, if any, to determine the AFS
inventory inclusion amount for the
current taxable year. Lastly, the taxpayer
reduces the AFS inventory inclusion
amount for the taxable year by the cost
of goods in progress offset for the
taxable year (which generally equals the
costs of goods in progress for the item
of inventory as of the end of the year
less the portion of such costs that were
taken into account as a cost of goods in
progress offset for a prior taxable year).
This net amount is the amount required
to be included in gross income in the
taxable year. However, in the taxable
year in which ownership of the item of
inventory is transferred to the customer,
the taxpayer performs the same ‘‘greater
of’’ computation noted earlier, but
rather than subtract the prior year AFS
inventory inclusion amount for the item
of inventory (which is gross of cost
offsets) from the result of the ‘‘greater
of’’ computation, the taxpayer subtracts
all prior year gross income inclusions
for the item of inventory from the result
of the ‘‘greater of’’ computation. This
net amount is the amount required to be
included in gross income in the taxable
year of ownership transfer. The effect of
this computation is that any revenue
reduced by a cost offset in a prior year
is included in gross in the taxable year
in which ownership of the item of
inventory is transferred to the customer.
Although no cost offset is permitted in
such year, the taxpayer would recover
costs capitalized and allocated to the
item of inventory transferred as cost of
goods sold in such year in accordance
with sections 471 and 263A or any other
applicable provision of the Code.
In the case of any other item of gross
income from a multi-year contract, the
taxpayer first compares the cumulative
amount of the item of gross income that
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§ 1.451–1(a) through the last day of the
taxable year with the cumulative
amount of revenue from the item of
gross income that is treated as taken into
account as AFS revenue through the last
day of the taxable year and identifies the
larger of the two amounts (or, if the two
amounts are equal, the equal amount).
The taxpayer then reduces such amount
by all prior year inclusion amounts
attributable to the item of gross income,
if any, to determine the amount required
to be included in gross income in the
current taxable year. Special
coordination rules for applying § 1.451–
8 are also provided to the extent certain
payments received under a multi-year
contract are advance payments. The
analysis in the examples is updated to
reflect the clarifications to the rule.
H. Proposed § 1.1275–2(l): OID Rule for
Income Item Subject to Section 451(b)
Under proposed § 1.1275–2(l),
notwithstanding any other rule in
sections 1271 through 1275 and
§§ 1.1271–1 through 1.1275–7, if, and to
the extent, a taxpayer’s item of income
for a debt instrument is subject to the
timing rules in proposed § 1.451–3(i)
(including credit card late fees, credit
card cash advance fees, or interchange
fees), then the taxpayer does not take
the item into account to determine
whether the debt instrument has any
OID. As a result, the taxpayer does not
treat the item as creating or increasing
any OID on the debt instrument.
Commenters agree with these rules and
note that these rules confirm that the
current treatment of items other than
specified fees will not be affected by
section 451(b). The commenters also
note that removing specified fees,
including specified credit card fees,
from the calculation of OID will permit
taxpayers to apply only the rules of
section 451(b) to these fees, without also
having to apply the OID rules, thereby
reducing taxpayer compliance burdens.
Accordingly, the Treasury Department
and the IRS adopt the rules in proposed
§ 1.1275–2(l) in the final regulations.
I. Other Comments
1. Burial Plots and Interment Rights
Commenters request clarification on
the treatment of income from contracts
with customers for the sale of burial
plots or interment rights, on a pre-need
basis (pre-need contracts). The terms of
the pre-need contracts typically require
the customer to make an initial down
payment and pay the balance of the
sales price over several years. If the
purchaser cancels or fails to perform
under the contract before the entire
purchase price is paid, commenters

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represent that, under every state law,
the taxpayer’s sole remedy is to keep all
or a portion of the installment payments
previously received from the customer
as liquidated damages. Commenters
highlighted that there may be an
extended period of time between the
date the pre-need contract is executed
and the date the taxpayer collects the
full sales price from the customer.
Commenters represented that ASC
606 requires the entire transaction price
from a pre-need contract, net of costs, to
be included in revenue in the year in
which the parties execute the contract.
However, for Federal income tax
purposes, commenters requested that
the final regulations clarify that
taxpayers with pre-need contracts
should not include the unpaid balance
of the transaction price in income in the
taxable year the contract is executed
under the AFS Income Inclusion Rule.
In commenters’ view, the sale of a burial
plot should not be treated as a
completed sale for tax purposes until
the entire sales price of the burial plot
is paid by the customer and ownership
rights in the burial plot are transferred.
Further, the taxpayer does not have an
enforceable right to payment for the
entire transaction price of the plot if the
customer cancels or fails to perform
under the contract.
Commenters concluded that these
taxpayers should be entitled to recover
any allocable cost basis in the burial
plot before including in gross income
any of the installment payments
received from the customer.
Commenters viewed the sale of a burial
plot as the sale of an interest in real
property and assert that the basis
recovery rules of sections 1016 and 1001
apply to prepayments for burial plots.
Under this approach, prepayments for
the purchase price of a burial plot before
the sale of the plot first decrease the
taxpayer’s basis in the burial plot. See
§ 1.1016–2(a). When the prepayments
exceed the taxpayer’s basis in the burial
plot, the taxpayer recognizes the excess
amount as gain. See § 1.1001–1(c)(1).
Accordingly, commenters requested that
the final regulations clarify the
application of sections 1001 and 1016 to
the sale of pre-need burial plots.
Commenters also requested
clarification on the income recognition
treatment of pre-need contracts with
customers for the sale of interment
rights. Commenters noted that the ASC
606 treatment for pre-need contracts for
the sale of interment rights resemble the
treatment for pre-need contracts for the
sale of burial rights. Commenters
viewed the receipt of any installment
payments prior to the transfer of those
rights and prior to the payment of the

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entire transaction price to be controlled
by sections 1001 and 1016, rather than
by sections 451 and 471. Under this
rationale, a taxpayer’s treatment of the
down payment and the installment
payments from pre-need contracts in its
AFS should not determine the timing of
income for tax purposes. Instead,
commenters suggested that the amounts
received before the transfer of the
interment rights should be viewed as a
return of capital and a reduction in the
taxpayer’s basis in the interment space.
The IRS and the Treasury Department
agree that the sale of burial plots and
interment rights are governed by
sections 1001 and 1016 but consider the
determination of whether a sale has
occurred to be a factual issue. If a sale
has occurred under the facts and
circumstances, any income resulting
from the sale is realized under section
1001 and the right to the income is
fixed, therefore the AFS Income
Inclusion Rule does not result in the
acceleration of AFS revenue. If the sale
has not occurred, and the right to the
future payments is extinguished if the
customer cancels the contract, the AFS
Income Inclusion Rule does not require
acceleration because there is no
enforceable right to the future payments
if the contract is cancelled by the
customer provided that the taxpayer is
not using the alternative AFS revenue
method in § 1.451–3(b)(2)(ii).
2. Book Percentage-of-Completion
Method (Book PCM)
One commenter expressed interest in
a Book PCM option as a special method
of accounting that taxpayers with
contracts accounted for using an overtime method of accounting for revenue
under ASC 606 could elect to include
the full amount of revenue reported on
its AFS without regard to any offset or
exception provided in these regulations,
but with an offset for the allocable costs
reported on its AFS, with some
potential tax adjustments. Under ASC
606, the over-time method, where
taxpayers recognize revenue over time
(as opposed to at a point in time) is used
for the following contracts where
control over promised goods or services
is transferred over time: (1) Where the
customer controls the asset as it is
created or enhanced by the entity’s
performance under the contract; (2)
where the customer receives and
consumes the benefits of the entity’s
performance as it performs under the
contract; or (3) where the entity’s
performance creates or enhances an
asset that has no alternative use to the
entity, and the entity has the right to
receive payment for work performed to
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as promised. An entity using an ‘‘overtime method’’ recognizes revenue using
either: (1) An output method, which
measures the value of the goods and
services transferred to date to the
customer (for example, units produced);
or (2) an input method, which
recognizes revenue based on the entity’s
efforts or inputs (for example, labor
hours expended, costs incurred) as
compared to the expected total costs to
satisfy the performance obligation.
Other commenters expressed concern
about allowing a Book PCM option.
Some commenters suggested that
limiting a Book PCM option to only
taxpayers that must report revenue on a
particular over-time basis, such as an
input cost-incurred method, could
create more complexity, not less. Other
commenters suggested that, while a
Book PCM option might achieve some
book-tax conformity, they would still
want the opportunity to take advantage
of tax rules that provide more beneficial
timing than available under Book PCM,
such as additional first year
depreciation. The Treasury Department
and the IRS will continue studying the
feasibility and efficacy of an optional
Book PCM approach. At this time,
however, the Treasury Department and
the IRS decline to adopt the Book PCM
option set forth by commenters because
of the concerns raised regarding the
complexity and the desire by some
taxpayers to obtain more beneficial
timing under tax rules when using a
Book PCM method.
3. AFS Issues
No formal comments were received
regarding the definition of AFS in
proposed § 1.451–3(c)(1). Accordingly,
the definition of AFS remains largely
unchanged in these final regulations.
See § 1.451–3(a)(5). One commenter
questioned the statutory language in
section 451(b) regarding financial
statements prepared using international
financial reporting standards (IFRS).
Specifically, section 451(b)(3)(B)
provides that a financial statement made
on the basis of IFRS is an AFS for
section 451(b) if the financial statement
is filed with a foreign government
agency that is equivalent to the United
States Securities and Exchange
Commission (SEC) and has financial
reporting standards not less stringent
than the standards imposed by the SEC.
Proposed § 1.451–3(c)(1)(iii)(A) and the
final regulations § 1.451–3(a)(5)(ii)(A)
mirror the statutory language. The
commenter questioned whether the
requirement in section 451(b)(3)(B) that
the financial reporting standards of a
foreign agency or government be not
less stringent than the standards

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required by the SEC, refers solely to
reporting standards related to revenue
or if it also refers to reporting standards
for other items that are not related to
revenue. The statutory language does
not distinguish the reporting standards
between revenue and other items that
are not related to revenue. Additionally,
Revenue Procedure 2004–34, which was
the model for the definition of AFS in
section 451(b)(3), did not have similar
language. Accordingly, based on the
plain language of the statute, if the
financial reporting standard for any item
is less stringent than SEC reporting
standards, even if that standard does not
relate to revenue reporting, the
statement will not be an AFS under
proposed § 1.451–3(c)(1)(iii)(A) or
§ 1.451–3(a)(5)(ii)(A) of the final
regulations. However, the financial
reporting standards relativity
requirement does not prevent the IFRS
financial statements from qualifying as
an AFS under proposed § 1.451–
3(c)(1)(iii)(B) or (C) or § 1.451–
3(a)(5)(ii)(B) or (C) of the final
regulations.
No formal comments were received
regarding the AFS issues addressed in
proposed § 1.451–3(h)(1). Accordingly,
the rules regarding an AFS that covers
a group of entities (consolidated AFS
rules) and mismatched reporting
periods remain largely unchanged in
these final regulations. However, the
Treasury Department and the IRS are
aware of questions regarding the
application of certain aspects of the
consolidated AFS rules. Under
proposed § 1.451–3(h)(1)(i), if a
taxpayer’s results are reported on the
AFS for a group of entities, the
taxpayer’s AFS is the group’s AFS.
Proposed § 1.451–3(h)(3) provides that if
a group’s AFS does not separately state
items, the portion of the revenue
allocable to the taxpayer is determined
by relying on the source documents that
were used to create the group’s AFS.
Under the proposed regulations, it
was unclear whether the portion of the
AFS revenue allocable to the taxpayer
includes amounts that are subsequently
eliminated in the group’s AFS
(consolidated AFS). Accordingly, the
final regulations clarify that, if the
consolidated AFS does not separately
state items, the portion of the AFS
revenue allocable to the taxpayer is
determined by relying on the taxpayer’s
separate source documents used to
create the consolidated AFS and
includes amounts that are subsequently
eliminated in the consolidated AFS.

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III. Comments and Revisions Regarding
§ 1.451–8
A. Proposed § 1.451–8(b)(1)(i):
Definition of Advance Payment
1. Prepayments for Pre-Need Burial
Plots
Under section 451(c)(4)(A), the term
advance payment means any payment
that meets the following three
requirements: (1) The full inclusion of
the payment in gross income in the year
of receipt is a permissible method of
accounting; (2) any portion of the
advance payment is included in revenue
in an AFS for a subsequent tax year; and
(3) the advance payment is for goods,
services, or such other items that the
Secretary has identified. Proposed
§ 1.451–8(b)(1)(i) largely mirrors the
definition of an advance payment in
section 4.01 of Revenue Procedure
2004–34, which expands upon the
goods, services, and other items for
which a payment can qualify as an
advance payment.
One commenter requested that the
Secretary exercise the authority to
broaden the definition of advance
payment to include prepayments for the
sale of an interest in real property,
including pre-need burial plots. If the
comment is adopted, prepayments for
pre-need burial plots would be eligible
for the one-year deferral of income.
Commenters agreed that taxpayers in
the death care industry uniformly treat
the entire amount of the sales price for
pre-need burial plots as income on an
AFS in the year the pre-need contract is
executed. To qualify as an advance
payment, a portion of the prepayment
must be included in revenue by the
taxpayer in an AFS for a subsequent
taxable year. Section 451(c)(4)(A)(ii).
Since prepayments for pre-need burial
plots cannot meet this requirement,
these prepayments cannot qualify as
advance payments. For this reason, the
Treasury Department and the IRS
decline to adopt this comment in the
final regulations.
No other requests were received to
expand the definition of advance
payment. Accordingly, the list of items
that are included in the definition of
advance payment under proposed
§ 1.451–8(b)(1)(i) is unchanged.

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2. Amount of Payment Included in AFS
Revenue in a Subsequent Year
Under section 451(c)(4)(A) and
proposed § 1.451–8(a)(1)(i), for a
payment to qualify as an advance
payment, a portion of the payment must
be included in revenue in an AFS for a
subsequent tax year. The final
regulations clarify that to determine the

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amount of the payment that is taken into
account as AFS revenue, the taxpayer
must adjust AFS revenue for any
amounts described in § 1.451–
3(b)(2)(i)(A), (C), and (D). As a result, to
the extent that AFS revenue in the
taxable year of receipt reflects, for
example, a reduction for liabilities that
are required to be accounted for under
provisions such as section 461 or
amounts anticipated to be in dispute,
AFS revenue in the taxable year of
receipt must be increased by such
amounts.
The final regulations make similar
clarifying changes to the deferral
method for taxpayers with an AFS in
§ 1.451–8(c). Under § 1.451–8(c), a
taxpayer that uses the deferral method
must include all or a portion of the
advance payment in gross income in the
taxable year of receipt to the extent
‘‘taken into account as AFS revenue’’ as
of the end of the taxable year of receipt,
and include the remaining portion of
the advance payment in gross income in
the following taxable year. To determine
the extent that an advance payment is
treated as ‘‘taken into account as AFS
revenue’’ as of the end of the taxable
year of receipt, the taxpayer must adjust
AFS revenue by the amounts described
in § 1.451–3(b)(2)(i)(A), (C), and (D).
Accordingly, to the extent that AFS
revenue reflects a reduction for
liabilities that are accounted for under
other provisions of the Code such as
section 461 or amounts anticipated to be
in dispute, AFS revenue is increased by
such amounts. Further, if the
transaction price, as defined in § 1.451–
3(a)(14), was increased because a
significant financing component is
deemed to exist under the standards the
taxpayer uses to prepare its AFS, then
any AFS revenue attributable to such
increase is disregarded.
B. Proposed § 1.451–8(b)(1)(ii)(H):
Specified Good Exception
Proposed § 1.451–8(b)(1)(ii) lists
exceptions to the definition of an
advance payment. Specifically,
proposed § 1.451–8(b)(1)(ii)(H) provides
that an advance payment does not
include a payment received in a taxable
year earlier than the taxable year
immediately preceding the taxable year
of the contractual delivery date for a
specified good. Proposed § 1.451–8(b)(8)
defines the ‘‘contractual delivery date’’
as the month and year of delivery listed
in the written contract to the
transaction. A ‘‘specified good’’ is
defined in proposed § 1.451–8(b)(9) as a
good for which: (1) The taxpayer does
not have the goods of a substantially
similar kind and in a sufficient quantity
at the end of the taxable year the upfront

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payment is received; and (2) the
taxpayer recognizes all of the revenue
from the sale of the good in its AFS in
the year of delivery. If the prepayment
satisfies the specified good exception,
the prepayment is analyzed under
section 451(b) and § 1.451–1.
1. Contractual Delivery Date
Requirement
Some commenters generally requested
that the Treasury Department and the
IRS re-examine the contractual delivery
date requirement. One commenter
requested that the definition of
contractual delivery date be broadened
to include contracts where the delivery
date can be reasonably determined
based on all the facts and circumstances
as provided in the contract. Another
commenter requested that the exception
be modified to cover any contract for the
sale or production of goods where,
based on all of the facts and
circumstances, it is reasonably certain
that the taxpayer’s performance to
which the advance payment relates will
in fact take place. The same commenter
also suggested that if the definition of
the contractual delivery date was
broadened, the requirement regarding
the period of time between when an
advance payment is received and the
delivery date for a specified good could
be modified to require that the expected
delivery date occur more than 24
months after the advance payment is
received.
The Treasury Department and the IRS
decline to adopt the comments to
broaden the definition of contractual
delivery date in the final regulations
because the suggested approaches
would decrease administrability and
increase uncertainty for taxpayers and
the potential for litigation. Therefore,
the definition of contractual delivery
date in the final regulations continues to
be limited to situations where the
written contract provides the month and
year of delivery for the goods.
In addition, because the Treasury
Department and the IRS are not
broadening the definition of contractual
delivery date, it is not necessary to limit
the specified good exception to
situations where there is more than 24
months between the date the advance
payment is received and the contractual
delivery date. The recommended rule is
more restrictive than the rule in the
proposed regulation which requires the
payment to be received in a taxable year
earlier than the taxable year
immediately preceding the taxable year
of the contractual delivery date.
Accordingly, the Treasury Department
and the IRS decline to adopt this
recommendation.

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2. Requirement That AFS Revenue Must
Be Recognized in the Year of Delivery
One commenter questioned why the
specified good exception in the
proposed section 451(c) regulations is
restricted to situations where all the
revenue from the sale of the good is
recognized in the taxpayer’s AFS in the
year of delivery. The commenter
requested that the exception be
expanded to include situations where
the taxpayer recognizes the revenue for
Federal income tax purposes no later
than the time when the revenue related
to the production of the goods is
recognized for financial accounting
purposes. As a result, taxpayers using
the over-time method to report revenue
under ASC 606 could be eligible for the
exception.
Payments that qualify for the
specified good exception are subject to
the general accrual method of
accounting rules under section 451(a)
and (b), including the all events test
under section 451(b)(1)(C) and § 1.451–
1(a) and the existing case law that
addresses the all events test. The
specified good exception was narrowly
crafted to allow a taxpayer meeting the
requirements to evaluate its treatment of
qualifying payments under the all
events test under section 451(b)(1)(C)
and § 1.451–1(a) and the existing case
law that addresses the all events test.
Taxpayers that meet the specified good
exception criteria, unlike those
taxpayers that use the over-time method
to report revenue from the sale of goods
under ASC 606, are generally not
required to test the payment for
inclusion under the AFS income
inclusion rule in section 451(b)(1)(A), as
the payment is not taken into account as
AFS revenue until the specified good is
delivered to the customer, and is only
required to analyze the payment for
inclusion under the all events test in
section 451(b)(1)(C). Additionally,
taxpayers that use the over-time method
under ASC 606 generally incur
production costs as AFS revenue is
recognized and can therefore benefit
from the advance payment cost offset
method under § 1.451–8(e). However,
taxpayers that use the point-in-time
method to report revenue from the sale
of goods under ASC 606 and that meet
the rest of the specified good exception
criteria generally don’t incur production
costs until closer to the delivery date
and may not be able to benefit from the
advance payment cost offset method
under § 1.451–8(e). For these reasons,
the Treasury Department and the IRS
decline to expand the specified good
exception to situations where taxpayers

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are using the over-time method to report
revenue under ASC 606.
For this reason, the Treasury
Department and the IRS do not adopt
this comment. Therefore, the definition
of specified good in the final regulations
retains the requirement that the
taxpayer recognizes all of the revenue
from the sale of the good in its AFS in
the year of delivery.
3. Integral Services
A commenter requested that the
definition of ‘‘specified good’’ in
proposed § 1.451–8(b)(8) be expanded to
include ‘‘integral services’’ furnished for
the good. However, the commenter
provided no definition of integral
services, a term which could be broadly
construed resulting in audit
controversies. Moreover, the Conference
Report expresses Congress’ intent for
section 451(c) to override former
§ 1.451–5, which defined an advance
payment to include prepayments for
services that were integral to the sale or
disposition of goods. See H.R. Rep. No.
115–466, at 429 fn. 880 (2017) (Conf.
Rep.). For these reasons, the Treasury
Department and the IRS decline to
accept this comment.
4. Reasonable Estimate of Unused Net
Operating Loss (NOL)
One commenter requested that, if
certain proposed changes to the
specified good exception are not
adopted, the Treasury Department and
the IRS should include an exclusion to
the definition of ‘‘advance payment’’ for
prepayments where the taxpayer
reasonably estimates, based on the facts
at the time the agreement is entered
into, that it will have a NOL that
remains unused for the 5-year period
after the year the prepayments received
are included in the taxpayer’s taxable
income. The requested rule would be
difficult to administer because it
requires a taxpayer to estimate that it
will have an NOL that remains unused
for a 5-year period after the advance
payments are included in gross income.
Accordingly, the Treasury Department
and the IRS decline to adopt this
comment in the final regulations.
5. Tax Consequences of Meeting the
Specified Good Exception
Several commenters provided
examples in which payments that
qualify for the specified good exception
in proposed § 1.451–8(a)(1)(ii)(H) are
deferred and included in gross income
when the payment is recognized as
revenue in the taxpayer’s AFS in the
year the good is delivered. As
mentioned in part III.B.2 of this
Summary of Comments and Explanation

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of Revisions and for additional
clarification, payments that qualify for
the specified good exception are subject
to the general accrual method of
accounting rules under section 451(a)
and (b), including the all events test
under section 451(b)(1)(C) and § 1.451–
1 and the existing case law that
addresses the all events test.
6. Method To Treat Prepayments
Satisfying the Specified Good Exception
as Advance Payments
One commenter asked that the
specified good exception be made
optional, particularly if meeting the
specified good exception does not result
in deferral of the prepayment to match
the book timing of the payment. The
commenter noted that some taxpayers
may prefer the section 451(c) regime,
especially if there is some uncertainty
whether the contract meets the specified
good exception. Further, some taxpayers
that had the choice of a longer deferral
under § 1.451–5 or a one-year deferral
under Revenue Procedure 2004–34 still
chose the 1-year deferral.
The Treasury Department and the IRS
agree with this comment. Accordingly,
the final regulations allow taxpayers to
treat all prepayments that satisfy the
specified good exception as advance
payments subject to section 451(c), the
‘‘specified good section 451(c) method.’’
See § 1.451–8(f). The requested election
provides flexibility for taxpayers. If the
taxpayer does not use the specified good
section 451(c) method, payments
satisfying the specified good exception
are not eligible for the deferral method
provided in section 451(c) and § 1.451–
8 but are subject to section 451(b) and
§ 1.451–1(a). If the taxpayer uses the
specified good section 451(c) method,
the prepayment is generally deferred for
one year; however, if a taxpayer also
uses the advance payment cost offset
method under § 1.451–8(e) to account
for such prepayments, a portion of the
prepayment may be deferred until the
year in which ownership of the good is
transferred to the customer.
The specified good section 451(c)
method is a method of accounting. The
method applies to all payments that
satisfy the specified good exception that
are received by each trade or business
that uses the method. The use of this
method results in the adoption of, or a
change in, a method of accounting
under section 446. See § 1.451–8(g).
C. Proposed § 1.451–8(c)(2)(i)(B):
Acceleration of Advance Payments
Under proposed § 1.451–8(c)(2)(i)(B),
a taxpayer that uses the deferral method
generally includes an advance payment
in gross income when it satisfies its

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obligation for the advance payment.
Example 11 of proposed § 1.451–
8(c)(8)(xi) provides an example of a
travel agent that received commission
income when it purchased and
delivered the ticket to the customer but
did not include the commission in
revenue in its AFS until the following
year. The example concludes that the
commission is not an advance payment
because it was not earned by the
taxpayer in a subsequent taxable year.
Example 11 incorrectly concludes that
the payment for the commission is not
an advance payment. The payment for
the commission income is an advance
payment because it meets the definition
of an advance payment under section
451(c)(4), including the requirement
that a portion of the payment is
included in the taxpayer’s revenue in an
AFS for a subsequent taxable year.
However, the commission income is
included in income in the year of
receipt because the taxpayer’s obligation
with respect to the advance payment
was satisfied in that year. Accordingly,
in the final regulations, this example
has been moved and revised into an
example of the rules on the acceleration
of advance payments. In addition, the
analysis has been changed to clarify that
(1) the commission income is an
advance payment, and (2) the taxpayer’s
satisfaction of its obligation for the
advance payment caused the
commission to be included in income in
the year of receipt.
D. Proposed § 1.451–8(c)(5): Contracts
With Multiple Performance Obligations
Section 451(c)(4) provides that for
purposes of the rules for advance
payments, rules similar to the rules in
section 451(b)(4), which allocate
transaction price among multiple
performance obligations, apply.
Proposed § 1.451–8(c)(5) provides rules
for taxpayers with an AFS for allocating
the transaction price when there is more
than one performance obligation in a
contract. Specifically, those taxpayers
allocate the transaction price based on
the method in proposed § 1.451–3(g),
namely, using the allocation in the
taxpayer’s AFS. No formal comments
were received on this provision.
Under the proposed regulations it was
not clear whether the taxpayer was
required to allocate the payment to
multiple performance obligations based
on their relative transaction price or
based on the payment allocation used
for AFS purposes. Accordingly, the final
regulations clarify that advance
payments received under a contract
with multiple performance obligations
are allocated to the corresponding item
of gross income in the same manner that

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the payments are allocated to the
performance obligations in the
taxpayer’s AFS. This rule is consistent
with the requirement in section
451(c)(4)(D) that ‘‘rules similar to the
rules in [section 451](b)(4) shall apply,’’
because it follows the manner in which
the taxpayer allocates the payment for
AFS purposes.
The rule for taxpayers without an AFS
remains unchanged. See § 1.451–8(d)(4).
2. Proposed § 1.451–8(c)(6): Contracts
With Advance Payments That Include
Items Subject to a Special Method of
Accounting
The proposed regulations requested
comments on the allocation of a
payment when the contract includes
income subject to section 451(c) and
income subject to section 460, but no
comments were received.
Consistent with the objective criteria
standard under Section 5.02(4) of Rev.
Proc. 2004–34, the final regulations
provide that if (1) a contract with a
customer includes item(s) of gross
income subject to a special method of
accounting and item(s) of gross income
described in § 1.451–8(a)(1)(i)(C), and
(2) the taxpayer receives an allocable
payment, then the taxpayer must
determine the portion of the payment
allocable to the items of gross income
described in § 1.451–8(a)(1)(i)(C) based
on objective criteria. The taxpayer is
deemed to satisfy the objective criteria
standard when it allocates the payment
to each item of gross income in
proportion to the amounts determined
in § 1.451–3(d)(5) or as otherwise
provided in guidance published in the
Internal Revenue Bulletin (see
§ 601.601(d)).
This rule is consistent with the
requirement in section 451(c)(4)(D) that
‘‘rules similar to the rules in [section
451](b)(4) shall apply.’’ The final
regulations also provide a similar
allocation rule for taxpayers using the
non-AFS deferral method.
E. Cost Offset for Advance Payments
The proposed regulations do not
provide for a cost offset. The preamble
to the proposed regulations explains the
rationale for rejecting a cost offset and
requests comments on this issue.
As they did with respect to the
proposed section 451(b) regulations,
commenters requested that the final
regulations under section 451(c) provide
a cost offset, such as a COGS offset for
expected future costs against advance
payments for the sale of goods.
Commenters asserted that a COGS offset
is supported by the definition of
‘‘receipt’’ in section 451(c)(4)(C), which
refers to an ‘‘item of gross income.’’

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Under section 61 and § 1.61–3(a), for the
sale of goods, an item of gross income
generally means total sales revenue
minus the cost of goods sold.
Commenters cited Hagen Advertising
Displays, Inc. v. Commissioner, 407
F.2d 1105 (6th Cir. 1969), as support for
this position. In Hagen Advertising, the
Sixth Circuit Court of Appeals
acknowledged that, to determine the
proper amount of gross income for
advance payments for the sale of goods
to be delivered in the future, it would
be appropriate for a taxpayer to reduce
the amount of the advance payment by
the estimated cost of the goods to be
delivered. Otherwise, denying an offset
for related COGS would tax the return
of capital. Id. at 1110. Accordingly,
commenters asserted that denying a
COGS offset could result in an
impermissible tax on gross receipts.
Commenters also asserted that not
allowing a cost offset could result in a
mismatch of revenue and costs and fails
to clearly reflect income. According to
commenters, a taxpayer would be
required to report the full amount of an
advance payment in income, in excess
of the expected profit associated with
that portion of the total contract price
being reported. When the costs are
actually incurred in subsequent years,
the taxpayer would report losses with
no associated revenue, which, in
extreme cases where the losses cannot
be used, could result in a permanent
loss of the tax benefit of the cost. For a
limited-life business, the acceleration of
revenue recognition may result in NOLs
that are permanently lost, as expenses
trail income throughout the life cycle of
the business. The commenters pointed
out that this mismatch of income and
associated costs does not reflect the
reality of the overall amount of gross
income realized by the taxpayer on the
contract as a whole.
Further, commenters reasoned that
allowing a cost offset under section
451(c) will not violate the economic
performance requirement of section
461(h). Since the acceleration of
advance payments under section 451(c)
is a departure from accrual method
accounting, the costs related to the
payments should also depart from
accrual method concepts. Commenters
pointed out that the allowance of a cost
offset for expected future COGS against
substantial advance payments under
former § 1.451–5(c), based on Hagen
Advertising, coexisted with section
461(h) for over 33 years. In addition, the
purpose of section 461(h) was not to
eliminate an offset for estimated COGS
for inventory to be delivered in the near
future, but to defer a deduction for costs
where the obligation was fixed but was

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going to be performed many years in the
future. Here, commenters asserted that a
COGS offset would help to determine
the proper amount of gross income to be
accelerated, which is not what the
economic performance requirement was
intended to prevent.
Commenters also reasoned that
section 451(c) was not meant to codify
all aspects of Revenue Procedure 2004–
34, including the lack of a cost offset in
Revenue Procedure 2004–34.
Announcement 2004–48, 2004–1 C.B.
998, explains that a COGS offset was not
permitted in Revenue Procedure 2004–
34 because it was inconsistent with the
simplification that the revenue
procedure was meant to achieve, and
taxpayers could still qualify for a COGS
offset under former § 1.451–5(c).
Commenters also found it significant
that the term ‘‘receipt’’ in section 451(c)
uses the specific term ‘‘an item of gross
income,’’ while the definition of
received in Revenue Procedure 2004–34
uses the general term ‘‘income.’’
The Treasury Department and the IRS
have considered these comments and
have determined that a cost offset based
on estimates of future costs would be
inappropriate. As discussed in the
preamble to the proposed section 451(c)
regulations, allowing a cost offset based
on estimated costs would be
inconsistent with sections 461, 263A,
and 471, and the regulations under
those sections of the Code and difficult
for the IRS to administer. Additionally,
allowing a cost offset based on
estimated costs is inconsistent with
Congress’ intent to override former
§ 1.451–5(c). Former § 1.451–5(c)
permitted a cost offset for both incurred
and estimated costs against certain
advance payments that were required to
be included in gross income in a taxable
year prior to the year in which
ownership of the item of inventory was
transferred to the customer, and was
recently withdrawn in final regulations
published in the Federal Register on
July 15, 2019. See H.R. Rep. No. 115–
466, at 429 fn. 880 (2017) (Conf. Rep.);
see also, 84 FR 33691 (July 15, 2019).
However, the Treasury Department and
the IRS agree with comments suggesting
that taxpayers should be afforded the
flexibility of applying an offset for costs
incurred against advance payments for
the future sale of inventory. In this case,
the final regulations provide that a
taxpayer determines the amount of the
advance payment that is included in
gross income for the taxable year by
reducing the amount that would
otherwise be included in gross income
for such taxable year under the
taxpayer’s full inclusion method or
deferral method, as applicable (advance

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payment inventory inclusion amount)
by the cost of goods related to the item
of inventory, the ‘‘cost of goods in
progress offset.’’ The method allows
taxpayers to offset advance payments
included in income under either the full
inclusion method or under the deferral
method. The portion of any advance
payment that is offset by a cost of goods
in progress offset for a taxable year is
deferred and generally included in gross
income in the taxable year in which
ownership of the item of inventory is
transferred to the customer.
Specifically, the final regulations
provide that the cost of goods in
progress offset for an item of inventory
for each taxable year is calculated as the
cost of goods incurred for such item
through the last day of the taxable year,
reduced by the cumulative cost of goods
in progress offset amounts in prior
taxable years, if any. However, the cost
of goods in progress offset cannot
reduce the advance payment inventory
inclusion amount for the taxable year
below zero. Further, the cost of goods in
progress offset attributable to one item
of inventory cannot reduce the advance
payment inventory inclusion amount
attributable to a separate item of
inventory. Any incurred costs that were
not used to offset the advance payment
for the item of inventory because they
were subject to limitation are
considered when the taxpayer
determines the cost of goods in progress
offset in a subsequent taxable year. In
addition, the cost of goods in progress
offset does not apply to the advance
payment inventory inclusion amount
that is included in gross income as a
result of the acceleration rules in
§ 1.451–8(c)(4), and any advance
payments previously deferred by way of
a cost of goods in progress offset in a
prior year are accelerated under such
rule.
The cost of goods in progress offset is
determined by reference to the costs and
expenditures related to items of
inventory produced or acquired for
resale, which costs have been incurred
under section 461 and have been
capitalized and included in inventory
under sections 471 and 263A or any
other applicable provision of the Code
as of the end of the year. The taxpayer
must be able to demonstrate that the
costs are properly capitalizable under
the Code to the items of inventory
produced or acquired for resale under
the contract to which the taxpayer is
applying the cost of goods in progress
offset. For a sale of a gift card or
customer reward program points, this
requirement cannot be met, and no cost
of goods in progress offset is permitted.
However, the cost of goods in progress

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offset does not reduce the costs that are
capitalized to the items of inventory
produced or acquired for resale by the
taxpayer under the contract. That is,
while the cost of goods in progress offset
reduces the amount of the advance
payment included in income, it does not
affect how and when costs are
capitalized to inventory under sections
471 and 263A or any other applicable
provision of the Code or when those
capitalized costs will be recovered.
The costs of goods comprising the
cost of goods in progress offset must be
determined by applying the taxpayer’s
inventory accounting methods. A
taxpayer must calculate its cost of goods
in progress offset by reference to all
costs that the taxpayer has permissibly
capitalized and allocated to items of
inventory under its method of
accounting for inventories for federal
income tax purposes, but may not
consider costs that are not properly
capitalized under such method.
The Treasury Department and the IRS
provided this cost offset method in the
final regulations because it provides a
reasonable matching of income from
advance payments and incurred cost of
goods, and more clearly reflects income.
The advance payment cost offset
method is a method of accounting that
applies to all advance payments
received by a trade or business for items
of inventory that satisfy the criteria in
§ 1.451–8(e). If a taxpayer chooses to use
the advance payment cost offset method
for a trade or business, it must also use
the AFS cost offset method in § 1.451–
3(c) for that trade or business. See prior
discussion regarding coordination
between the AFS cost offset method and
the advance payment cost offset
method. Additional guidance on the
cost offset method for advance
payments may be provided in guidance
published in the Internal Revenue
Bulletin (see § 601.601(d)).
F. Continued Application of Revenue
Procedure 2004–32 and Revenue
Procedure 79–38
Commenters requested clarification of
whether Revenue Procedure 2004–32,
2004–1 C.B. 988, and Revenue
Procedure 79–38, 1997–2 C.B. 501,
remain in effect after the enactment of
section 451(c). Revenue Procedure
2004–32 allows an accrual method
taxpayer to account for income from
credit card annual fees ratably over the
period covered by the fees, as described
in section 4 of Revenue Procedure
2004–32. Revenue Procedure 79–38
generally allows accrual method
manufacturers, wholesalers, and
retailers of motor vehicles or other
durable goods to include a portion of an

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advance payment related to the sale of
a multi-year service warranty contract in
gross income over the life of the service
warranty obligation. Revenue Procedure
2004–32 and Revenue Procedure 79–38
remain effective after the enactment of
section 451(c) and may be relied upon
after these regulations are finalized.
Effect on Other Documents
The preamble to proposed § 1.451–3
requested comments on the proposed
obsolescence of Revenue Procedure
2004–33, 2004–1 C.B. 989 (relating to
credit card late fees), Revenue
Procedure 2005–47, 2005–2 C.B. 269
(relating to credit card cash advance
fees), Revenue Procedure 2013–26,
2013–22 I.R.B. 1160 (relating to a safe
harbor method of accounting for OID on
a pool of credit card receivables), and
Chief Counsel Notice CC–2010–018
(relating to interchange). Instead of
obsoleting Revenue Procedure 2013–26,
commenters recommended limiting the
scope of Revenue Procedure 2013–26 to
OID that is not subject to the timing
rules in proposed § 1.451–3(i) and thus,
not excluded from the OID rules under
proposed § 1.1275–2(l). Commenters
explained that retaining Revenue
Procedure 2013–26 would allow
taxpayers to continue to use the
proportional method described in the
revenue procedure as a safe harbor
method of accounting for certain
amounts that are not OID under section
1272, such as bond premium and
market discount, as well as certain
kinds of OID such as promotional
discount. See discussion of promotional
discount in part II.F. of the Summary of
Comments and Explanation of
Revisions. The Treasury Department
and the IRS agree with the
recommendations not to obsolete
Revenue Procedure 2013–26. In
addition, the Treasury Department and
the IRS intend to modify Revenue
Procedure 2013–26 to make clear that
the safe harbor method does not apply
to any specified fees, including the
specified credit card fees. However,
based on section 451(b) and the final
regulations, Revenue Procedure 2004–
33, Revenue Procedure 2005–47, and
Chief Counsel Notice CC–2010–018 no
longer provide current guidance on the
treatment of the specified credit card
fees. Accordingly, these items are
obsolete as of January 1, 2021.
In addition, Revenue Procedure 2004–
34, Revenue Procedure 2011–18,
Revenue Procedure 2013–29 and Notice
2018–35 are obsolete for taxable years
beginning on or after January 1, 2021.
Taxpayers that relied on the now
obsoleted guidance should determine
whether a change in method of

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accounting occurs once they cease to
use the obsoleted guidance.
Applicability Dates
In general, the rules in §§ 1.451–3 and
1.451–8 apply for taxable years
beginning on or after January 1, 2021.
However, the rules in § 1.451–3(j) for
specified fees that are not specified
credit card fees apply for taxable years
beginning on or after January 6, 2022.
Also, for a specified credit card fee as
defined in § 1.451–3(j)(2), § 1.1275–
2(l)(1) applies for taxable years
beginning on or after January 1, 2021,
and, for a specified fee that is not a
specified credit card fee, § 1.1275–2(l)(1)
applies for taxable years beginning on or
after January 6, 2022.
However, pursuant to section
7805(b)(7), taxpayers and their related
parties, within the meaning of sections
267(b) and 707(b), may apply the rules
in these final regulations, in their
entirety and in a consistent manner, to
a taxable year beginning after December
31, 2017, and before January 1, 2021,
provided that, once applied to such a
taxable year, such rules are applied in
their entirety and in a consistent
manner to all subsequent taxable years.
Notwithstanding the preceding
sentence, pursuant to section 7805(b)(7),
taxpayers and their related parties,
within the meaning of sections 267(b)
and 707(b), may apply the rules in these
final regulations that apply to specified
credit card fees in their entirety and in
a consistent manner, to a taxable year
beginning after December 31, 2018, and
before January 1, 2021, provided that,
once applied to such a taxable year,
such rules are applied in their entirety
and in a consistent manner to all
subsequent taxable years. Taxpayers
that choose to apply the rules in the
final regulations to a taxable year
beginning before January 1, 2021 must
follow the rules for changes in method
of accounting under section 446 and the
applicable procedural guidance.
Alternatively, a taxpayer may rely on
the proposed regulations for taxable
years beginning after December 31, 2017
(or December 31, 2018, in the case of
specified credit card fees) and before
January 1, 2021.
In the case of a specified fee that is
not a specified credit card fee, a
taxpayer may neither choose to apply
the final regulations to, nor rely on the
proposed regulations for, a taxable year
beginning after December 31, 2018, and
before January 6, 2022.
Statement of Availability of IRS
Documents
The IRS Notices, Revenue Rulings,
and Revenue Procedures cited in this

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document 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 http://www.irs.gov.
Special Analyses
I. Regulatory Planning and Review—
Economic Analysis
Executive Orders 12866, 13563, and
13771 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, of
reducing costs, of harmonizing rules,
and of promoting flexibility. For
purposes of E.O. 13771 this rule is
regulatory.
These regulations have been
designated as subject to review under
Executive Order 12866 pursuant to the
Memorandum of Agreement (April 11,
2018) between the Treasury Department
and the Office of Management and
Budget (OMB) regarding review of tax
regulations. The Office of Information
and Regulatory Affairs has designated
these regulations as economically
significant under section 1(c) of the
MOA. Accordingly, the OMB has
reviewed these regulations.
A. Need for the Final Regulations
The Tax Cuts and Jobs Act (TCJA)
substantially modified the statutory
rules of section 451, which generally
governs when income is recognized for
Federal tax purposes. As a result of
those changes, the Treasury Department
and the IRS recognized that questions
were likely to arise regarding the
definitions and rules that taxpayers are
required to apply in calculating a
business’s gross income. To provide
greater specificity, the Treasury
Department and the IRS previously
issued separate proposed regulations
related to section 451(b) and 451(c) on
September 9, 2019.
The proposed regulations regarding
section 451(b): (1) Clarify how section
451(b) applies to multi-year contracts;
(2) provide rules for taxpayers whose
financial results are included on an
Applicable Financial Statement (AFS)
covering a group of entities; (3) describe
and clarify the definition of transaction
price and revenue; (4) specify the
allocation of a transaction price in the

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case of a contract which contains
multiple performance obligations; and
(5) specify rules for certain debt
instruments.
The proposed regulations for section
451(c) describe the deferral rules for
advance payments for taxpayers with
and without an AFS; (2) provide
acceleration rules for taxpayers that
cease to exist; (3) clarify the treatment
of financial statement adjustments for
taxpayers with 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. They also
list items excluded from the definition
of an advance payment. In response to
taxpayer comments received during the
development of the proposed
regulations, that list includes goods for
which (1) the taxpayer does not have
goods of a substantially similar kind and
in a sufficient quantity at the end of the
taxable year the upfront payment is
received; and (2) the taxpayer
recognizes all of the revenue from the
sale of the good in its AFS in the year
of delivery.
Comments were received on the
proposed regulations for 451(b) and
451(c) requesting further clarification of
or changes to those regulations. Based
on these comments, the Treasury
Department and the IRS determined that
final regulations are needed to bring
clarity to instances where the statute
may be subject to multiple
interpretations in the absence of further
guidance and to respond to comments
received on the proposed regulations.
Among other benefits, the final
regulations provide greater certainty and
consistency in the application of section
451 by taxpayers and the IRS.
B. Background and Overview of Final
Regulations
Under section 451(a) of the 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
items 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 the amount
of income can be determined with
reasonable accuracy (all events test).
The timing of income recognition on
a firm’s financial statement may deviate

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from these principles. Both the U.S.
generally accepted accounting
principles (GAAP) and the international
financial reporting standards (IFRS)
provide income recognition rules that
differ from tax reporting rules under
certain circumstances. For example,
financial accounting rules may require
revenue to be recognized when the costs
of providing goods or services pursuant
to a contract are incurred, while the allevents test may not be satisfied until the
contract obligation is fulfilled. New
accounting standards released by the
Financial Accounting Standards Board
(FASB) and the International
Accounting Standards Board (IASB) in
2014 further accelerated the timing of
income recognition for financial
reporting purposes, widening the gap
between financial and tax reporting.
The timing of income recognition for
tax purposes may also deviate from the
all-events test in certain circumstances.
For instance, 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
on the taxpayer’s AFS. Such payments
are referred to as ‘‘advance payments.’’
Prior to the enactment of TCJA on
December 22, 2017, 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. Under
prior law, the period over which an
advance payment was deferred varied
depending on the alternative regulatory
treatment chosen (Revenue Procedure
2004–34 or § 1.451–5) and, within
§ 1.451–5, the type of good for which an
advance payment was accepted
(inventoriable goods versus noninventoriable goods).
Under Revenue Procedure 2004–34, a
taxpayer who receives an advance
payment includes the advance payment
in taxable income in the year of receipt
to the extent that the payment is earned
(if the taxpayer does not have an AFS)
or, if the taxpayer has an AFS, to the
extent that the payment is included in
revenues in the AFS. The taxpayer
includes the remaining amount of the
advance payment in taxable income in
the next taxable year, unless the next
taxable year is a short year of 92 days
or less. In the event of such a short year,
the taxpayer includes in taxable income
the part of the advance payment
included in revenue in the AFS for the
short tax year or, in the case of a
taxpayer that does not have an AFS, the
part of the advance payment which is
earned in the short tax year. The

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825

remaining balance of the advance
payment is included in income for the
taxable year following the short tax year.
Revenue Procedure 2004–34 applies to
numerous types of advance payments
beyond advance payments for the
provision of services and sales of goods.
For example, it applies to advance
payments for the use of intellectual
property and software, the occupancy or
use of property if the occupancy or use
is ancillary to the provision of services,
guaranty or warranty contracts,
subscriptions, memberships in
organizations, and eligible gift card
sales.
Under § 1.451–5, advance payments
were defined more narrowly than under
Revenue Procedure 2004–34 to include
payments received by an accrualmethod taxpayer for the future sale of
goods held by the taxpayer in the
ordinary course of trade or business and
as payments for the building, installing,
constructing, or manufacturing of goods
by the taxpayer in a future taxable year.
Such advance payments were generally
included in taxable income either in the
year of receipt or in the year in which
the payment was properly accruable
under the taxpayer’s method of
accounting.
An exception to this general rule
occurred in the case of certain advance
payments for certain goods properly
held in inventory by the taxpayer. In the
case of such goods, the receipt of a
substantial advance payment required
that all previously unrecognized
advance payments be included in
taxable income by the end of the second
taxable year following the taxable year
in which the substantial advance
payment was received. The taxpayer
was considered to have received a
substantial advance payment if the sum
of the advance payment received in the
current taxable year and prior taxable
years for the same contract was greater
than or equal to total inventoriable costs
and expenditures.
The TCJA substantially amended
section 451 providing, among other
things, new rules addressing deviations
from the all-events test. The amended
section 451(b) more closely aligns when
income is recognized for Federal tax
purposes with when it is recognized on
businesses’ financial accounting
statements. In particular, section 13221
of the TCJA amends section 451(b), such
that an item of gross income must be
included in gross income no later than
the period when the item is included in
revenue on an AFS. Thus, this new rule
requires taxpayers to recognize income
upon the earlier of when the all-events
test is met or when the taxpayer
includes the amount in revenue

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(broadly defined) in its AFS (AFS
income inclusion rule). For these
taxpayers, income recognition is
accelerated for tax purposes when
income has been recognized for
financial accounting purposes before the
all events test has been satisfied.
The amendments made to section
451(b) only apply to taxpayers that use
accrual accounting and have an AFS.
Neither the statutory changes to 451(b)
nor the final regulations regarding
451(b) change the time at which income
is recognized for accrual method
taxpayers without an AFS.
Section 451(c), added by the TCJA,
allows accrual-method taxpayers to
elect to recognize as income only a
portion of 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.) The new section 451(c), a subject
of the final regulations, addresses how
advance payments are defined and
when they need to be recognized in a
business’s gross income.
C. Economic Analysis
1. Baseline
In this analysis, the Treasury
Department and the IRS assess the
benefits and costs of the final
regulations relative to a no-action
baseline reflecting anticipated Federal
income tax-related behavior in the
absence of these final regulations.

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2. Summary of Economic Effects
The final regulations provide
certainty and consistency in the
application of sections 451(b) and 451(c)
by providing definitions and
clarifications regarding the statute’s
terms and rules. In the absence of the
guidance provided in these final
regulations, the chance 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. Similar situations may arise
under each of the provisions addressed

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by these regulations. Certainty and
clarity over tax treatment generally also
reduce compliance costs for taxpayers.
An economic loss might also arise if
all taxpayers have similar
interpretations under the baseline of the
tax treatment of particular items of
income but those interpretations differ
slightly from the interpretation Congress
intended for these income streams. For
example, the final regulations may
specify a tax treatment that few or no
taxpayers would adopt in the absence of
specific guidance but that nonetheless
advances Congressional intent. In these
cases, guidance provides value by
bringing economic decisions closer in
line with the intent and purpose of the
statute.
While no guidance can curtail all
differential or inaccurate interpretations
of the statute, the final regulations
significantly mitigate the chance for
differential or inaccurate interpretations
and thereby increase economic
efficiency.
Because the final regulations clarify
the tax treatment of items of gross
income for certain taxpayers, there is
the possibility that business decisions
may change as a result of these
regulations. The final regulations
generally have the effect of delaying the
timing of tax liability, thus reducing
effective tax rates for affected taxpayers.
This reduction in effective tax rates,
viewed in isolation, will generally lead
to an increase in economic activity by
these taxpayers.
This delay in the timing of tax
liability, viewed in isolation, will also
decrease Federal tax revenue. A
decrease in Federal tax revenue either
increases the deficit or necessitates
increases in other taxes or a reduction
in spending. This revenue effect will be
mitigated to some degree by improved
economic performance (and
accompanying tax revenues) under
these regulations due to (i) the enhanced
alignment in the timing of taxes on
income and costs; (ii) the enhanced
certainty and clarity provided by the
final regulations as described
previously; and (iii) enhanced economic
activity due to lower effective tax rates
for affected taxpayers.
The Treasury Department and the IRS
have not estimated these effects relative
to the no-action baseline or alternative
regulatory approaches because they do
not have readily available data or
models that measure: (i) The volume of
cost offsets allowed under the final
regulations; 1 (ii) the effect on economic
1 Cost offsets are not reported on current tax
returns and will not be separately reported on
future tax returns.

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activity by affected taxpayers from the
enhanced alignment of income and
costs under the final regulations relative
to the no-action baseline or alternative
regulatory approaches; (iii) the tax
positions that taxpayers would take on
other provisions of the final regulations,
relative to the no-action baseline or
alternative regulatory approaches; or (iv)
the economic activities that taxpayers
would engage in under those tax
positions.
The Treasury Department and the IRS
have also not made projections of any
change in compliance costs arising from
the final regulations, relative to the noaction baseline. Treasury generally
projects that compliance costs will be
lower under the final regulations
relative to the no-action baseline
because enhanced clarity and certainty
reduce compliance costs. The Treasury
Department and the IRS recognize that
some taxpayers may take advantage of
favorable provisions in the final
regulations and that this decision could
increase their compliance costs.
Taxpayers would not take advantage of
these provisions, however, unless the
overall treatment was beneficial to the
taxpayer.
The proposed regulations noted that
the economic analysis of the final
regulations under section 451(c) would
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 was issued between
the proposed and final regulations.
Since the release of the proposed
regulations on September 5, 2019, no
such regulatory guidance has been
issued.
The proposed regulations for 451(b)
and 451(c) solicited comments on the
economic effects of the proposed
regulations. No such comments were
received.
3. Number of Affected Taxpayers
The Treasury Department and the IRS
estimate that between 174,000 and
299,000 entities are likely to be affected
by the final regulations.
Section 451(b) and (c) and the
regulations under § 1.451–3 affect only
those business entities that (i) use an
accrual method of accounting, and (ii)
have an AFS. One provision in § 1.451–
8 applies to accrual method taxpayers
without an AFS. Regarding the accrual
method of accounting, section 13102 of
TCJA modified section 448 to expand
the number of taxpayers eligible to use
the cash receipts and disbursements
method of accounting (cash method of
accounting). In general, C corporations
and partnerships with a C corporation

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Federal Register / Vol. 86, No. 3 / Wednesday, January 6, 2021 / Rules and Regulations
partner are now permitted to use the
cash method of accounting if average
annual gross receipts are $25 million or
less for taxable years beginning in 2018
(up from $5 million or less in 2017).
This amount was adjusted for inflation
for taxable years beginning after
December 31, 2018. The amount was
$26 million in taxable year 2019.
The statute and the regulations
generally affect only those entities that
also have an AFS although one
provision in the regulations under
§ 1.451–8 applies to non-AFS taxpayers.
The Treasury Department and the IRS
do not have readily available data to
measure the prevalence of these affected
entities. However, Schedule M–3, which
is used to reconcile an entity’s net
income or loss for tax purposes with its
book income or loss, reports whether an
entity has a certified audited income
statement. Schedule M–3 is required to
be filed only by entities with at least $10
million of assets. This population is
more likely to possess an AFS and,
conversely, entities that do not file
Schedule M–3 are less likely to possess
an AFS or otherwise be affected by the
regulations as owners and/or creditors

of such smaller entities are less likely to
require the entity to certify its financial
results via a financial statement audit.
Data are currently available only for
electronic filers.
The Treasury Department and the IRS
estimated the number of affected
taxpayers separately for entities with
gross receipts of $26 million or less and
those with gross receipts above $26
million. For taxable year 2017, 89
percent of accrual-method entities filing
Forms 1120, 1120–S, and 1065 with
gross receipts of $26 million or less
were filers of electronic tax forms.
About 11 percent, or 288,000 returns,
included a Schedule M–3. About 40
percent of the returns with Schedule M–
3, or 113,000, indicated they had a
certified audited income statement.2
Based on the assumption that filers of
paper tax forms have the same
incidence as electronic filers and that
entities that do not file a Schedule M–
3 generally do not have an AFS, then
the Treasury Department and the IRS
estimate that roughly 127,000 (113,000/
0.89) entities with gross receipts of $26
million or less are accrual-method
entities that have an AFS. If 5 percent

827

of entities that do not file a Schedule
M–3 also have an AFS, then
approximately 251,000 of these entities
are potentially impacted by the final
regulations.
For entities with gross receipts above
$26 million and that are accrual method
entities, the comparable calculations are
that 95 percent of returns are e-filed and
that 73 percent of those included a
Schedule M–3. Based on the assumption
that filers of paper tax forms have the
same incidence as electronic filers and
that entities that do not include a
Schedule M–3 generally do not have an
AFS, the Treasury Department and the
IRS estimate that 47,000 (45,000/0.95)
entities with gross receipts above $26
million are accrual-method entities that
have an AFS. If 5 percent of entities that
do not file a Schedule M–3 also have an
AFS, then approximately 48,000 of
these entities are potentially affected by
these regulations.
Together, these calculations imply
that between 174,000 and 299,000
entities are potentially affected by the
final regulations.

CORPORATION AND PARTNERSHIP RETURNS USING AN ACCRUAL METHOD OF ACCOUNTING ***
[Taxable year 2017; thousands of returns]
Entities with gross receipts not
greater than $26 million
E-filed
Returns .................................................................
Returns with a Schedule M–3 .............................
Returns with a Schedule M–3 and an audited income statement ................................................
Returns without a Schedule M–3 ........................
Returns without a Schedule M–3, but with an
audited income statement (estimated) .............
Returns with an audited income statement .........

Paper-filed

Entities with gross receipts
greater than $26 million

Total

E-filed

Paper-filed

Total

2,503
288

307
* 35

2,810
* 323

73
62

4
*3

77
* 65

113
2,215

* 14
* 272

* 127
* 2,487

45
11

*2
*1

* 47
* 12

** 111
** 224

** 13
** 27

** 124
** 251

** 1
** 46

** 0
** 2

** 1
** 48

* Estimates are obtained by assuming paper-filed returns are similar to e-filed returns as regards the incidence of a filing entity having a
Schedule M–3 and an audited income statement.
** Estimates are obtained by assuming that 5 percent of returns without a Schedule M–3 have an audited income statement.
*** This table does not include sole proprietorships because the number of sole proprietorships with gross receipts above $26 million that used
accrual accounting was statistically indistinguishable from zero in 2017. The number of sole proprietorships with gross receipts of $26 million or
below that are affected by these regulations is projected to be minimal.
Source: Data compiled by the IRS Research, Applied Analytics and Statistics Division using data from the Compliance Data Warehouse. The
total number of accrual method returns of corporations and partnerships may differ slightly from other estimates due to different data sources.

4. Economic Effects of Provisions Under
Section 451(b)
a. Provisions Substantially Revised
From the Proposed Section 451(b)
Regulations

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i. Cost Offset Under Section 451(b)
Section 451(b) as amended by TCJA
addresses the timing of revenue
recognition for tax purposes but makes

no mention of the timing of cost
recognition. The Treasury Department
and the IRS considered three options for
addressing the treatment of costs under
section 451(b): (i) Do not allow a cost
offset; (ii) allow a cost offset for incurred
costs; and (iii) expand the allowance for
incurred costs by further allowing a cost
offset for projected costs. The proposed
regulations did not provide a cost offset
for the AFS income inclusion rule.

In the proposed section 451(b)
regulations (in this part C.4, proposed
regulations), the Treasury Department
and the IRS argued that allowing a cost
offset would be inconsistent with the
economic performance rules under
section 461 and inventory accounting
rules under section 471. The proposed
regulations further argued that Congress
did not make clear any intention to alter
those sections of the Code or their

2 Data are based on estimates from the IRS’s
Research, Applied Analytics and Statistics Division
using data from the Compliance Data Warehouse.

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associated regulations. The proposed
regulations stated, however, that the
subject was still under consideration
and requested comments addressing
appropriate cost offset rules.
In response to the comments received,
the Treasury Department and the IRS
have decided to include in the final
regulations an offset for the cost of
goods in progress (cost offset). This cost
offset allows taxpayers to reduce the
amount of revenue from the sale of
inventory that is otherwise required to
be included in gross income under the
AFS income inclusion rule in a taxable
year prior to the year in which
ownership of the inventory is
transferred to the customer and defer
such revenue to the taxable year in
which the ownership of the inventory is
transferred to the customer. The amount
of such reduction, or cost offset, is
determined by reference to the
inventoriable costs incurred to date. The
offset applies only to incurred costs, not
estimated or projected costs. Further,
the cost offset cannot reduce the amount
of revenue that is included in gross
income under the AFS inclusion rule
below zero. Any incurred costs subject
to this limitation may be carried forward
to determine the cost offset in
subsequent taxable years.
The cost offset in the final regulations
generally reduces the amount of revenue
that is required to be included in gross
income in a taxable year prior to the
year in which ownership of inventory is
transferred to the customer relative to
the proposed regulations. An improved
match of income and cost timing is
generally held to provide a more
accurate measure of economic activity
and thus would lead to a more efficient
tax system than under the proposed
regulations, within the context of the
statute and the overall Code.
This enhanced alignment in the tax
treatment of revenue and costs can be
expected to reduce financing costs for at
least some projects and taxpayers. This
reduction in financing costs relative to
the proposed regulations may arise
because in some cases under the
proposed regulations, the inability of
taxpayers to match the timing of
revenue and cost associated with a
project leads to a large, front-loaded tax
liability, which may require a costly
rebalancing of other assets, particularly
for liquidity-constrained taxpayers.
Taxpayers who experience a reduction
in financing costs as a result of these
final regulations, relative to the
proposed regulations, may, as a result,
increase other expenditures, including
investment. The provision of the cost
offset in the final regulations may

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further encourage longer-run projects
relative to the proposed regulations.
The Treasury Department and the IRS
considered expanding the cost offset to
allow for projected costs, with several
possible formats for how projected costs
would be accounted for. Allowing an
offset for projected costs would entail a
higher administrative burden than the
offset (only) for incurred costs and
would not definitively improve the
alignment of when income and costs are
recognized for tax purposes relative to
the offset for incurred costs. The
Treasury Department and the IRS
project that under an offset for projected
costs, more disputes would likely arise
over the projected costs because
taxpayers would have an incentive to
overstate projected costs in order to
delay income recognition.
The Treasury Department and the IRS
have not estimated the difference in
compliance costs, administrative
burden, or income-cost alignment (and
any subsequent effects on economic
activity) between the final regulations
and alternative regulatory approaches
using projected costs. The Treasury
Department and the IRS have not
undertaken this estimation because they
do not have sufficiently detailed data or
models that capture possible differences
in cost offset formats that use incurred
costs versus projected costs.
ii. Scope of the AFS Income Inclusion
Rule
The final regulations also address
concerns raised by commenters
regarding recent changes to the financial
accounting standards. The commenters
suggested that the AFS inclusion rule is
overly broad in light of these new
standards, which generally accelerate
AFS revenue recognition relative to the
prior standards, and could cause
taxpayers to incur a tax liability before
they receive, or have a fixed right to
receive, the money to pay the liability.
Accordingly, the final regulations
provide that under the AFS inclusion
rule, amounts taken into account as AFS
revenue include only those amounts
that the taxpayer has an enforceable
right to recover if the customer were to
terminate the contract at the end of the
taxable year.
The final regulations further provide,
however, that a taxpayer may treat any
amount reported as AFS revenue as
being taken into account as AFS
revenue regardless of whether the
taxpayer has an enforceable right to
recover such amounts. The Treasury
Department and the IRS project that this
option will lead to reduced compliance
burden, reduced administrative burden,
and to fewer taxpayer disputes relative

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to an alternative regulatory approach
under which amounts taken into
account as AFS revenue include only
those amounts that the taxpayer has an
enforceable right to recover if the
customer were to terminate the contract
at the end of the taxable year. Under this
‘‘enforceable right’’ approach, taxpayers
would be required to analyze each
contract to determine amounts for
which the taxpayer has an enforceable
right to recover if the customer were to
terminate the contract at the end of the
year; this analysis would be potentially
costly.
The Treasury Department and the IRS
also considered an alternative regulatory
approach under which taxpayers would
be permitted to defer ‘‘increases’’ in the
transactions price that are taken into
account as AFS revenue in a given year
but to which a taxpayer’s entitlement is
contingent on a future event (contingent
transaction price approach). This
alternative regulatory approach was
reflected in the proposed regulations.
However, commenters expressed
confusion as to what constitutes an
‘‘increase’’ in the transaction price and
the types of contingencies that were
intended to be included within the
scope of the rule. Because of the
uncertainties created by the contingent
transaction price approach, and the
potential for multiple interpretations,
the Treasury Department and the IRS
decided against this approach. The
enforceable right standard adopted by
the final regulations may accelerate
income inclusion relative to the
contingent transaction price approach,
although the Treasury Department and
the IRS recognize that the opposite
result may hold for some taxpayers.
The Treasury Department and the IRS
have not estimated the differences in
income inclusion between the final
regulations and this alternative
regulatory approach because they do not
have readily available data on the
income inclusion timing differences
under an enforceable right standard
versus the contingent transactions price
approach. Because of this lack of data,
the Treasury Department and the IRS
have further not estimated the
difference in compliance costs between
the final regulations and the alternative
regulatory approach.
b. Provisions Not Substantially Revised
From the Proposed Section 451(b)
Regulations
i. Application of the AFS Income
Inclusion Rule to Multi-Year Contracts
The final regulations clarify how
section 451(b) applies to multi-year
contracts. The Treasury Department and

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Federal Register / Vol. 86, No. 3 / Wednesday, January 6, 2021 / Rules and Regulations
the IRS considered two alternative
approaches for such contracts: (i) An
annual approach and (ii) a cumulative
approach. Under an annual approach,
for each taxable year under the contract
a taxpayer would compare the amount
of income taken into account as AFS
revenue for that taxable year and the
amount of income that meets the
requirements for recognition under the
all events test for that same taxable year
to determine its gross income inclusion
for that taxable year; that is, the
taxpayer would include the larger of the
two amounts. The total amount of gross
income recognized under the contract
through the end of such taxable year is
not to exceed the total contract price.
In contrast, under a cumulative
approach, in each taxable year a
taxpayer would compare the cumulative

amount of revenue included in its AFS
up to and including that taxable year
with the cumulative amount of income
that meets the requirements for
recognition under the all events test up
to and including that taxable year. The
taxpayer would then take the larger of
the two amounts and reduce it for any
prior taxable year income inclusions
with respect to that item of gross income
to determine the amount that is required
to be included in gross income in the
current taxable year.
The difference between the annual
approach and the cumulative approach
are illustrated by the following example.
In 2021, D, an engineering services
provider, enters into a non-severable
contract with a customer to provide
engineering services through 2024 for a
total of $100x. Under the contract, D
2021

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Payments .............................................................................
AFS Revenue .......................................................................
Gross Income (cumulative approach) ..................................
Gross Income (annual approach) ........................................

An annual approach could accelerate
the recognition of taxable income to a
greater degree than what is reflected in
revenue for AFS purposes. In this
example, such an approach would
ignore in 2022 the fact that cumulative
AFS revenue of $50x had been
recognized as taxable gross income in
2021. Accordingly, the annual approach
would require that an additional $25x of
income be recognized in 2022, since a
payment of that amount was received in
that year. In effect, an annual approach
would accelerate the recognition of $25x
from 2023 to 2022 relative to gross
income recognition under the
cumulative AFS income inclusion rule.
The Treasury Department and IRS
concluded that the extent of
acceleration of income that may occur
when using an annual approach would
be excessive relative to the cumulative
approach when considered against the
intent and purpose of the statute. The
final regulations therefore adopt the
cumulative approach.
The Treasury Department and the IRS
have not estimated the difference in
compliance costs, administrative
burden, or economic activity between
the final regulations and an alternative
regulatory approach of using an annual
comparison. The Treasury Department
and the IRS have not undertaken this
estimation because they do not have
sufficiently detailed data or models that
capture possible differences in
taxpayers’ income inclusions under

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2022
$25x
50x
50x
50x

$25x
0x
0x
25x

ii. Applicable Financial Statement
Covering a Group of Entities
The final regulations provide rules for
taxpayers whose financial results are
included on an AFS covering a group of
entities. These rules specify that, if a
taxpayer’s financial results are reported
on the AFS for a group of entities, the
taxpayer’s AFS is the group’s AFS.
However, if the taxpayer also reports
financial results on a separate AFS that
is of equal or higher priority, then the
separate AFS is the taxpayer’s AFS. The
rules also specify how a taxpayer using
a group AFS is to determine the amount
of revenue allocated to the taxpayer.
The Treasury Department and the IRS
considered as an alternative not
providing substantive rules on how
taxpayers should apply the AFS income
inclusion rule when their financial
results are included in an AFS for a
group of entities. This alternative was
rejected because it would have
increased compliance burdens and
potentially led to similarly situated
taxpayers applying the AFS income
inclusion rule differently.
The Code does not specify how the
AFS income inclusion rule is to
function whenever the AFS accounting
period and the taxable year do not
coincide. The final regulations do not
adopt a single, one-size-fits-all
approach, but rather provide taxpayers
three separate options for addressing

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receives payments of $25x in each
calendar year of the contract. For its
AFS, D reports $50x, $0, $20x, and $30x
of AFS revenue from the contract for
2021, 2022, 2023, and 2024,
respectively. D has an enforceable right,
as defined in § 1.451–3(a)(9), to recover
all amounts reported as AFS revenue
through the end of a given contract year
if the customer were to terminate the
contract on the last day of such year.
The $25x payment received for 2023 is
an advance payment, as defined in
§ 1.451–8(a)(1), because $5x of the $25x
payment is reported as AFS revenue for
2024. D uses the full inclusion method
for advance payments.
The accompanying table shows the
treatment of gross income under the two
approaches.
2023

these two alternative regulatory
approaches.

829

2024
$25x
20x
25x
25x

Total
$25x
30x
25x
0x

$100x
100x
100x
100x

this situation. A change from one option
to another, however, would be
considered a change in method of
accounting requiring the permission of
the IRS. By providing taxpayers with
several options, the final regulations
will minimize taxpayer compliance
costs when dealing with non-congruent
tax and financial accounting periods
relative to an alternative approach of
specifying a single option, with no
significant revenue implications or
effects on economic decisions.
iii. Revenue in an AFS
The final regulations describe and
clarify the definition of AFS revenue to
broadly include amounts characterized
as revenue in a taxpayer’s AFS as well
as amounts reported in other
comprehensive income or retained
earnings provided such amounts relate
to an item of gross income that is subject
to the rules under section 451(b) and (c).
The Treasury Department and the IRS
considered and rejected a narrower
definition of revenue or a definition that
was tied to the AFS definition of
revenue. The definition of revenue
advanced in the final regulations is
consistent with the current application
of the all events test under § 1.451–1(a)
and ensures that all relevant financial
statement items are taken into account
for tax purposes. In contrast, a narrow
definition of revenue would allow, or
even encourage, taxpayers to avoid the
AFS income inclusion rule by not

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classifying an item as revenue on their
financial statement.
iv. Rules for Certain Debt Instruments
Section 451(b)(2) states that the AFS
inclusion rule does not apply to items
of gross income for which a taxpayer
uses a special method of accounting
provided under the Code. However, the
Code does not apply this exception to
special accounting rules that apply to
original issue discount (OID), market
discount, and certain other items with
respect to debt instruments under part
V of Subchapter P of the Code.
The final regulations implement this
provision by providing a non-exhaustive
list of special methods of accounting,
and by clarifying how section 451(b)
applies to certain credit card
receivables. The final regulations
specifically except from section 451(b)
the timing rules for accrued market
discount on bonds and the general OID
timing rules, as well as the timing rules
for OID determined with respect to
special debt instruments (contingent
payment and variable rate debt
instruments, certain hedged debt
instruments, and inflation-indexed debt
instruments). Nevertheless, following
the legislative history of the TCJA (see
Conference Report, p. 276), the final
regulations provide that credit card late
fees, credit card cash advance fees, and
interchange fees are subject to the AFS
income inclusion rule. The final
regulations further specify that if these
credit card fees are subject to the AFS
income inclusion rule, they are not to be
taken into account in determining
whether a debt instrument associated
with them has OID. Existing rules
continue to apply to these items for
taxpayers not possessing an AFS. The
Treasury Department and the IRS expect
that this treatment will provide a
straightforward application of section
451(b) consistent with Congressional
intent without unnecessarily
complicating OID calculations and
adding to taxpayer compliance burdens.
The Treasury Department and the IRS
considered and rejected a broader
application of the AFS income inclusion
rule to include all amounts determined
under the OID and market discount
accounting methods, even in cases
where the items are treated as discount
or as an adjustment to the yield of a debt
instrument over the life of the
instrument in its AFS for financial
reporting purposes. The final
regulations do not subject these
amounts to the AFS income inclusion
rule because these special accounting
methods do not generally rely on the all
events test to determine the timing of
income inclusion and these current

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special accounting methods provide
workable income-recognition timing
rules that appropriately measure
income. The Treasury Department and
the IRS expect that subjecting these
items to the AFS income inclusion rule
of section 451(b) would disrupt and
complicate current tax accounting
practices with no general economic
benefit.
5. Economic Effects of Provisions Under
451(c)
a. Provisions Substantially Revised
From the Proposed Section 451(c)
Regulations
i. Cost Offset for Advance Payments
The Treasury Department and the IRS
considered three options for addressing
the treatment of costs under section
451(c): (i) No cost offset; (ii) a cost offset
for incurred costs; and (iii) a cost offset
that further allowed for projected costs.
The proposed section 451(c) regulations
(in this part C.5, proposed regulations)
did not provide for a cost offset for
advanced payments. At the time, the
Treasury Department and the IRS
argued 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 § 1.451–5. Taxpayers
commenting on the proposed
regulations were concerned that the
failure to provide a cost offset rule in
451(c) would cause a mismatch of
income and expenses and result in the
taxation of gross receipts. For example,
if a business has a multi-year contract to
build or manufacture a highly
customized good, it would report any
advance payment in income in the year
of receipt or in the following taxable
year. If it uses the advance payment to
purchase materials and to pay workers
as part of the project, it would recover
those costs only when the sale takes
place. Under the proposed regulations,
the statute would generate a tax on the
total amount of the advance payment in
the first years of the contract with all
related costs being recovered later in the
contract.
In response to these comments on the
proposed regulations, the Treasury
Department and the IRS have written
the final regulations to include an offset
for cost of goods in progress (cost offset).
This cost offset allows taxpayers to
reduce the amount of an advance
payment for the future sale of inventory
that is required to be included in gross
income in a year prior to the year in

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which ownership of the inventory is
transferred to the customer. The amount
of such reduction, or cost offset, is equal
to the inventoriable costs incurred as of
the end of the taxable year in which the
advance payment is required to be
included in gross income under the
taxpayer’s method of accounting for
advance payments. This provision of the
final regulations allows taxpayers to
offset advance payments included in
income under either the full inclusion
method or the deferral method.
However, the cost of goods in progress
offset cannot reduce the amount of the
advance payment income inclusion
below zero. Any incurred costs subject
to this limitation may be carried forward
to determine the cost of goods in
progress in subsequent taxable years.
The cost offset in the final regulations
generally reduces the amount of the
advance payment that is required to be
included in gross income in a taxable
year prior to the year in which
ownership of the inventory is
transferred to the customer relative to
the proposed regulations. An improved
match of income and cost timing is
generally held to provide a more
accurate measure of economic activity
and thus provide a more efficient tax
system than under the proposed
regulations. For further discussion of
the economic effects of the cost offset
for advance payments and for income
more generally see 4.a.i.
The Treasury Department and the IRS
considered expanding the cost offset to
allow for projected costs, with several
possible formats being considered for
how projected costs would be treated.
Allowing an offset for projected costs
would entail a higher administrative
burden than the offset for incurred costs
and may not definitively improve the
alignment of when income and costs are
recognized for tax purposes relative to
the offset for incurred costs.
The Treasury Department and the IRS
have not estimated the difference in
compliance costs, administrative
burden, or income-cost alignment (and
any subsequent effects on economic
activity) between the final regulations
and alternative regulatory approaches
using projected costs associated with
advance payments. The Treasury
Department and the IRS have not
undertaken this estimation because they
do not have sufficiently detailed data or
models that capture possible differences
in cost offset formats that use incurred
costs versus projected costs.

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b. Provisions Not Substantially Revised
From the Proposed 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 (nonAFS taxpayers). To remedy this gap, the
proposed and final 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.

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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
they were received. The final
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.

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The Treasury Department and the IRS
considered not modifying or expanding
the acceleration rule contained in
section 451(c) but rejected this
alternative because the remaining
amount may never be included in
income, thus 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 and
final regulations treat the expanded set
of accelerated transactions consistently
with similar types of transactions based
on the timing and structure of the
payments involved.
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 were upheld, taxpayers
could convert an income ‘‘deferral’’
amount into an income ‘‘exemption’’
amount. To address this issue and avoid
this possibility, the proposed and final
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 writedowns 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.
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

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831

issue, the proposed and final 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.
v. Performance Obligations for Non-AFS
Taxpayers
A performance obligation is generally
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. Further, each
performance obligation in a contract
generally yields a separate item of gross
income. The Treasury Department and
the IRS interpret the statute as requiring
taxpayers to allocate payments
attributable to multiple items of gross
income in the same manner as such
payments are allocated to the
corresponding performance obligations
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
and final regulations provide allocation
rules for non-AFS taxpayers consistent
with a similar rule in Revenue
Procedure 2004–34. That rule specifies
that a payment that is attributable to
multiple items of gross income is
required to be allocated to such items in
a manner that is based on objective
criteria. The objective criteria standard
will be satisfied if the allocation method
is based on payments the taxpayer
regularly receives for an item or items
that are regularly sold or provided
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 relative
to the rules provided in the final
regulations. While the allocation rules
for AFS taxpayers and non-AFS
taxpayers differ to some degree under
the final regulations, the chosen
provision 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.

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vi. Specified Good Exception
Section 451(c) provides that certain
items are excluded from the definition
of an advance payment. Those items
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.
This list of items excluded from the
definition of an advance payment is
generally comparable to the list of items
excluded from the definition of an
advance payment in Revenue Procedure
2004–34.
Prior to release of the proposed
regulations, several commenters
requested that the list of excluded items
be expanded to include certain goods
that require a significant amount of
capital to produce and that 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 and the title and risk of loss
have transferred to the customer.
To address this issue, the proposed
regulations crafted a narrow specifiedgoods exception for taxpayers who
receive advance payments but do not
perform the work or deliver the good for
several years in the future. Specifically,
an exclusion was introduced for certain
goods for which a taxpayer requires a

deferral period has the potential to
increase book-tax accounting differences
relative to the final regulations. For
some companies, a one-year deferral
period may require the creation of
separate records to track advance
payments for accounting and tax
purposes. Thus, for these taxpayers, the
final regulations may provide greater
conformity between accounting (book)
income and taxable income to the extent
that applicable case law would defer the
inclusion of income related to the
specified goods exception.
II. Paperwork Reduction Act
These regulations do not impose any
additional information collection
requirements in the form of reporting,
recordkeeping requirements or thirdparty disclosure requirements related to
tax compliance. Instead, because section
451(b) and section 451(c) and these
regulations provide various methods of
accounting affecting the timing of
income inclusion, taxpayers without an
existing method of accounting for these
items may initially adopt such method
without the consent of the
Commissioner. However, the consent of
the Commissioner under section 446(e)
and the accompanying regulations is
required before implementing method
changes from one method to another
method. See §§ 1.451–3(l) and 1.451–
8(g). Some of the methods of accounting
referenced by and discussed in these
regulations are represented in the
following chart.

Section

Brief description of method

§ 1.451–3(b)(2)(i) ..................
§ 1.451–3(b)(2)(ii) .................

Application of AFS income inclusion rule by making all AFS revenue adjustments.
Application of AFS income inclusion rule by making certain AFS revenue adjustments (Alternative AFS Revenue
method).
AFS cost offset method.
Computing revenue when the AFS and taxable years are mismatched.
Change in the method of recognizing revenue in an AFS.
Deferral method for taxpayers with an AFS.
Deferral method for taxpayer without an AFS.
Advance payment cost offset method.
Election for the specified goods exception to not apply.
Change in the method for recognizing advance payments on an AFS.

§ 1.451–3(c) ..........................
§ 1.451–3(i)(4) ......................
§ 1.451–3(l) ...........................
§ 1.451–8(c) ..........................
§ 1.451–8(d) .........................
§ 1.451–8(e) .........................
§ 1.451–8(f) ..........................
§ 1.451–8(g) .........................

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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 final regulations make one minor
modification to the specified good
exception. In response to comments, the
final regulations give taxpayers the
option to treat upfront payments that
satisfy the criteria for the specified good
exception as a typical advance payment
under section 451(c). In other words,
taxpayers have the option of including
the advance payment in gross income
under the full inclusion method or the
deferral method. This flexibility in the
section 451(c) regime reduces
uncertainty for taxpayers who may be
unsure if a contract meets the specified
good exception relative to the proposed
regulations. It also allows taxpayers
using the 1-year deferral under Revenue
Procedure 2004–34 prior to the passage
of the TCJA the option to continue to do
so.
The Treasury Department and the IRS
considered as an alternative not using
the authority granted to the Secretary in
section 451(c)(4)(B)(vii) to exclude
certain payments. For manufacturers of
highly customizable goods with a
delivery date more than two years after
the upfront payment, the one-year

Taxpayers request consent to use a
method in these regulations by filing
Form 3115, Application for Change in
Accounting Method (Parts I, II, IV and
Schedule B). Filing of Form 3115 and
any statements attached thereto (for
taxpayers who are required to do so or
who elect certain methods of accounting
described in the regulations) is the sole
collection of information requirement
imposed by the statute and the
regulations.

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For the Paperwork Reduction Act
(PRA), the reporting burden associated
with the collections of information in
these regulations will be reflected in the
IRS Form 3115 PRA Submissions (OMB
control numbers 1545–0074 for
individual filers, 1545–0123 for
business filers, and 1545–2070 for all
other types of filers).
In 2018, the IRS released and invited
comment on a draft of Form 3115 to give
the public the opportunity to benefit
from certain specific revisions made to

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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. Form 3115
applies to changes of accounting
methods generally and is therefore
broader than section 451(b).
On November 25, 2019, the Treasury
Department and the IRS published
Revenue Procedure 2019–43, 2019–28
I.R.B. 1107, which updated Revenue
Procedure 2018–31, and provides a

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Federal Register / Vol. 86, No. 3 / Wednesday, January 6, 2021 / Rules and Regulations
global list of automatic method change
procedures, including procedures for
taxpayers to comply with various
provisions in section 451(b) and (c) and
the proposed regulations. Under the
procedures, taxpayers can request
permission to change to a method of
accounting to comply with the various
provisions in section 451(b) and (c) and
the proposed regulations using reduced
filing requirements, such as by filing a
short Form 3115, or for certain
taxpayers, by using a streamlined
method change procedure that involves
not filing a Form 3115.
The current status of the PRA
submissions that will be revised as a
result of the information collections in
these regulations is provided in the
accompanying table. As described
earlier, the reporting burdens associated
with the information collections in
these regulations are included in the
aggregated burden estimates for OMB
control numbers 1545–0074 (in the case
of individual filers of Form 3115), 1545–
0123 (in the case of business filers of
Form 3115 and filers subject to Revenue
Procedure 2018–31). The overall burden
Form/
revenue
procedure
Form 3115 ...............................

estimates associated with the OMB
control numbers identified later 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
these regulations. These numbers are
therefore unrelated to the future
calculations needed to assess the burden
imposed by these regulations. These
burdens have been reported for other
income tax regulations that rely on the
same information collections, and the
Treasury Department and the IRS urge
readers to recognize that these numbers
are duplicates and to guard against
overcounting the burdens imposed by
tax provisions prior to the TCJA.
No burden estimates specific to the
forms affected by these 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 these
regulations. For the OMB control

Type of filer
All other Filers (mainly trusts
and estates) (Legacy system).

numbers discussed in the preceding
paragraphs, 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 TCJA and those that arise out of
discretionary authority exercised in
these regulations and other regulations
that affect the compliance burden for
that form.
The Treasury Department and IRS
request comment on all aspects of
information collection burdens related
to these regulations, including estimates
for how much time it would take to
comply with the paperwork burdens
described earlier 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.

OMB no.(s)
1545–2070

833

Status
Published in the Federal Register on 2/15/17. Public comment period closed on 4/17/17.

Link: https://www.federalregister.gov/documents/2017/02/15/2017-02985/proposed-information-collection-comment-request.
Business (NEW Model) ..........

1545–0123

Published in the Federal Register on 10/8/18. Public comment period closed on 12/10/18.

Link: https://www.federalregister.gov/documents/2018/10/09/2018-21846/proposed-collection-comment-requestfor-forms-1065-1065-b-1066-1120-1120-c-1120-f-1120-h-1120-nd.
Individual (NEW Model) ..........

1545–0074

Limited scope submission (1040 only) on 10/11/18 at OIRA
for review. Full ICR submission for all forms in 2019.

Link: https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201808-1545-031.
Revenue Procedure 2018–31

IRS Research estimates .........

1545–0123

Published in the Federal Register on 9/30/19. Public Comment period closed on 12/23/19.

Link: https://www.federalregister.gov/documents/2019/10/22/2019–23009/proposed-collection-comment-requestfor-rev-proc-2018-31.

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III. Regulatory Flexibility Act
Pursuant to the Regulatory Flexibility
Act (5 U.S.C. chapter 6), it is hereby
certified that these 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 (small
entities). This certification can be made
because the Treasury Department and
the IRS have determined that the
regulations may affect a substantial

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number of small entities but have also
concluded that the economic effect on
small entities as a result of these
regulations is not expected to be
significant. Section 451(b) requires that
an item of income be included in gross
income for tax purposes no later than
when the item is counted as revenue in
an AFS. Due to the revised financial
accounting standards for calculating
revenue in an AFS under ASC 606, the
result of section 451(b) generally will be

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to move the recognition of income
forward by a year or two compared to
previous law. Section 451(c) provides
rules regarding the treatment of advance
payments. These regulations provide
general guidance on the rules, including
the scope of the rules, exceptions to the
rules, definitions of key terms, and
examples demonstrating applicability of
the rules.
The Treasury Department and the IRS
have estimated the number of small

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business entities that may be affected by
the statute and these regulations.
Section 451(b) and (c) and the
regulations under § 1.451–3 affect only
those business entities that (i) use an
accrual method of accounting, and (ii)
have an AFS. One provision in § 1.451–
8 applies to accrual method taxpayers
without an AFS. The remaining
provisions in § 1.451–8 apply to accrual
method taxpayers with an AFS.
Regarding the accrual method of
accounting, section 13102 of TCJA
modified section 448 to expand the
number of taxpayers eligible to use the
cash receipts and disbursements method
of accounting (cash method of
accounting). In general, C corporations

and partnerships with a C corporation
partner are now permitted to use the
cash method of accounting if average
annual gross receipts are $25 million or
less for taxable years beginning in 2018
(up from $5 million or less in 2017). The
$25 million figure is considered for
adjustment for inflation annually. This
amount was adjusted for inflation for
taxable years beginning after December
31, 2018. The amount was $26 million
for taxable year 2019. The Treasury
Department and the IRS estimate that
approximately 3,128,000 business
entities with gross receipts of $26
million or less used an accrual method
of accounting in taxable year 2017,
which represents approximately 8.5

percent of all business entities with
gross receipts of $26 million or less. The
Treasury Department and the IRS
project that in future years, the number
of entities with gross receipts not greater
than $26 million that will be using the
accrual method will be less than 8.5
percent of all entities with gross receipts
of $26 million or less.
Many small business entities use the
cash method of accounting, as opposed
to an accrual method, and thus are not
subject to these regulations. The percent
of returns that use an accrual method of
accounting, by entity types and for
entities with gross receipts not greater
than $26 million, is shown in the
accompanying table.

TOTAL RETURNS AND RETURNS USING ACCRUAL METHOD OF ACCOUNTING
[Taxable year 2017]
Entities with gross receipts not greater than $26 million

Total returns
(thousands)

Entity

Returns using
an accrual
method of
accounting
(thousands)

Percent of
returns
using accrual
method of
accounting

C corporations .............................................................................................................................
S corporations ..............................................................................................................................
Partnerships .................................................................................................................................
Sole proprietors and LLCs ...........................................................................................................

1,570
4,684
3,884
26,425

691
1,146
912
379

44
24
23
1

All entities .............................................................................................................................

36,425

3,128

8.5

Source: Internal Revenue Service, RAAS, KDA.

The Treasury Department and the IRS
next examined the second condition,
that entities with an AFS are affected by
section 451(b) and the regulations. The
Treasury Department and the IRS do not
have readily available data to measure
the prevalence of entities with an AFS,
as defined in the statute and in § 1.451–
3(b)(1). However, Schedule M–3, which
is used to reconcile an entity’s net
income or loss for tax purposes with its
book income or loss, reports whether an
entity has a certified audited income
statement. The Schedule M–3 is
required to be filed only by entities with
at least $10 million of assets. This
population is more likely to possess an
AFS and, conversely, entities that do

not file Schedule M–3 are less likely to
possess an AFS as owners and/or
creditors of such smaller entities are less
likely to require the entity to certify its
financial results via a financial
statement audit. Data is currently
available only for electronic filers.
For taxable year 2017, approximately
89 percent of accrual-method entities
filing Forms 1120, 1120–S, and 1065
with gross receipts of $26 million or less
were filers of electronic tax forms.
About 11 percent, or 288,000 returns,
included a Schedule M–3. About 40
percent of the returns with Schedule M–
3, or 113,000, indicated they had a
certified audited income statement.
Based on the assumption that filers of

paper tax forms have the same
incidence as electronic filers and that
entities that do not file a Schedule M–
3 generally do not have an AFS, then
the Treasury Department and the IRS
estimate that roughly 127,000 (113,000/
0.89) entities with gross receipts of $26
million or less are accrual-method
entities that have an AFS. If 5 percent
of entities that do not file a Schedule
M–3 also have an AFS then
approximately 224,000 entities with
gross receipts of $26 million or less are
potentially affected by these regulations.
These estimates of affected filing
entities are reproduced in the following
table.

CORPORATION AND PARTNERSHIP RETURNS USING AN ACCRUAL METHOD OF ACCOUNTING—TAXABLE YEAR 2017
[Thousands of returns]

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Entities with gross receipts not greater than $26 million
E-filed
returns
Returns
Returns
Returns
Returns
Returns

........................................................................................................................................
with a Schedule M–3 .....................................................................................................
with a Schedule M–3 and an audited income statement ..............................................
without a Schedule M–3 ................................................................................................
without a Schedule M–3, but with an audited income statement .................................

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2,503
288
113
2,215
** 111

06JAR4

Paper-filed
returns
307
* 35
* 14
* 272
** 13

Total
returns
2,810
* 323
* 127
* 2,487
** 124

Federal Register / Vol. 86, No. 3 / Wednesday, January 6, 2021 / Rules and Regulations

835

CORPORATION AND PARTNERSHIP RETURNS USING AN ACCRUAL METHOD OF ACCOUNTING—TAXABLE YEAR 2017—
Continued
[Thousands of returns]
Entities with gross receipts not greater than $26 million
E-filed
returns
Returns with an audited income statement .................................................................................

** 224

Paper-filed
returns
** 27

Total
returns
** 251

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* Estimates are obtained by assuming paper-filed returns are similar to e-filed returns as regards the incidence of a filing entity having a
Schedule M–3 and an audited income statement.
** Estimates are obtained by assuming that 5% of returns without a Schedule M–3 have an audited income statement. This compares with approximately 40% of returns with a Schedule M–3 having such a statement.
Source: Non-italic entries are estimates taken from the IRS Research, Applied Analytics and Statistics KDA Division using data from the Compliance Data Warehouse. The total number of accrual method returns of corporations and partnerships differs slightly from that reported in the
earlier table due to the use of different data sources for the two estimates. Italicized entries are additional estimates obtained in the manner indicated in the table notes.

This rule would not have a significant
economic impact on small entities
affected. The costs to comply with these
regulations are reflected in modest
reporting activities. Taxpayers needing
to make method changes pursuant to
these regulations will be required to file
a Form 3115. The Treasury Department
and the IRS have provided streamlined
procedures for certain taxpayers to
change their method of accounting to
comply with section 451(b) and (c), and
plan to provide streamlined procedures
for such taxpayers to change to the
methods of accounting described in
these regulations. Under the streamlined
procedures, eligible taxpayers would
either complete only a portion of the
Form 3115 or would not complete the
Form 3115 at all to comply with the
guidance. The streamlined method
change procedures are available to
taxpayers, other than a tax shelter, who
satisfy the gross receipts test under
section 448(c) and for taxpayers making
such a method change which results in
a zero section 481(a) adjustment. In
addition, contemporaneous with these
regulations, the Treasury Department
and the IRS are issuing a streamlined
procedure for taxpayers using a section
451(b) method who have a change in
their AFS for revenue recognition that
requires a method change for tax
purposes.
The estimated cumulative annual
reporting and/or recordkeeping burden
for the statutory method changes
relating to the streamlined procedures
used to be described under OMB control
number 1545–1551. In 2019, OMB
number 1545–1551 was merged into
OMB number 1545–0123. The estimated
number of respondents, after taking into
account the streamlined procedures that
are being issued is 28,046 respondents,
and a total annual reporting and/or
recordkeeping burden of 34,279 hours.
The estimated annual burden per
respondent/recordkeeper under OMB

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control number 1545–0123 before
publication of this revenue procedure
varies from 1⁄6 hour to 81⁄2 hours,
depending on individual circumstances,
with an estimated average of 11⁄2 hours.
The estimated monetized burden for
compliance is $95 per hour. The
estimated cumulative annual reporting
and/or recordkeeping burden for the
method changes described under OMB
control number 1545–0123 after the
revenue procedure is accounted for is
28,046 respondents, and a total annual
reporting and/or recordkeeping burden
is 34,279 hours. These burdens are
essentially unaffected by these
regulations.
Accordingly, the Secretary certifies
that the rule will not have a significant
economic impact on a substantial
number of small entities.
Pursuant to section 7805(f), the notice
of proposed rulemaking preceding this
final rule was submitted to the Chief
Counsel for the Office of Advocacy of
the Small Business Administration for
comment on its impact on small
business. No comments on the notice
were received from the Chief Counsel
for the Office of Advocacy of the Small
Business Administration.
IV. Unfunded Mandates Reform Act
Section 202 of the Unfunded
Mandates Reform Act of 1995 (UMRA)
requires that agencies assess anticipated
costs and benefits and take certain
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 section,
of $100 million in 1995 dollars, update
annually for inflation. This rule does
not include any Federal mandate that
may result in expenditures by state,
local, or tribal governments, or by the
private section in excess of that
threshold.

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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
final 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.
VI. Congressional Review Act
The Administrator of the Office of
Information and Regulatory Affairs of
the Office of Management and Budget
has determined that this is a major rule
for purposes of the Congressional
Review Act (5 U.S.C. 801 et seq.). Under
5 U.S.C. 801(a)(3), a major rule takes
effect 60 days after the rule is published
in the Federal Register.
Notwithstanding this requirement, 5
U.S.C. 808(2) allows agencies to
dispense with the requirements of 5
U.S.C. 801 when the agency for good
cause finds that such procedure would
be impracticable, unnecessary, or
contrary to the public interest and the
rule shall take effect at such time as the
agency promulgating the rule
determines. Pursuant to 5 U.S.C. 808(2),
the Treasury Department and the IRS
find, for good cause, that a 60-day delay
in the effective date is contrary to the
public interest.
Following the amendments to section
451(b) and (c) by the TCJA, the Treasury
Department and the IRS published the
proposed regulations to provide
certainty to taxpayers. In particular, as
demonstrated by the wide variety of
public comments in response to the
proposed regulations received,

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taxpayers continue to express
uncertainty regarding the proper
application of the statutory rules under
section 451(b) and (c). This is especially
the case for taxpayers in the
manufacturing and retail industries
producing or reselling inventoriable
goods because the final regulations
allow such taxpayers to more clearly
reflect their income for Federal income
tax purposes compared to the approach
of the proposed regulations. An earlier
effective date will allow taxpayers to
implement the final regulations earlier
to take advantage of certain provisions
in the Coronavirus Aid, Relief, and
Economic Security Act, Public Law
116–136 (March 27, 2020) that were
designed to enhance liquidity, such as
the 5-year net operating loss carryback
provisions. Consistent with Executive
Order 13924 (May 19, 2020), the
Treasury Department and the IRS have
therefore determined that an expedited
effective date of the final regulations
would more appropriately provide such
critical businesses greater liquidity
needed to remain open or ‘‘re-open by
providing guidance on what the law
requires.’’ 85 FR 31353–54.
Accordingly, the Treasury Department
and the IRS have determined that the
rules in this Treasury decision will take
effect on the date of filing for public
inspection in the Federal Register.
Drafting Information
The principal author of these
regulations is Jo Lynn Ricks (Office of
the Associate Chief Counsel (Income
Tax and Accounting)). Other personnel
from the Treasury Department and the
IRS, including Kate Abdoo, John
Aramburu, James Beatty (formerly
Income Tax and Accounting), David
Christensen, Alexa Dubert, Sean Dwyer,
Peter Ford, Christina Glendening, Anna
Gleysteen, Charlie Gorham, Evan
Hewitt, William Jackson, Doug Kim,
Tom McElroy, and Karla Meola, Office
of the Associate Chief Counsel (Income
Tax and Accounting); and William E.
Blanchard, Charles Culmer, and Deepan
Patel, Office of the Associate Chief
Counsel (Financial Institutions and
Products), participated in their
development.

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List of Subjects in 26 CFR Part 1
Income taxes, Reporting and
recordkeeping requirements.
Amendments to the Regulations
Accordingly, 26 CFR part 1 is
amended as follows:

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PART 1—INCOME TAXES
Paragraph 1. The authority citation
for part 1 is amended by adding entries
in numerical order for §§ 1.451–3 and
1.451–8 to read, in part, as follows:

■

Authority: 26 U.S.C. 7805.

*

*

*

*

*

Section 1.451–3 also issued under 26
U.S.C. 451(b)(1)(A)(ii), (b)(3)(C) and 461(h).
Section 1.451–8 also issued under 26
U.S.C. 451(c)(2)(A), (3), (4)(A)(iii), (4)(b)(vii),
and 461(h).

*

*
*
*
*
Par. 2. Section 1.446–1 is amended by
adding a parenthetical sentence between
the first and second sentences of
paragraph (c)(1)(ii)(A) to read as follows:

■

§ 1.446–1 General rule for methods of
accounting.

*

*
*
*
*
(c) * * *
(1) * * *
(ii) * * *
(A) * * * (See § 1.451–1 for rules
relating to the taxable year of inclusion.)
* * *
■ Par. 3. Section 1.446–2 is amended by
removing ‘‘or’’ at the end of paragraph
(a)(2)(i)(E), removing the period at the
end of paragraph (a)(2)(i)(F) and adding
‘‘; or’’ in its place, and adding paragraph
(a)(2)(i)(G) to read as follows:
§ 1.446–2
interest.

Method of accounting for

(a) * * *
(2) * * *
(i) * * *
(G) Section 1.451–3(j) (special
ordering rule for specified fees).
*
*
*
*
*
■ Par. 4. Section 1.451–1 is amended
by:
■ a. Adding ‘‘(all events test)’’ to the end
of the second sentence of paragraph (a).
■ b. Redesignating paragraphs (b)
through (g) as (d) through (i).
■ c. Adding new paragraphs (b) and (c).
The additions read as follows:
§ 1.451–1 General rule for taxable year of
inclusion.

*

*
*
*
*
(b) Timing of income inclusion for
accrual method taxpayers with an
applicable financial statement. For the
timing of income inclusion for taxpayers
that have an applicable financial
statement, as defined in § 1.451–3(b)(1),
and that use an accrual method of
accounting, see section 451(b) and
§ 1.451–3.
(c) Special rule for timing of income
inclusion from advance payments. For
the timing of income inclusion for
taxpayers that receive advance
payments, as defined in § 1.451–8(a)(1),

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and that use an accrual method of
accounting, see section 451(c) and
§ 1.451–8.
*
*
*
*
*
■ Par. 5. Section 1.451–3 is added to
read as follows:
§ 1.451–3 Timing of income inclusion for
taxpayers with an applicable financial
statement using an accrual method of
accounting.

(a) Definitions. The following
definitions apply for this section:
(1) AFS income inclusion amount.
The term AFS income inclusion amount
means the amount of an item of gross
income that is required to be included
in gross income under the AFS income
inclusion rule in paragraph (b)(1) of this
section.
(2) AFS income inclusion rule. The
term AFS income inclusion rule has the
meaning provided in paragraph (b)(1) of
this section.
(3) AFS inventory inclusion amount.
The term AFS inventory inclusion
amount has the meaning provided in
paragraph (c)(2)(i)(A) of this section.
(4) AFS revenue. The term AFS
revenue means revenue reported in the
taxpayer’s AFS. The characterization of
an amount in the AFS is not
determinative of whether the amount is
AFS revenue. For example, AFS
revenue can include amounts reported
as other comprehensive income or
adjustments to retained earnings in an
AFS. See paragraph (b) of this section
for adjustments to AFS revenue that
may need to be made to apply the rules
of this section.
(5) Applicable financial statement
(AFS). Subject to the rules in paragraph
(a)(5)(iv) of this section, the terms
applicable financial statement and AFS
are synonymous and mean the
taxpayer’s financial statement listed in
paragraph (a)(5)(i) through (iii) of this
section that has the highest priority,
including priority within paragraphs
(a)(5)(i)(B) and (a)(5)(ii)(B) of this
section. The financial statements are, in
order of descending priority:
(i) GAAP statements. A financial
statement that is certified as being
prepared in accordance with United
States generally accepted accounting
principles (GAAP) and is:
(A) A Form 10–K (or successor form),
or annual statement to shareholders,
filed with the United States Securities
and Exchange Commission (SEC);
(B) An audited financial statement of
the taxpayer that is used for:
(1) Credit purposes;
(2) Reporting to shareholders,
partners, or other proprietors, or to
beneficiaries; or

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Federal Register / Vol. 86, No. 3 / Wednesday, January 6, 2021 / Rules and Regulations
(3) Any other substantial non-tax
purpose; or
(C) A financial statement, other than
a tax return, filed with the Federal
Government or any Federal agency,
other than the SEC or the Internal
Revenue Service (IRS);
(ii) IFRS statements. A financial
statement that is certified as being
prepared in accordance with
international financial reporting
standards (IFRS) and is:
(A) Filed by the taxpayer with an
agency of a foreign government that is
equivalent to the SEC, and has financial
reporting standards not less stringent
than the standards required by the SEC;
(B) An audited financial statement of
the taxpayer that is used for:
(1) Credit purposes;
(2) Reporting to shareholders,
partners, or other proprietors, or to
beneficiaries; or
(3) Any other substantial non-tax
purpose; or
(C) A financial statement, other than
a tax return, filed with the Federal
Government, Federal agency, a foreign
government, or agency of a foreign
government, other than the SEC, IRS, or
an agency that is equivalent to the SEC
or the IRS; or
(iii) Other statements. A financial
statement, other than a tax return, filed
with the Federal Government or any
Federal agency, a state government or
state agency, or a self-regulatory
organization including, for example, a
financial statement filed with a state
agency that regulates insurance
companies or the Financial Industry
Regulatory Authority. Additional
financial statements beyond those
included in this paragraph (a)(5)(iii)
may be provided in guidance published
in the Internal Revenue Bulletin (see
§ 601.601(d) of this chapter).
(iv) Additional rules for determining
priority. If a taxpayer restates AFS
revenue for a taxable year prior to the
date that the taxpayer files its Federal
income tax return for such taxable year,
the restated AFS must be used instead
of the original AFS. If using the restated
AFS revenue results in a change in
method of accounting, the preceding
sentence applies only if the taxpayer
receives permission to change its
method of accounting to use the restated
AFS revenue. In addition, if a taxpayer
with different financial accounting and
taxable years is required to file both
annual financial statements and
periodic financial statements covering
less than a year with a government or
government agency, the taxpayer must
prioritize the annual financial statement
in accordance with this paragraph (a)(5).

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(6) Cost of goods. The term cost of
goods means the costs that are properly
capitalized and included in inventory
under sections 471 and 263A or any
other applicable provision of the
Internal Revenue Code (Code) and that
are allocable to an item of inventory for
which an AFS inventory inclusion
amount is calculated. See paragraph
(c)(5)(iii) of this section for specific
rules for taxpayers using simplified
methods under section 263A.
(7) Cost of goods in progress offset.
The term cost of goods in progress offset
has the meaning provided in paragraph
(c)(3) of this section.
(8) Cumulative cost of goods in
progress offset. The term cumulative
cost of goods in progress offset means
the cumulative cost of goods in progress
offset amounts under paragraph (c) of
this section for a specific item of
inventory that have reduced an AFS
inventory inclusion amount attributable
to such item of inventory in prior
taxable years.
(9) Enforceable right. The term
enforceable right means any right that a
taxpayer has under the terms of a
contract or under applicable Federal,
state, or international law, including
rights to amounts recoverable in equity
and liquidated damages. A contract can
include, but is not limited to, a
statement of work, purchase order, or
invoice.
(10) Equity method. The term equity
method means a method of accounting
for financial accounting purposes under
which an investment is initially
recorded at cost and subsequently
increased or decreased in carrying value
by the investor’s proportionate share of
income and losses and such income or
losses are reported as separate items on
the investor’s statement of income.
(11) Performance obligation. The term
performance obligation means a
promise in a contract with a customer
to transfer to the customer a distinct
good, service, or right; or a series of
distinct goods, services, or rights, or a
combination thereof, that are
substantially the same and that have the
same pattern of transfer to the customer.
A performance obligation includes a
promise to grant or transfer a right to
use or access intangible property.
Performance obligations in a contract
are identified by applying the
accounting standards the taxpayer uses
to prepare its AFS. Additionally, to the
extent the contract with the customer
provides the taxpayer with an
enforceable right to payment, the
revenue from which is not allocated to
a performance obligation described in
the first two sentences of this paragraph
(a)(11) in the taxpayer’s AFS but is

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837

accounted for as a separate source of
revenue in the taxpayer’s AFS, such
right shall be treated as a separate
performance obligation under this
section. A fee described in paragraph
(j)(2) of this section is an example of an
enforceable right that is treated as a
separate performance obligation.
(12) Prior income inclusion amounts.
The term prior income inclusion
amounts means amounts of an item of
gross income that were required to be
included in the taxpayer’s gross income
under this section or § 1.451–8 in prior
taxable years.
(13) Special method of accounting.
The term special method of accounting
means a method of accounting expressly
permitted or required under any
provision of the Code, the regulations in
this part, or other guidance published in
the Internal Revenue Bulletin (see
§ 601.601(d) of this chapter) under
which the time for taking an item of
gross income into account in a taxable
year is not determined under the all
events test in § 1.451–1(a). See,
however, paragraph (j) of this section
relating to certain items of income for
debt instruments. The term special
method of accounting does not include
any method of accounting expressly
permitted or required under this
section. The following are examples of
special methods of accounting to which
the AFS income inclusion rule does not
apply:
(i) The crop method of accounting
under sections 61 and 162;
(ii) Methods of accounting provided
in sections 453 through 460;
(iii) Methods of accounting for
notional principal contracts under
§ 1.446–3;
(iv) Methods of accounting for
hedging transactions under § 1.446–4;
(v) Methods of accounting for REMIC
inducement fees under § 1.446–6;
(vi) Methods of accounting for gain on
shares in a money market fund under
§ 1.446–7;
(vii) Methods of accounting for certain
rental payments under section 467;
(viii) The mark-to-market method of
accounting under section 475;
(ix) Timing rules for income and gain
associated with a transaction that is
integrated under § 1.988–5, and income
and gain under the nonfunctional
currency contingent payment debt
instrument rules in § 1.988–6;
(x) Except as otherwise provided in
paragraph (j) of this section, timing rules
for original issue discount (OID) under
section 811(b)(3) or 1272 (and the
regulations in this part under section
1272 of the Code), income under the
contingent payment debt instrument
rules in § 1.1275–4, income under the

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variable rate debt instrument rules in
§ 1.1275–5, income and gain associated
with a transaction that is integrated
under § 1.1275–6, and income under the
inflation-indexed debt instrument rules
in § 1.1275–7;
(xi) Timing rules for de minimis OID
under § 1.1273–1(d) and for de minimis
market discount (as defined in section
1278(a)(2)(C));
(xii) Timing rules for accrued market
discount under sections 1276 and
1278(b);
(xiii) Timing rules for short-term
obligations under sections 1281 through
1283;
(xiv) Timing rules for stripped bonds
under section 1286; and
(xv) Methods of accounting provided
in sections 1502 and 1503 and the
regulations thereunder, including the
method of accounting relating to
intercompany transactions under
§ 1.1502–13.
(14) Transaction price amount. The
term transaction price amount means
the total amount of consideration to
which a taxpayer is, or expects to be,
entitled from all performance
obligations under a contract. The
transaction price amount is determined
under the standards the taxpayer uses to
prepare its AFS.
(b) AFS income inclusion rule—(1) In
general. Except as otherwise provided
in this section, if a taxpayer uses an
accrual method of accounting for
Federal income tax purposes and has an
AFS, the all events test under § 1.451–
1(a) for any item of gross income, or
portion thereof, is met no later than
when that item, or portion thereof, is
taken into account as AFS revenue (AFS
income inclusion rule). See paragraph
(b)(2) of this section for rules regarding
when an item of gross income, or
portion thereof, is treated as taken into
account as AFS revenue under the AFS
income inclusion rule. See paragraph (c)
of this section for optional rules to
determine the AFS income inclusion
amount for an item of gross income from
the sale of inventory. See paragraph (d)
of this section for rules regarding the
allocation of the transaction price
amount to multiple items of gross
income. See paragraph (e) of this section
for rules to determine the AFS income
inclusion amount for an item of gross
income from a multi-year contract. See
paragraphs (f) and (g) of this section for
limitations of the AFS income inclusion
rule. See paragraph (h) of this section
for special rules that may affect the
determination of AFS revenue under the
AFS income inclusion rule. See
paragraph (j) of this section for special
ordering rules for certain items of

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income with respect to debt
instruments.
(2) Amounts taken into account as
AFS revenue—(i) General rule. Unless
the taxpayer uses the alternative AFS
revenue method described in paragraph
(b)(2)(ii) of this section, the amount of
the item of gross income that is treated
as taken into account as AFS revenue
under paragraph (b)(1) of this section is
determined by making adjustments to
AFS revenue for the amounts described
in paragraphs (b)(2)(i)(A) through (D) of
this section.
(A) If AFS revenue reflects a
reduction for amounts described in
paragraph (b)(2)(i)(A)(1) or (2) of this
section, AFS revenue is increased by the
amount of the reduction.
(1) Cost of goods sold and liabilities
that are required to be accounted for
under other provisions of the Code such
as section 461, including liabilities for
allowances, rebates, chargebacks,
rewards issued in credit card
transactions and other reward programs,
and refunds, regardless of when any
amount described in this paragraph
(b)(2)(i)(A)(1) is incurred.
(2) Amounts anticipated to be in
dispute or anticipated to be
uncollectable.
(B) If AFS revenue includes an
amount the taxpayer does not have an
enforceable right to recover if the
customer were to terminate the contract
on the last day of the taxable year
(regardless of whether the customer
actually terminates the contract), AFS
revenue is reduced by such amount.
(C) If the transaction price was
increased because a significant
financing component is deemed to exist
under the standards the taxpayer uses to
prepare its AFS, then any AFS revenue
attributable to such increase is
disregarded.
(D) AFS revenue may be increased or
reduced by additional amounts as
provided in guidance published in the
Internal Revenue Bulletin (see
§ 601.601(d) of this chapter).
(ii) Alternative AFS revenue method.
A taxpayer that chooses to apply the
AFS income inclusion rule by using the
alternative AFS revenue method
described in this paragraph (b)(2)(ii) in
lieu of the rules in paragraph (b)(2)(i) of
this section, determines the amount of
the item of gross income that is treated
as taken into account as AFS revenue
under paragraph (b)(1) of this section by
making adjustments to AFS revenue for
only the amounts described in
paragraphs (b)(2)(i)(A), (C), and (D) of
this section. A taxpayer that uses the
alternative AFS revenue method for a
trade or business must apply the
method to all items of gross income in

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the trade or business that are subject to
the AFS income inclusion rule.
(3) Exceptions. The AFS income
inclusion rule in paragraph (b)(1) of this
section does not apply to:
(i) Any item of gross income, or
portion thereof, if the timing of income
inclusion for that item, or portion
thereof, is determined using a special
method of accounting;
(ii) Any item of gross income, or
portion thereof, in connection with a
mortgage servicing contract; or
(iii) Any taxable year that is not
covered for the entire year by one or
more AFS.
(4) Examples. The following examples
illustrate the provisions of paragraph (b)
of this section. Unless the facts
specifically state otherwise, the taxpayer
has an AFS, is on a calendar year for
Federal income tax purposes and AFS
purposes, and uses an accrual method of
accounting for Federal income tax
purposes. Further, the taxpayer does not
use the alternative AFS revenue method
under paragraph (b)(2)(ii) of this section
or the AFS cost offset method under
paragraph (d) of this section, and does
not use a special method of accounting:
(i) Example 1: Provision of
installation services—(A) Facts. In 2021,
B enters into a 2-year service contract
with a customer to install the customer’s
manufacturing equipment for $100,000.
Throughout the term of the contract, the
customer retains control of the
equipment. B begins providing the
installation services in 2021 and
completes the installation services in
2022. Under the contract, B bills the
customer $55,000 in 2021 when
installation begins, but does not have a
fixed right to receive the remaining
$45,000 until installation is complete
and approved by the customer.
However, if the customer were to
terminate the contract prior to
completion, B would have an
enforceable right to payment for all
services performed prior to the
termination date. For its AFS, B reports
$60,000 of AFS revenue for 2021 and
$40,000 of AFS revenue for 2022, in
accordance with the services performed
in each respective year.
(B) Analysis. Under the all events test
in § 1.451–1(a), B is required to include
$55,000 in gross income in 2021 as B
has a fixed right to receive $55,000 as
of the end of 2021. However, under the
AFS income inclusion rule, because B
has an enforceable right to recover the
entire $60,000 that was reported in AFS
revenue for 2021 had the customer
terminated the contract on the last day
of 2021, the entire $60,000 is treated as
taken into account as AFS revenue in
2021. Accordingly, the all events test is

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met for the $60,000 of gross income no
later than the end of 2021 and B is
required to include $60,000 in gross
income in 2021.
(ii) Example 2: Provision of goods
included in AFS with enforceable
right—(A) Facts. In November 2021, C
enters into a contract with a customer to
provide 50 customized computers for
$80,000. Under the contract, C can bill
$80,000 after the customer accepts
delivery of the computers. However, the
contract provides that C has an
enforceable right to be paid for work
performed to date if the customer were
to terminate the contract prior to
delivery. C produces and ships all of the
computers in 2021. In 2022, the
customer accepts delivery of the
computers and C bills the customer. For
its AFS, C reports $80,000 of AFS
revenue for 2021.
(B) Analysis. Under the all events test
in § 1.451–1(a), C does not have a fixed
right to receive the $80,000 until the
customer accepts delivery of the
computers in 2022. However, under the
AFS income inclusion rule, because C
has an enforceable right to recover the
entire $80,000 of AFS revenue that was
reported for 2021 had the customer
terminated the contract on the last day
of 2021, the entire $80,000 is treated as
‘‘taken into account as AFS revenue’’ in
2021. Accordingly, the all events test is
met for the $80,000 no later than in
2021 and C is required to include
$80,000 in gross income in 2021.
(iii) Example 3: Provision of services
included in AFS with enforceable
right—(A) Facts. In 2021, D, an
engineering services provider, enters
into a 4-year contract with a customer
to provide services for a total of $100x.
Under the contract, D bills and receives
$25x for each year of the contract. If the
customer were to terminate the contract
prior to completion, D has an
enforceable right to only the billed
amounts. For its AFS, D reports $60x,
$0, $20x, and $20x of AFS revenue from
the contract for 2021, 2022, 2023, and
2024, respectively.
(B) Analysis. Under the all events test
in § 1.451–1(a), D is required to include
$25x in gross income in 2021 as D has
a fixed right to receive $25x as of the
end of 2021. Although D reports $60x of
AFS revenue from the provision of
services for 2021, D has an enforceable
right to recover only $25x if the
customer were to terminate the contract
on the last day of 2021. Accordingly,
pursuant to paragraph (b)(2)(i)(B) of this
section, of the $60x of AFS revenue
reported for 2021, only $25x is treated
as ‘‘taken into account as AFS revenue’’
under the AFS income inclusion rule.
As a result, D is required to include only

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$25x in gross income in 2021. Similarly,
in 2022, 2023 and 2024, D includes in
gross income only the yearly $25x
contract payments under the all events
test as only the billed amounts are
treated as ‘‘taken into account as AFS
revenue’’ under the AFS income
inclusion rule.
(iv) Example 4: Sale of good under
cost-plus contract—(A) Facts. In 2021,
E, a manufacturer, enters into a contract
with Fire Department for the
manufacture and delivery of a fire truck.
The fire truck takes 10 months to
manufacture at an estimated cost of
$60,000. The contract provides E with
an enforceable right to recover costs
incurred in manufacturing the fire truck
regardless of whether the Fire
Department accepts delivery of the fire
truck or terminates the contract, and an
enforceable right to an additional
$20,000 if the fire truck is accepted by
the Fire Department. E does not have an
enforceable right to recover any portion
of the additional $20,000 if the Fire
Department were to terminate the
contract before it accepts the fire truck.
E has an obligation to cure any defects
if the customer rejects the fire truck. In
August 2021, E begins manufacturing
the fire truck ordered by Fire
Department and incurs $30,000 of costs
for materials and labor for the contract.
For its AFS, E reports $40,000 of AFS
revenue for 2021 ($30,000 costs plus
$10,000 expected profit on the sale of
the fire truck).
(B) Analysis for 2021 taxable year.
Under the all events test in § 1.451–1(a),
E is required to include $30,000 in gross
income in 2021 as E has a fixed right to
receive $30,000 as of the end of 2021.
Although E reports $40,000 of AFS
revenue for 2021, E has an enforceable
right to recover only $30,000 if the Fire
Department were to terminate the
contract on the last day of 2021.
Accordingly, pursuant to paragraph
(b)(2)(i)(B) of this section, of the $40,000
of AFS revenue reported for 2021, only
$30,000 is treated as ‘‘taken into account
as AFS revenue’’ under the AFS income
inclusion rule. As a result, E is required
to include only $30,000 in gross income
in 2021.
(v) Example 5: Sale of goods with AFS
revenue adjustments—(A) Facts. In July
2021, F, a manufacturer of automobile
parts, enters into a contract to sell 1,000
parts to a customer for $10 per part, for
a total of $10,000 (1,000 × $10). The
contract also provides that F will
receive a $200 bonus if it delivers all the
parts to the customer by February 1,
2022. F delivers 500 non-defective parts
to the customer on December 31, 2021
and schedules the remaining 500 parts
for delivery to the customer on January

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839

1, 2022. F does not have an enforceable
right to recover any portion of the $200
bonus if the customer were to terminate
the contract before all 1,000 parts are
delivered. F expects to earn the $200
bonus and have 5% of the non-defective
parts returned. For its AFS, F reports
$4,850 ($5,000 + $100¥$250) of AFS
revenue for 2021, which includes a $100
(50% × $200) adjustment to increase
AFS revenue for the expected bonus and
a $250 (5% × $5,000) adjustment to
decrease AFS revenue for anticipated
returns.
(B) Analysis. Under the all events test
in § 1.451–1(a), F is required to include
$5,000, less the corresponding cost of
goods sold under sections 263A and 471
as applicable, in gross income in 2021
as F has a fixed right to receive $5,000
from the delivery of 500 parts to the
customer in 2021. However, F does not
have a fixed right to receive any portion
of the $200 delivery bonus as of the end
of 2021 as the remaining 500 parts had
yet to be delivered. Under the AFS
income inclusion rule and, specifically,
paragraphs (b)(2)(i)(A)(1) and (b)(2)(i)(B)
of this section, the amount treated as
‘‘taken into account as AFS revenue’’ for
2021 is also $5,000, calculated as $4,850
of AFS revenue that was reported for
2021, decreased by $100 for the
expected delivery bonus that F does not
have an enforceable right to recover if
the customer were to terminate the
contract as of the end of 2021 and
increased by $250 for anticipated return
liabilities that are accounted for under
section 461 ($4,850¥$100 + $250 =
$5,000). Accordingly, F is required to
include $5,000, less the corresponding
cost of goods sold determined under
sections 263A and 471 as applicable, in
gross income in 2021.
(vi) Example 6: Chargebacks—(A)
Facts. In November 2021, G, a
pharmaceutical manufacturer, enters
into a contract to sell 1,000 units to W,
a wholesaler, for $10 per unit, totaling
$10,000 (1,000 × $10). The contract also
provides that G will credit or pay W $4
per unit (a 40% ‘‘chargeback’’) for sales
W makes to certain qualifying
customers. G delivers 600 units to W on
December 31, 2021, and bills W $6,000
under the contract. W does not make
any sales to qualifying customers in
2021. For its AFS, G reports $3,600
($6,000¥$2,400) of AFS revenue for
2021, which includes a reduction of the
$6,000 of sales revenue by $2,400 (40%
× $6,000) for anticipated chargebacks.
(B) Analysis. Under the all events test
in § 1.451–1(a), G is required to include
$6,000, less the corresponding cost of
goods sold under sections 263A and 471
as applicable, in gross income in 2021
as G has a fixed right to receive $6,000

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from the delivery of 600 units to W in
2021. The anticipated chargebacks are
liabilities that are accounted for under
section 461. Under the AFS income
inclusion rule and, specifically,
paragraph (b)(2)(i)(A)(1) of this section,
the amount treated as ‘‘taken into
account as AFS revenue’’ for 2021 is
also $6,000, calculated as $3,600 of AFS
revenue reported for 2021, increased by
$2,400 of anticipated chargeback
liabilities that are accounted for under
section 461 ($3,600 + $2,400 = $6,000).
Accordingly, G is required to include
$6,000, less the corresponding cost of
goods sold under sections 263A and 471
as applicable, in gross income in 2021.
(vii) Example 7: Sale of property using
a special method of accounting. In 2021,
H, a financial services provider, sells a
building for $100,000, payable in five
annual payments of $20,000 together
with adequate stated interest, starting in
2021. For its AFS, H reports $100,000 of
AFS revenue for 2021 from the sale of
the building. For Federal income tax
purposes, H uses the installment
method under section 453 for the sale of
the building. Because the installment
method under section 453 is a special
method of accounting under paragraphs
(a)(13)(ii) and (b)(3)(i) of this section,
the AFS income inclusion rule does not
apply to H’s sale of the building.
Accordingly, the gain from the sale is
included in income as prescribed in
section 453.

(viii) Example 8: Insurance contract
renewals—(A) Facts. J, an insurance
agent, is engaged by an insurance carrier
to sell insurance. Pursuant to the
contract between J and the insurance
carrier, J is entitled to receive a $50
commission from the insurance carrier
at the time a policy is sold to a
customer. The contract also provides
that J is entitled to receive an additional
$25 commission each time a policy is
renewed. J does not have an enforceable
right to a renewal commission if the
insurance carrier terminates the contract
before a policy is renewed. J sells 1,000
one-year policies in 2021, of which 800
are expected to be renewed in 2022 and
700 are expected to be renewed in 2023.
J does not have any ongoing obligation
to provide additional services to the
insurance carrier or the customers after
the initial sale of the policy. For its AFS,
J reports $87,500 of AFS revenue for
2021, which includes $50,000 ($50 ×
1,000) of commission income for
policies sold in 2021 and an estimate of
$37,500 ($25 × 1,500) of commission
income for the policies expected to be
renewed in 2022 and 2023.
(B) Analysis. Under the all events test
in § 1.451–1(a), J is required to include
$50,000 in gross income in 2021 as J has
a fixed right to receive $50,000 of
commission income for the policies it
sold during 2021. However, as of the
end of 2021, J does not have a fixed
right to receive any commission income

from anticipated policy renewals. Under
the AFS income inclusion rule,
although J reports $87,500 of AFS
revenue for 2021, J does not have an
enforceable right to recover the $37,500
of anticipated commission income from
future policy renewals if the insurance
carrier were to terminate the contract on
the last day of 2021. Accordingly,
pursuant to paragraph (b)(2)(i)(B) of this
section, of the $87,500 of AFS revenue
reported for 2021, only $50,000 is
treated as ‘‘taken into account as AFS
revenue’’ under the AFS income
inclusion rule. As a result, J is required
to include $50,000 in gross income in
2021. Alternatively, if J uses the
alternative AFS revenue method in
paragraph (b)(2)(ii) of this section, all
$87,500 of AFS revenue reported for
2021 would be treated as ‘‘taken into
account as AFS revenue’’ under the AFS
income inclusion rule and J would be
required to include $87,500 of
commission income in gross income in
2021.
(ix) Example 9: Escalating rents—(A)
Facts. (1) K is a landlord in the business
of leasing office space. On January 1,
2021, K enters into a 5-year lease with
a tenant that provides for annual rent of
$30,000 for 2021 and increases by 5%
each year over the lease term. The
annual rents are due at the end of each
year. Accordingly, the rent for each year
(rounded to the nearest dollar) is as
follows:

TABLE 1 TO PARAGRAPH (b)(4)(ix)(A)
Year

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2021
2022
2023
2024
2025

Calculation

Total rent

.................................................................................................................................................................
.................................................................................................................................................................
.................................................................................................................................................................
.................................................................................................................................................................
.................................................................................................................................................................

$30,000
30,000 * 1.05
31,500 * 1.05
33,075 * 1.05
34,729 * 1.05

$30,000
31,500
33,075
34,729
36,465

Total Rent for Five Years .........................................................................................................................

................................

165,769

(2) The lease is not a section 467
rental agreement as defined under
section 467(d). If the tenant terminates
the lease early, the tenant must pay K
the balance of the rent due for the
remainder of the termination year. On
its AFS, K reports AFS revenue from
rents on a straight-line basis over the
term of the lease, or approximately
$33,154 per year ($165,769 total rent/5
years). Accordingly, for its AFS, K
reports $33,154 of AFS revenue for
2021.
(B) Analysis. Under the all events test
in § 1.451–1(a), K is required to include
$30,000 in gross income in 2021 as K
has a fixed right to receive $30,000 for
the 2021 rental period under the terms

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of the lease agreement. Under the AFS
income inclusion rule, although K
reports $33,154 of AFS revenue for
2021, K has an enforceable right to
recover only $30,000 if the tenant were
to cancel the lease on the last day of
2021. Accordingly, pursuant to
paragraph (b)(2)(i)(B) of this section, of
the $33,154 of AFS revenue reported for
2021, only $30,000 is treated as ‘‘taken
into account in AFS revenue’’ under the
AFS income inclusion rule. As a result,
K is required to include $30,000 in gross
income in 2021.
(x) Example 10: Licensing income
from digital services—(A) Facts. M is
engaged in the business of licensing
media entertainment content packages.

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M licenses content packages to
customers by entering into subscription
plans with customers. In January 2021,
M enters into a two-year subscription
plan with Customer. M charges
Customer $40 per month billed monthly
in arrears. If Customer terminates the
plan prior to the two-year term, it must
pay the balance of the subscription fee
for the remaining term of the contract.
For its AFS, M reports $960 ($40 × 24
months) of AFS revenue for 2021.
(B) Analysis. Under the all events test
in § 1.451–1(a), M is required to include
$480 in gross income in 2021 as M has
a fixed right to receive $480 ($40 × 12)
for the 12 months of media content
licensed to Customer in 2021. M does

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not have a fixed right to receive any
portion of the 2022 subscription fee as
of the end of 2021 as such fee is not due
under the terms of the subscription
agreement until 2022 and M has yet to
provide the media content for the 2022
subscription period. However, under the
AFS income inclusion rule, because M
has an enforceable right to recover all
$960 of AFS revenue reported for 2021
if Customer were to terminate the
contract at the end of 2021, all $960 is
treated as ‘‘taken into account as AFS
revenue’’ in 2021. Accordingly, M is
required to include $960 in gross
income in 2021.
(c) Cost offsets—(1) In general. This
paragraph (c) provides an optional
method of accounting that may be used
to determine the AFS income inclusion
amount for an item of gross income from
the sale of inventory (AFS cost offset
method). A taxpayer that uses the AFS
cost offset method for a trade or
business must apply this method to all
items of gross income in the trade or
business that meet the criteria in this
paragraph (c). Additionally, a taxpayer
that uses this method for a trade or
business must also use the advance
payment cost offset method described in
§ 1.451–8(e) to account for all advance
payments received by such trade or
business that meet the criteria in
§ 1.451–8(e), if applicable. A taxpayer
that uses the AFS cost offset method to
account for gross income from the sale
of an item of inventory, but not the
advance payment cost offset method
because it does not receive any advance
payments for such item, determines the
corresponding AFS income inclusion
amount for a taxable year by following
the rules in paragraph (c)(2) of this
section. A taxpayer that uses the AFS
cost offset method and the advance
payment cost offset method to account
for gross income, including advance
payments, from the sale of an item of
inventory, determines the
corresponding AFS income inclusion
amount and the advance payment
income inclusion amount, as defined in
§ 1.451–8(a)(2), for a taxable year by
following the rules in paragraph (c)(2) of
this section rather than the rules under
§ 1.451–8(e). However, if all payments
received for the sale of an item of
inventory meet the definition of an
advance payment under § 1.451–8(a)(1),
a taxpayer that uses the advance
payment cost offset method determines
the corresponding advance payment
income inclusion amount for a taxable
year by following the rules in § 1.451–
8(e).
(2) AFS cost offset method. A taxpayer
that uses the AFS cost offset method
and, if applicable, the advance payment

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cost offset method, to account for gross
income from the sale of an item of
inventory determines the AFS income
inclusion amount, or, if applicable, the
advance payment income inclusion
amount, for a taxable year prior to the
taxable year in which ownership of the
item of inventory is transferred to the
customer by following the rules in
paragraph (c)(2)(i) of this section,
subject to the additional rules and
limitations in paragraphs (c)(4) through
(6) of this section. Such taxpayer
determines the AFS income inclusion
amount or, if applicable, the advance
payment income inclusion amount, for
the taxable year in which ownership of
the item of inventory is transferred to
the customer by following the rules in
paragraph (c)(2)(ii) of this section. A
taxpayer described in this paragraph
(c)(2) that receives advance payments
for the sale of the item of inventory may
be required to include in gross income
for a taxable year an amount that is
comprised of both an AFS income
inclusion amount and an advance
payment income inclusion amount. In
such case, it is not necessary to
determine the portion of the total
inclusion that is comprised of the AFS
income inclusion amount and the
portion of the total inclusion that is
comprised of the advance payment
income inclusion amount.
(i) Determining gross income for a
year prior to the year of sale. To
determine the amount required to be
included in gross income from the sale
of an item of inventory for a taxable year
prior to the taxable year in which
ownership of the item of inventory is
transferred to the customer, a taxpayer
must first determine the AFS inventory
inclusion amount for such item for such
year by applying the steps in paragraph
(c)(2)(i)(A) of this section. This AFS
inventory inclusion amount is then
reduced by the cost of goods in progress
offset for the taxable year, as determined
under paragraphs (c)(3) through (5) of
this section. This net amount is required
to be included in gross income for the
taxable year.
(A) AFS inventory inclusion amount
for a taxable year. To determine the
AFS inventory inclusion amount for an
item of inventory for a taxable year:
(1) The taxpayer first takes the greater
of the amount described in paragraph
(c)(2)(i)(A)(1)(i) of this section, or the
amount described in paragraph
(c)(2)(i)(A)(1)(ii) of this section (or if the
two amounts are equal, the equal
amount).
(i) The cumulative amount of revenue
from the item of inventory that satisfies
the all events test under § 1.451–1(a)
through the last day of the taxable year,

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less any advance payment inventory
inclusion amount, as defined in § 1.451–
8(a)(3), with respect to a subsequent
taxable year.
(ii) The cumulative amount of revenue
from the item of inventory that is treated
as ‘‘taken into account as AFS revenue’’
under paragraph (b)(2) of this section
through the last day of the taxable year.
(2) The taxpayer then reduces the
amount determined under paragraph
(c)(2)(i)(A)(1) of this section by the
amount computed under paragraph
(c)(2)(i)(A)(1) of this section for that
item of inventory for the immediately
preceding taxable year.
(B) [Reserved]
(ii) Determining the gross income for
the year of sale. To determine the
amount required to be included in gross
income from the sale of an item of
inventory for the taxable year in which
ownership of the item of inventory is
transferred to the customer:
(A) The taxpayer first takes the greater
of the amount described in paragraph
(c)(2)(ii)(A)(1) of this section, or the
amount described in paragraph
(c)(2)(ii)(A)(2) of this section (or if the
two amounts are equal, the equal
amount).
(1) The cumulative amount of revenue
from the item of inventory that satisfies
the all events test under § 1.451–1(a)
through the last day of the taxable year,
including the full amount of any
advance payment received for the item
of inventory.
(2) The cumulative amount of revenue
from the item of inventory that is treated
as ‘‘taken into account as AFS revenue’’
under paragraph (b)(2) of this section
through the last day of the taxable year.
(B) The taxpayer then reduces such
amount by any prior income inclusion
amounts with respect to such item of
inventory. This net amount is required
to be included in gross income for the
taxable year. The taxpayer does not
further reduce such amount by a cost of
goods in progress offset under paragraph
(c)(3) of this section. However, the
taxpayer is entitled to recover the costs
capitalized to the item of inventory as
cost of goods sold in accordance with
sections 471 and 263A or any other
applicable provision of the Internal
Revenue Code. See § 1.61–3.
(3) Cost of goods in progress offset for
a taxable year. The cost of goods in
progress offset for the taxable year is
calculated as:
(i) The cost of goods allocable to the
item of inventory through the last day
of the taxable year; reduced by
(ii) The cumulative cost of goods in
progress offset attributable to the item of
inventory, if any.

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(4) Limitations to the cost of goods in
progress offset. The cost of goods in
progress offset is determined separately
for each item of inventory. Further, the
cost of goods in progress offset
attributable to one item of inventory
cannot reduce the AFS inventory
inclusion amount attributable to a
separate item of inventory. The cost of
goods in progress offset cannot reduce
the AFS inventory inclusion amount for
the taxable year below zero.
(5) Inventory methods—(i) Inventory
costs not affected by cost of goods in
progress offset. The cost of goods
comprising the cost of goods in progress
offset does not reduce the costs that are
capitalized to the items of inventory
produced or items of inventory acquired
for resale by the taxpayer. While the
cost of goods in progress offset reduces
the AFS inventory inclusion amount,
the cost of goods in progress offset does
not affect how and when costs are
capitalized to inventory under sections
471 and 263A or any other applicable
provision of the Internal Revenue Code
or when those capitalized costs will be
recovered.
(ii) Consistency between inventory
methods and AFS cost offset method.
The costs of goods comprising the cost
of goods in progress offset must be
determined by applying the taxpayer’s
method of accounting for inventory for
Federal income tax purposes. A
taxpayer using the AFS cost offset
method and, if applicable, the advance
payment cost offset method must
calculate its cost of goods in progress
offset by reference to all costs that the
taxpayer has permissibly capitalized
and allocated to items of inventory
under its method of accounting for
inventory for Federal income tax
purposes, but including no more costs
than what the taxpayer has permissibly
capitalized and allocated to items of
inventory.
(iii) Allocation of ‘‘additional section
263A costs’’ for taxpayers using
simplified methods. If a taxpayer uses
the simplified production method as
defined under § 1.263A–2(b), the
modified simplified production method
as defined under § 1.263A–2(c), or the
simplified resale method as defined
under § 1.263A–3(d) to determine the
amount of its additional section 263A
costs, as defined under § 1.263A–
1(d)(3), to be included in ending
inventory, then solely to compute the
cost of goods in progress offset, the
taxpayer must determine the portion of
additional section 263A costs allocable
to an item of inventory by multiplying
its total additional section 263A costs
accounted for under the simplified
method for all items of inventory subject

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to the simplified method by the
following ratio:
Section 471 costs allocable to the
specific item of inventory
Total section 471 costs for all items of
inventory subject to the simplified
method
(6) Acceleration of gross income. A
taxpayer that uses the AFS cost offset
method or the advance payment cost
offset method must include in gross
income for a taxable year prior to the
taxable year in which an item of
inventory is transferred to the customer,
all payments received for the item of
inventory that were not previously
included in gross income:
(i) 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
(ii) If, and to the extent that, in that
taxable year, the taxpayer’s obligation to
the customer with respect to the item of
inventory ends other than in:
(A) A transaction to which section
381(a) applies; or
(B) A section 351(a) transfer that is
part of a section 351 transaction in
which:
(1) Substantially all assets of the trade
or business, including the item of
inventory, are transferred;
(2) The transferee adopts or uses, in
the year of the transfer, the same
methods of accounting for the item of
inventory under this section and
§ 1.451–8 as those used by the
transferor; and
(3) The transferee and the transferor
are members of the same consolidated
group, as defined in § 1.1502–1(h).
(7) Additional procedural guidance.
The IRS may publish procedural
guidance in the Internal Revenue
Bulletin (see § 601.601(d) of this
chapter) that provides alternative
procedures for complying with the rules
under this paragraph (c), including
alternative methods of accounting for
cost offsets.
(8) Examples. The following examples
illustrate the AFS cost offset method.
Unless the facts specifically state
otherwise, the taxpayer has an AFS, is
on a calendar year for both Federal
income tax purposes and AFS purposes,
uses an accrual method of accounting
for Federal income tax purposes, and
does not use a special method of
accounting. Further, the taxpayer
properly applies its inventory
accounting method, uses the AFS cost
offset method under paragraph (c) of
this section, and, except as otherwise
provided, does not receive advance
payments. Lastly, the taxpayer does not
produce unique items, as described in
§ 1.460–2(a)(1) and (b), or any item that

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normally requires more than 12
calendar months to complete, as
determined under § 1.460–2(a)(2) and
(c). Any production period that exceeds
12 calendar months is due to unforeseen
production delays.
(i) Example 1—(A) Facts. During
2021, A enters into a contract with
Customer to manufacture and deliver a
good with a total contract price of
$100x. The costs to produce the good
are required to be capitalized under
sections 471 and 263A as the good is
inventory in the hands of A. Ownership
of the good is transferred from A to
Customer upon its delivery in 2022. A
determines, under paragraph (c)(2)(i)(A)
of this section, that its AFS inventory
inclusion amount for 2021 is $20x. A
incurs $12x of costs in 2021, and $48x
of costs in 2022 ($60x in total) that are
permissibly capitalized and allocated to
the produced good under sections 471
and 263A. A has a fixed right to receive
the $100x contract price when it
delivers the good in 2022. A does not
receive any payments from Customer
prior to delivery. Further, all $100x is
treated as ‘‘taken into account as AFS
revenue’’ as of the last day of 2022.
(B) Analysis for 2021. For 2021, A’s
AFS income inclusion amount, as
determined under paragraph (c)(2)(i) of
this section, is $8x ($20x AFS inventory
inclusion amount less $12x cost of
goods in progress offset, which is the
cost of goods incurred through
December 31, 2021).
(C) Analysis for 2022. During 2022,
ownership of the good is transferred to
Customer. Accordingly, pursuant to
paragraph (c)(2)(ii) of this section, A
determines the AFS income inclusion
amount for 2022 by:
(1) First taking the greater of:
(i) The cumulative amount of revenue
that satisfies the all events test under
§ 1.451–1(a) through the last day of 2022
($100x); or
(ii) The cumulative amount of
revenue that is treated as ‘‘taken into
account as AFS revenue’’ through the
last day of 2022 ($100x) (or if the two
amounts are equal, the equal amount).
(2) Then subtracting from such
amount ($100x) the prior income
inclusion amounts attributable to the
transferred good ($8x). This net amount
of $92x is the AFS income inclusion
amount for 2022. Although A does not
reduce such amount by a cost of goods
in progress offset under this paragraph
(c), A is entitled to recover the $60x of
costs capitalized to the good as cost of
goods sold in 2022 in accordance with
sections 471 and 263A. See § 1.61–3.
Accordingly, A’s gross income for 2022
is $32x.

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Federal Register / Vol. 86, No. 3 / Wednesday, January 6, 2021 / Rules and Regulations
(ii) Example 2—(A) Facts. In
December of 2021, A enters into a
contract with Customer to manufacture
and deliver 10 items of inventory at a
price of $10x per item by the end of
2023. A determines, under paragraph
(c)(2)(i)(A) of this section, that the AFS
inventory inclusion amount attributable
to each item of inventory under the
contract is $3x for 2021. A also incurs
$10x of inventory costs during 2021.
Such costs are permissibly capitalized
and allocated under sections 471 and
263A and are allocated equally to each
item of inventory under the contract
($1x per item). During 2022, the
taxpayer incurs $18x of costs to finish
manufacturing 6 of the 10 items and
delivers such items to Customer in
October of 2022. Such costs are
permissibly capitalized and allocated
under sections 471 and 263A and are
allocated equally to each of the 6 items
delivered in October of 2022 ($3x per
item). Upon delivering the 6 items,
ownership of the delivered items
transfers to Customer, A has a fixed
right to receive $60x of the total contract
price, and all $60x is treated as ‘‘taken
into account as AFS revenue.’’ A does
not incur any inventory costs during
2022 that are allocable to the 4
remaining undelivered items, nor does
the taxpayer have an AFS inventory
inclusion amount attributable to such
items for 2022. During 2023, A incurs
$12x of costs to finish manufacturing
the 4 remaining items and delivers such
items to Customer. Such costs are
permissibly capitalized and allocated
under sections 471 and 263A and are
allocated equally to each of the 4 items
delivered in 2023 ($3x per item). Upon
delivering the 4 remaining items,
ownership of the items transfers to
Customer, A has a fixed right to receive
the remaining $40x contract price, and
all $40x is treated as ‘‘taken into
account as AFS revenue.’’
(B) Analysis for 2021 A’s AFS income
inclusion amount for 2021 is $2x per
item ($3x AFS inventory inclusion
amount per item less $1x cost of goods
in progress offset per item, which is the
cost of goods as of December 31, 2021).
Accordingly, A’s total gross income
inclusion for 2021 is $20x.
(C) Analysis for 2022. During 2022,
ownership of 6 of the 10 items is
transferred to Customer. Accordingly,
pursuant to paragraph (c)(2)(ii) of this
section, A determines the AFS income
inclusion amount for 2022 by:
(1) First taking the greater of:
(i) The cumulative amount of revenue
that satisfies the all events test under
§ 1.451–1(a) through the last day of 2022
($10x per item); or

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(ii) The cumulative amount of revenue
that is treated as taken into account as
AFS revenue through the last day of
2022 ($10x per item) (or if the two
amounts are equal, the equal amount).
(2) Then subtracting from such
amount ($10x per item) the prior
income inclusion amounts attributable
to each transferred item ($2x per item).
This net amount of $8x per item is the
AFS income inclusion amount for each
transferred item for 2022. Although A
does not reduce such amount by a cost
of goods in progress offset under this
paragraph (c), A is entitled to recover
the $4x of costs capitalized to each item
delivered as cost of goods sold in 2022
in accordance with sections 471 and
263A. Accordingly, on an aggregate
basis, A’s gross income for 2022 is $24x
(aggregate AFS income inclusion
amount for the 6 items delivered in
2022 of $ 48x less aggregate cost of
goods sold of $24x). A does not include
any amounts in gross income for 2022
with respect to the 4 items of inventory
that were not delivered to Customer
until 2023 as A does not have an AFS
inventory inclusion amount attributable
to such items for 2022.
(D) Analysis for 2023. During 2023,
ownership of the 4 remaining items are
transferred to Customer. Based on the
facts, A did not have an AFS inventory
inclusion amount attributable to the 4
remaining items for 2022, nor did it
incur any cost for such items in 2022 so
the analysis for the 4 remaining items
for 2023 is similar to the analysis for the
6 items transferred to the customer in
2022 on a per item basis. Pursuant to
paragraph (c)(2)(ii) of this section, A
determines the AFS income inclusion
amount for 2023 by:
(1) First taking the greater of:
(i) The cumulative amount of revenue
that satisfies the all events test under
§ 1.451–1(a) through the last day of 2023
($10x per item); or
(ii) The cumulative amount of
revenue that is treated as taken into
account as AFS revenue through the last
day of 2023 ($10x per item) (or if the
two amounts are equal, the equal
amount).
(2) Then subtracting from such
amount ($10x per item) the prior
income inclusion amounts attributable
to each transferred item ($2x per item).
This net amount of $8x per item is the
AFS income inclusion amount for each
transferred item for 2023. Although A
does not reduce such amount by a cost
of goods in progress offset under this
paragraph (c), A is entitled to recover
the $4x of costs capitalized to each item
delivered as cost of goods sold in 2023
in accordance with sections 471 and
263A. On an aggregate basis, A’s gross

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843

income for 2023 is $16x (aggregate AFS
income inclusion amount for the 4 items
delivered in 2023 of $32x less aggregate
cost of goods sold of $16x).
(iii) Example 3—(A) Facts. In
December of 2021, A enters into a
contract with Customer to manufacture
and deliver a good with a total contract
price of $100x. The costs to produce the
good are required to be capitalized
under sections 471 and 263A as the
good is inventory in the hands of the
taxpayer. Ownership of the good is
transferred from A to Customer upon its
delivery in January of 2023. A
determines, under paragraph (c)(2)(i)(A)
of this section, that its AFS inventory
inclusion amount for 2021 and 2022 is
$40x per year. A incurs $25x of costs
each year ($75x in total) that are
permissibly capitalized and allocated to
the manufactured good under sections
471 and 263A. A has a fixed right to
receive the $100x contract price when it
delivers the good in January of 2023. A
does not receive any payments from
Customer prior to delivery. Further, all
$100x is treated as ‘‘taken into account
as AFS revenue’’ as of the last day of
2023.
(B) Analysis for 2021 and 2022. For
2021, A’s AFS income inclusion
amount, as determined under paragraph
(c)(2)(i) of this section, is $15x ($40x
AFS inventory inclusion amount for
2021 less the $25x cost of goods in
progress offset for 2021, which is equal
to the cost of goods as of December 31,
2021). For 2022, A’s AFS income
inclusion amount is $15x ($40x AFS
inventory inclusion amount for 2022
less the $25x cost of goods in progress
offset for 2022, which is the $50x cost
of goods as of December 31, 2022 less
the 25x cumulative cost of goods in
progress offset amount taken into
account in 2021).
(C) Analysis for 2023. During 2023,
ownership of the good is transferred to
Customer. Accordingly, pursuant to
paragraph (c)(2)(ii) of this section, A
determines the AFS income inclusion
amount for 2023 by:
(1) First taking the greater of:
(i) The cumulative amount of revenue
that satisfies the all events test under
§ 1.451–1(a) through the last day of 2023
($100x); or
(ii) The cumulative amount of revenue
that is treated as ‘‘taken into account as
AFS revenue’’ through the last day of
2023 ($100x) (or if the two amounts are
equal, the equal amount).
(2) Then subtracting from such
amount ($100x) the prior income
inclusion amounts attributable to the
transferred good of $30x ($15x for 2021
and $15x for 2022). This net amount of
$70x is the AFS income inclusion

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amount for 2023. Although A does not
reduce such amount by a cost of goods
in progress offset under this paragraph
(c), A is entitled to recover the $75x of
costs capitalized to the good as cost of
goods sold in 2023 in accordance with
sections 471 and 263A. See § 1.61–3.
Accordingly, A’s gross income for 2025
is ¥$5x.
(iv) Example 4—(A) Facts. In
December 2021, A enters into a contract
with Customer to manufacture and
deliver a good with a total contract price
of $100x. A reports $5x of AFS revenue
for 2021, $90x of cumulative AFS
revenue through the end of 2022, and
$100x of cumulative AFS revenue
through the end of 2023. A has an
enforceable right to recover all AFS
revenue reported through the end of
each contract year if Customer were to
terminate the contract on the last day of
each year. Under the terms of the
contract, A is entitled to and receives a
payment of $40x in 2021 and a payment
of $60x when Customer accepts delivery
of the good in 2023, which is also when
ownership of the good transfers to
Customer. The costs to produce the
good are required to be capitalized
under sections 471 and 263A as the
good is inventory in the hands of A. A
incurs $10x of costs in 2021, $55x of
costs in 2022, and $5x of costs in 2023
($70x in total). Such costs are
permissibly capitalized and allocated to
the produced good under sections 471
and 263A. A uses the AFS cost offset
method under paragraph (c) of this
section and accounts for advance
payments, as defined in § 1.451–8(a)(1),
under the deferral method and advance
payment cost offset method under
§ 1.451–8(c) and (e), respectively.
(B) Analysis for 2021. The $40x
payment A receives in 2021 meets the
definition of an advance payment under
§ 1.451–8(a)(1) as the full inclusion of
$40x in gross income in the year of
receipt is a permissible method of
accounting, a portion of the payment
($35x) is ‘‘taken into account as AFS
revenue’’ in a subsequent year, and the
payment is for a good. Pursuant to
§ 1.451–8(a)(3), A’s advance payment
inventory inclusion amount for 2022 is
$35x (the portion of the payment
deferred for AFS purposes). Pursuant to
paragraph (c)(2)(i) of this section, A
must first determine the AFS inventory
inclusion amount for 2021 by applying
the rules in paragraph (c)(2)(i)(A) of this
section. A then reduces such amount by
the cost of goods in progress offset for
2021, as determined under paragraphs
(c)(3) through (5) of this section.
(1) Pursuant to paragraph
(c)(2)(i)(A)(1) of this section, A first
takes the greater of:

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(i) The cumulative amount of revenue
that satisfies the all events test under
§ 1.451–1(a) through the last day of
2021, less any advance payment
inventory inclusion amount attributable
to a subsequent year ($5x, determined as
the $40x under the all events test, less
the $35x of advance payment inventory
inclusion amount attributable to 2022);
or
(ii) The cumulative amount of revenue
that is treated as ‘‘taken into account as
AFS revenue’’ through the last day of
2021 ($5x) (or if the two amounts are
equal, the equal amount).
(2) Pursuant to paragraph
(c)(2)(i)(A)(2) of this section, A then
subtracts from such amount ($5x) the
amount determined under paragraph
(c)(2)(i)(A)(1) of this section for the item
of inventory for the immediately
preceding year ($0). This net amount of
$5x is the AFS inventory inclusion
amount for 2021.
(3) Pursuant to paragraph (c)(2)(i) of
this section, A reduces this $5x AFS
inventory inclusion amount by the cost
of goods in progress offset for 2021 of
$5x, determined as the cost of goods as
of December 31, 2021 of $10x, less the
cumulative cost of goods in progress
offset taken into account in prior years
of $0, less 5x for the AFS inventory
inclusion amount limitation under
paragraph (c)(4) of this section.
Accordingly, A is required to include $0
in gross income for 2021.
(C) Analysis for 2022. Pursuant to
paragraph (c)(2)(i) of this section, A
must first determine the AFS inventory
inclusion amount for 2022 by applying
the rules in paragraph (c)(2)(i)(A) of this
section. A then reduces such amount by
the cost of goods in progress offset for
2022, as determined under paragraphs
(c)(3) through (5) of this section.
(1) Pursuant to paragraph
(c)(2)(i)(A)(1) of this section, A first
takes the greater of:
(i) The cumulative amount of revenue
that satisfies the all events test under
§ 1.451–1(a) through the last day of 2022
($40x); or
(ii) The cumulative amount of revenue
that is treated as ‘‘taken into account as
AFS revenue’’ through the last day of
2022 ($90x).
(2) Pursuant to (c)(2)(i)(A)(2) of this
section, A then subtracts from such
amount ($90x) the amount determined
under paragraph (c)(2)(i)(A)(1) of this
section for the item of inventory for
2021 ($5x). This net amount of $85x is
the AFS inventory inclusion amount for
2022.
(3) Pursuant to paragraph (c)(2)(i) of
this section, A reduces this $85x AFS
inventory inclusion amount by the cost
of goods in progress offset for 2022 of

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$60x, determined as the cost of goods as
of December 31, 2022 of $65x, less the
cumulative cost of goods in progress
offset taken into account in prior years
of $5x. Accordingly, A is required to
include $25x in gross income for 2022.
(D) Analysis for 2023. During 2023,
ownership of the good is transferred to
Customer. Accordingly, pursuant to
paragraph (c)(2)(ii) of this section, A
determines its gross income inclusion
for 2023 by:
(1) First taking the greater of:
(i) The cumulative amount of revenue
that satisfies the all events test under
§ 1.451–1(a) through the last day of 2023
($100x); or
(ii) The cumulative amount of revenue
that is treated as ‘‘taken into account as
AFS revenue’’ through the last day of
2023 ($100x) (or if the two amounts are
equal, the equal amount).
(2) Then subtracting from such
amount ($100x) the prior income
inclusion amounts attributable to the
transferred good of $25x ($0 for 2021
plus $25x for 2022). A is required to
include this net amount of $75x in gross
income for 2023. Although A does not
reduce such amount by a cost of goods
in progress offset under this paragraph
(c), A is entitled to recover the $70x of
costs capitalized to the good as cost of
goods sold in 2023 in accordance with
sections 471 and 263A. See § 1.61–3.
Accordingly, A’s gross income for 2023
is $5x.
(v) Example 5—(A) Facts. The same
facts as in paragraph (c)(8)(iv) of this
section (Example 4) apply, except that
in 2022, A’s obligation to Customer with
respect to the good ends other than in
a transaction to which section 381(a)
applies, or a section 351 transaction
described in paragraph (c)(6)(ii)(B) of
this section. A does not receive any
additional payments in 2022.
(B) Analysis for 2021. The analysis for
2021 is the same as in paragraph
(c)(8)(iv) of this section (Example 4).
(C) Analysis for 2022. Because, in
2022, A’s obligation to Customer with
respect to the good ends in a transaction
other than a transaction described in
paragraph (c)(6)(ii)(A) or (B) of this
section, A is required to apply the
acceleration rules in paragraph (c)(6) of
this section. Accordingly, because A
received $40x of payments as of the date
of the transaction, but did not include
any portion of such payments in gross
income in prior years, A is required to
include the remaining $40x of the
payments received in gross income in
2022 pursuant to paragraph (c)(6) of this
section. A is not permitted to further
reduce the $40x income inclusion by a
cost of goods in progress offset under
this paragraph (c).

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Federal Register / Vol. 86, No. 3 / Wednesday, January 6, 2021 / Rules and Regulations
(vi) Example 6—(A) Facts. In 2021, A
enters into a contract with Customer to
produce and deliver a good. The
contract provides that A will receive
payments equal to AFS costs plus a
100% mark-up, however, A can only
bill the customer on December 31, 2022
and, if the good is not delivered by
December 31, 2022, A can also bill
Customer upon delivery of the good, for
the AFS costs (plus markup) incurred to
date, less any amounts previously
billed. A recognizes AFS revenue based
on a percentage of completion (cost to
cost) method. A recognizes AFS revenue
of $100 through the last day of 2021,
$150 through the last day of 2022, and
$300 through the last day of 2023, and
has an enforceable right to all AFS
revenue reported as of the end of each
year if the customer were to terminate
the contract on the last day of the year.
A bills the customer $150 on December
31 of 2022 and $150 in 2023 when A
delivers the good and ownership
transfers to Customer. The costs to
produce the good are required to be
capitalized under sections 471 and
263A as the good is inventory in the
hands of the taxpayer. A incurs the
following costs each year that are
permissibly capitalized and allocated to
the produced good under sections 471
and 263A: $125 in 2021; $0 in 2022; and
$25 in year 2023.
(B) Analysis for taxable year 2021.
Pursuant to paragraph (c)(2)(i) of this
section, A must first determine the AFS
inventory inclusion amount for 2021 by
applying the rules in paragraph
(c)(2)(i)(A) of this section. A then
reduces such amount by the cost of
goods in progress offset for 2021, as
determined under paragraphs (c)(3)
through (5) of this section.
(1) Pursuant to paragraph
(c)(2)(i)(A)(1) of this section, A first
takes the greater of:
(i) The cumulative amount of revenue
that satisfies the all events test under
§ 1.451–1(a) through the last day of 2021
($0); or
(ii) The cumulative amount of revenue
that is treated as ‘‘taken into account as
AFS revenue’’ through the last day of
2021 ($100).
(2) Pursuant to paragraph
(c)(2)(i)(A)(2) of this section, A then
subtracts from such amount ($100) the
amount determined under paragraph
(c)(2)(i)(A)(1) of this section for the item
of inventory for the immediately
preceding year ($0). This net amount of
$100 is the AFS inventory inclusion
amount for 2021.
(3) Pursuant to paragraph (c)(2)(i) of
this section, A reduces this $100 AFS
inventory inclusion amount by the cost
of goods in progress offset for 2021 of

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$100. Although A’s cost of goods in
progress as of the end of 2021 is $125,
the cost of goods in progress offset is
limited to $100, the amount of A’s AFS
inventory inclusion amount for 2021.
Accordingly, A is required to include $0
in gross income in 2021.
(C) Analysis for taxable year 2022.
Pursuant to paragraph (c)(2)(i) of this
section, A must first determine the AFS
inventory inclusion amount for 2022 by
applying the rules in paragraph
(c)(2)(i)(A) of this section. A then
reduces such amount by the cost of
goods in progress offset for 2022, as
determined under paragraphs (c)(3)
through (5) of this section.
(1) Pursuant to paragraph
(c)(2)(i)(A)(1) of this section, A first
takes the greater of:
(i) The cumulative amount of revenue
that satisfies the all events test under
§ 1.451–1(a) through the last day of 2022
($150 due under the terms of the
contract); or
(ii) The cumulative amount of revenue
that is treated as ‘‘taken into account as
AFS revenue’’ through the last day of
2022 ($150) (or if the two amounts are
equal, the equal amount).
(2) Pursuant to paragraph
(c)(2)(i)(A)(2) of this section, A then
subtracts from such amount ($150) the
amount determined under paragraph
(c)(2)(i)(A)(1) of this section for the item
of inventory for the immediately
preceding year ($100). This net amount
of $50 is the AFS inventory inclusion
amount for 2022.
(3) Pursuant to paragraph (c)(2)(i) of
this section, A reduces this $50 AFS
inventory inclusion amount by the cost
of goods in progress offset for 2022 of
$25, determined as $125 cost of goods
as of December 31, 2022 minus $100
cumulative cost of goods in progress
offset amount taken into account in
2021. Accordingly, A is required to
include $25 in gross income for 2022.
(D) Analysis for taxable year 2023.
During 2023, ownership of the good is
transferred to the customer.
Accordingly, pursuant to paragraph
(c)(2)(ii) of this section, A determines its
gross income inclusion for 2023 by:
(1) First taking the greater of:
(i) The cumulative amount of revenue
that satisfies the all events test under
§ 1.451–1(a) through the last day of 2023
($300x); or
(ii) The cumulative amount of revenue
that is treated as ‘‘taken into account as
AFS revenue’’ through the last day of
2025 ($300x) (or if the two amounts are
equal, the equal amount).
(2) Then subtracting from such
amount ($300x) the prior income
inclusion amounts attributable to the
transferred good of $25 ($0 for 2021 plus

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845

$25 for 2022). This net amount of $275
is the AFS income inclusion amount for
2023. Although A does not reduce such
amount by a cost of goods in progress
offset under this paragraph (c), A is
entitled to recover the $150 of costs
capitalized to the good as cost of goods
sold in 2023 in accordance with
sections 471 and 263A. See § 1.61–3.
Accordingly, A’s gross income for 2023
is $125 ($275 AFS income inclusion
amount less $150 cost of goods sold).
(d) Contracts with multiple
performance obligations—(1) In general.
Each performance obligation generally
yields a corresponding item of gross
income that must be accounted for
separately under the AFS income
inclusion rule in paragraph (b)(1) of this
section. Except as provided in
paragraph (d)(5) of this section, if a
contract contains more than one
performance obligation, and thus yields
more than one corresponding item of
gross income, the transaction price
amount shall be allocated to each
corresponding item of gross income in
accordance with the transaction price
amount allocated to each performance
obligation for AFS purposes, subject to
the adjustments to the transaction price
amount and special allocation rules in
paragraph (d)(3) of this section.
(2) Single performance obligation with
more than one item of gross income. If
a single performance obligation yields
more than one corresponding item of
gross income, the transaction price
amount allocated to the single
performance obligation for AFS
purposes must be further allocated
among the corresponding items of gross
income using any reasonable method.
(3) Adjustments to transaction price
amount and special allocation rules—(i)
Increases to transaction price amount. If
the transaction price amount includes a
reduction for amounts described in
paragraph (b)(2)(i)(A)(1) or (2) of this
section, or has been reduced because a
significant financing component is
deemed to exist under the standards the
taxpayer uses to prepare its AFS, the
taxpayer must determine the specific
performance obligation to which such
reduction relates and increase the
transaction price amount allocable to
the corresponding item of gross income
by the amount of such reduction
(specific identification approach). If it is
impracticable from the taxpayer’s
records to use the specific identification
approach, the taxpayer may use any
reasonable method to allocate the
reduction amount to the items of gross
income in the contract. A pro-rata
allocation of the reduction amount
across all items of gross income under
the contract based on the relative

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transaction price amounts allocated to
such items under paragraph (d)(1) of
this section is a reasonable method.
(ii) Decrease to transaction price
amount. If the transaction price amount
has been increased because a significant
financing component is deemed to exist
under the standards the taxpayer uses to
prepare its AFS, the taxpayer must
determine the specific performance
obligation to which such amount relates
and decrease the transaction price
amount allocable to the corresponding
item of gross income by such amount
(specific identification approach). If it is
impracticable from the taxpayer’s
records to use the specific identification
approach, the taxpayer may use any
reasonable method to allocate such
amount to the items of gross income in
the contract. A pro-rata allocation of
such amount across all items of gross
income under the contract based on the
relative transaction price amounts
allocated to such items under paragraph
(d)(1) of this section is a reasonable
method.
(4) Examples. The following examples
illustrate the rules of paragraph (d)(1)
through (3) of this section. Unless the
facts specifically state otherwise, the
taxpayer has an AFS, is on a calendar
year for Federal income tax purposes
and AFS purposes, and uses an accrual
method of accounting for Federal
income tax purposes.
(i) Example 1—(A) Facts. On
November 1, 2021, A, a software
developer, enters into a contract with a
customer to transfer a software license,
perform software installation services,
and provide technical support for a twoyear period for $100x. The installation
service does not significantly modify the
software and the software remains
functional without the technical
support. A receives an additional $10x
bonus if the installation service is
performed before February 1, 2022,
which A expects to receive. Further, the
customer is entitled to a refund of $2x
if technical support does not meet
performance standards set forth in the
contract, which A expects it will pay to
the customer. For its AFS, A identifies
three performance obligations in the
contract:
(1)(i) The software license;
(ii) The installation service; and
(iii) Technical support.
(2) Also, for its AFS, A determines
that the transaction price amount is
$108x, determined as $100x contract
price plus $10x bonus for installation
services minus $2x customer refund.
Finally, for its AFS, A allocates the
$108x transaction price amount to the
three performance obligations as
follows: $60x to the software license;

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$40x to the installation service ($30x +
$10x bonus); and $8x to technical
support ($10x¥$2x refund).
(B) Analysis. Pursuant to paragraph
(d)(1) of this section, A’s contract with
the customer has three performance
obligations, and each performance
obligation yields a corresponding item
of gross income that is accounted for
separately. Pursuant to paragraph (d)(1)
of this section, A is required to allocate
the $108x transaction price amount to
each corresponding item of gross
income in accordance with the
transaction price amount allocated to
each respective performance obligation
for AFS purposes. Accordingly, A
initially allocates $60x to the software
license item, $40x to the installation
service item, and $8 to the technical
support item. However, because the
transaction price amount was reduced
by the anticipated refund of $2x, which
relates specifically to the technical
support item, A must increase the
transaction price allocable to that item
of gross income pursuant to the specific
identification approach in paragraph
(d)(3) of this section. Accordingly, the
amount allocated to the item of gross
income related to technical support is
$10x.
(ii) Example 2—(A) Facts. In 2021, B,
a manufacturer and servicer of airplane
parts, enters into a contract with a
customer to sell airplane parts in 2021
and to service those parts, as necessary,
in 2021, 2022, and 2023 for $100x. B
regularly sells the airline parts and the
services separately. For its AFS, B
identifies two performance obligations
in the contract:
(1)(i) The sale of airplane parts; and
(ii) The services for those parts.
(2) The customer receives a refund of
$5x if it does not require a specified
level of service for the parts, which B
expects it will pay to the customer.
Also, for its AFS, B determines that the
transaction price amount is $95x,
determined as the $100x contract price
minus the $5x refund that it expects to
pay the customer. Finally, for its AFS,
B allocates the $95x transaction price
amount to the two performance
obligations as follows: $40x to the sale
of parts and $55x to the provision of
services ($60x¥$5x refund).
(B) Analysis. Pursuant to paragraph
(d)(1) of this section, B’s contract with
the customer has two performance
obligations, and each performance
obligation yields a corresponding item
of gross income that is accounted for
separately. Pursuant to paragraph (d)(1)
of this section, B is required to allocate
the $95x transaction price amount to
each corresponding item of gross
income in accordance with the

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transaction price amount allocated to
each respective performance obligation
for AFS purposes. Accordingly, B
initially allocates $40x to the sale of
parts item and $55x to the provision of
services item. However, because the
transaction price amount was reduced
by the anticipated refund of $5x, which
relates specifically to provision of
services item, B must increase the
transaction price allocable to that item
of gross income pursuant to the specific
identification approach in paragraph
(d)(3) of this section. Accordingly, the
amount allocated to the item of gross
income related to servicing the parts is
$60x.
(iii) Example 3: Reward points—(A)
Facts. On December 31, 2021, 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. For its AFS, U
identifies two performance obligations
from the transaction:
(1)(i) The sale of the TV; and
(ii) The provision of rewards points.
(2) Also, for its AFS, U allocates $950
of transaction price amount to the sale
of the TV and the remaining $50 of the
transaction price amount to the reward
points.
(B) Analysis. Pursuant to paragraph
(d)(1) of this section, U’s contract with
the customer has two performance
obligations, and each performance
obligation yields a corresponding item
of gross income that is accounted for
separately. Pursuant to paragraph (d)(1)
of this section, U is required to allocate
the $1,000 transaction price amount to
each corresponding item of gross
income in accordance with the
transaction price amount allocated to
each respective performance obligation
for AFS purposes. Accordingly, U
allocates the transaction price amount
as follows: $950 to the TV sale item and
$50 to the reward points item. If U
reports any portion of the $50 payment
allocated to the reward points as AFS
revenue for 2022, or later, the payment
is an advance payment, as defined in
§ 1.451–8(a)(1), and may be accounted
for under the deferral method if U
satisfies the criteria in § 1.451–8(c).
(iv) Example 4: Airline reward miles—
(A) Facts. On January 1, 2021, W, a
passenger airline company, sells a
customer a $700 airline ticket to fly
roundtrip in 2021. As part of the
purchase, the customer receives 7,000
points (air miles) from W to be
redeemed for future air travel. For its
AFS, W identifies two performance
obligations in the contract:
(1)(i) The sale of the airline ticket; and

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(ii) The provision of air miles.
(2) W also anticipates that it will issue
a rebate to the customer for $10. Also,
for its AFS, W determines that the
transaction price amount is $690,
determined as the $700 ticket price
minus the anticipated $10 rebate.
Finally, for its AFS, W allocates the
$690 transaction price amount to the
separate performance obligations as
follows: $660 to the ticket ($670¥$10
rebate = $660) and $30 to the air miles.
(B) Analysis. Pursuant to paragraph
(d)(1) of this section, W’s contract with
the customer has two performance
obligations, and each performance
obligation yields a corresponding item
of gross income that is accounted for
separately. Pursuant to paragraph (d)(1)
of this section, W must allocate the $690
transaction price amount to each
corresponding item of gross income in
accordance with the transaction price
amount allocated to each respective
performance obligation for AFS
purposes. Accordingly, W initially
allocates $660 to the ticket sale item and
$30 to the air miles item. However,
because the transaction price amount
was reduced by the anticipated rebate of
$10x, which relates to the ticket sale
item, W must increase the transaction
price allocable to that item of gross
income pursuant to paragraph (d)(3) of
this section. Accordingly, the amount
allocated to the item of gross income
related to the ticket sale is $670. If W
reports any portion of the $30 payment
allocated to the air miles item as AFS
revenue for 2022, or later, the payment
is an advance payment, as defined in
§ 1.451–8(a)(1), and may be accounted
for under the deferral method if W
satisfies the criteria in § 1.451–8(c).
(v) Example 5: Contract with
significant financing component
amounts—(A) Facts. On January 1,
2021, C, a manufacturer and servicer of
airline parts, enters into a contract with
a customer to sell airline parts in
December 2022, and to service those
parts, as necessary, through 2024. The
contract contains two alternative
payment options: payment of $5,000 in
December 2022 when the customer
obtains control of the parts or payment
of $4,000 when the contract is signed.
The customer pays $4,000 when the
contract is signed, which reflects an
implicit interest rate of 11.8% and is C’s
incremental borrowing rate. C regularly
sells the airline parts and the services
separately. For its AFS, C identifies two
performance obligations in the contract:
(1)(i) The sale of airplane parts; and
(ii) The services for those parts.
(2) Also, for its AFS, although the
contract only requires the customer to
pay $4,000, the transaction price is

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increased by $1,000 to $5,000 because
the customer is deemed to provide
financing to C under the standards C
uses to prepare its AFS. The $1,000
increase is attributable to a significant
financing component. Finally, for its
AFS, C allocates the $5,000 transaction
price amount to the separate
performance obligations as follows:
$3,750 to the sale of parts ($3,000
upfront payment plus $750 financing
component) and $1,250 ($1,000 upfront
payment plus $250 financing
component) to the provision of services.
(B) Analysis. Pursuant to paragraph
(d)(1) of this section, C’s contract with
the customer has two performance
obligations, and each performance
obligation yields a corresponding item
of gross income that is accounted for
separately. Pursuant to paragraph (d)(1)
of this section, C must allocate the
$5,000 transaction price amount to each
corresponding item of gross income in
accordance with the transaction price
amount allocated to each respective
performance obligation for AFS
purposes. Accordingly, C initially
allocates $3,750 to the sale of the parts
item and $1,250 to the provision of
services item. However, because the
transaction price was increased by a
significant financing component of
$1,000, $750 of which was allocated to
sale of the parts item and $250 of which
was allocated to the provision of
services item, pursuant to paragraph
(d)(3) of this section, C must decrease
the transaction price amount allocable
to the sale of parts item from $3,750 to
$3,000 and must decrease the
transaction price allocable to the
provision of services from $1,250 to
$1,000.
(5) Contracts accounted for in part
under this section and in part under a
special method of accounting—(i) In
general. If a taxpayer has a contract with
a customer that includes one or more
items of gross income that are subject to
a special method of accounting and one
or more items of gross income that are
subject to this section (special method/
451 contract), the transaction price
allocation rule in paragraph (d)(1) of
this section does not apply to determine
the amount of each item of gross income
that is subject to a special method of
accounting. For purposes of this
paragraph (d)(5)(i), a special method of
accounting has the meaning set forth in
paragraph (a)(13) of this section, except
as otherwise provided in guidance
published in the Internal Revenue
Bulletin (see § 601.601(d) of this
chapter). For special method/451
contracts, paragraphs (d)(5)(ii) and (iii)
of this section apply to determine the
transaction price amount and the

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portion of such amount that is allocated
to each item of gross income that is
subject to this section.
(ii) Transaction price adjustments. If
the transaction price amount for the
special method/451 contract includes a
reduction for amounts described in
paragraph (b)(2)(i)(A)(1) or (2) of this
section, or has been reduced because a
significant financing component is
deemed to exist under the standards the
taxpayer uses to prepare its AFS, the
taxpayer must increase the transaction
price amount by the amount of such
reduction. If the transaction price
amount for the special method/451
contract has been increased because a
significant financing component is
deemed to exist under the standards the
taxpayer uses to prepare its AFS, the
taxpayer must decrease the transaction
price amount by the amount of such
increase.
(iii) Transaction price allocation.
After the taxpayer determines the
adjusted transaction price amount for
the special method/451 contract under
paragraph (d)(5)(ii) of this section, the
taxpayer first allocates such amount to
the item(s) of gross income subject to a
special method of accounting and then
allocates the remainder (residual
amount) to the item(s) of gross income
that are subject to this section. If the
contract contains more than one item of
gross income that is subject to this
section, the taxpayer allocates the
residual amount to such items in
proportion to the amounts allocated to
the corresponding performance
obligations for AFS purposes or as
otherwise provided in guidance
published in the Internal Revenue
Bulletin (see § 601.601(d) of this
chapter).
(iv) Example—(1) Facts. B is a
calendar-year accrual method taxpayer
with an AFS. In 2020, B enters into a
$100x contract to design, build, operate
and maintain a toll road. The contract
meets the definition of a long-term
contract under § 1.460–1(b)(1). B
determines that the obligations to design
and build the toll road are long-term
contract activities under § 1.460–1(d)(1)
and accounts for the gross income from
these activities under section 460 and
the regulations in this part under
section 460 of the Code. In addition, B
determines that the obligations to
operate and maintain the toll road are
non-long-term contract activities under
§ 1.460–1(d)(2) and that the gross
income attributable to these activities is
required to be accounted for under this
section. B determines that of the $100x
transaction price amount, $60x is
properly allocable to the items of gross
income that are subject to section 460

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and the regulations in this part under
section 460 of the Code. However, for its
AFS, B allocates $55x of the transaction
price amount to performance obligations
that are long-term contract activities,
$30x to the toll road operation
performance obligation and $15x to the
toll road maintenance performance
obligation.
(2) Analysis. A method of accounting
under section 460 is a special method of
accounting that is within the scope of
paragraph (d)(5) of this section.
Pursuant to paragraph (d)(5) of this
section, B first allocates $60x of the
transaction price amount to the items of
gross income that are subject to section
460 and the regulations in this part
under section 460 of the Code and then
allocates the residual amount of $40x to
the two items of gross income that are
required to be accounted for under this
section in proportion to the amounts
allocated to the corresponding
performance obligations for AFS
purposes. Accordingly, B allocates $26.7
× ($30x/$45x × $40x residual amount) to
the toll road operations item of gross
income and $13.3x ($15x/$45x × $40x
residual amount) to the toll road
maintenance item of gross income.
(e) Cumulative rule for multi-year
contracts—(1) In general. In the case of
an item of gross income from a multiyear contract, a taxpayer determines the
AFS income inclusion amount for a
taxable year by applying the steps in
paragraph (e)(1)(i) or (ii) of this section.
For this paragraph (e), the term multiyear contract means a contract that
spans more than one taxable year.
(i) Inventory items. If the item of gross
income is from the sale of an item of
inventory and the taxpayer uses the cost
offset method under paragraph (c) of
this section, see paragraph (c) of this
section.
(ii) Other items of gross income. For
all other items of gross income, the
taxpayer first compares the cumulative
amount of the item of gross income that
satisfies the all events test under
§ 1.451–1(a) through the last day of the
taxable year, including the full amount
of any advance payment received for
such item in a prior taxable year, with
the cumulative amount of the item of
gross income that is treated as ‘‘taken
into account as AFS revenue’’ under
paragraph (b)(2) of this section through
the last day of the taxable year and
identifies the larger of the two amounts
(or, if the two amounts are equal, the
equal amount). The taxpayer then
reduces such amount by all prior year
inclusion amounts attributable to the
item of gross income, if any, to
determine the AFS income inclusion
amount for the current taxable year. If,

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however, the taxpayer receives an
advance payment, as defined in § 1.451–
8(a)(1), that is allocable to an item of
gross income from a multi-year contract,
the taxpayer applies the applicable rules
in § 1.451–8, rather than the rules in this
paragraph (e)(1)(ii), to determine the
amount of the item of gross income that
is required to be included in gross
income in the taxable year in which
such advance payment is received, or, if
applicable, in a short taxable year
described in § 1.451–8(c)(6).
(2) Examples. The following examples
illustrate the rules of paragraph (e)(1) of
this section. Unless the facts specifically
state otherwise, the taxpayer has an
AFS, is on a calendar year for both
Federal income tax purposes and AFS
purposes and uses an accrual method of
accounting for Federal income tax
purposes. Further, the taxpayer does not
use a special method of accounting.
(i) Example 1: Provision of services
included in AFS revenue with full
inclusion method for advance
payments—(A) Facts. In 2021, D, an
engineering services provider, enters
into a nonseverable contract with a
customer to provide engineering
services through 2024 for a total of
$100x. Under the contract, D receives
payments of $25x in each calendar year
of the contract. For its AFS, D reports
$50x, $0, $20x, and $30x of AFS
revenue from the contract for 2021,
2022, 2023, and 2024, respectively. D
has an enforceable right to recover all
amounts reported as AFS revenue
through the end of a given contract year
if the customer were to terminate the
contract on the last day of such year.
The $25x payment received in 2023 is
an advance payment, as defined in
§ 1.451–8(a)(1), because $5x of the $25x
payment is reported as AFS revenue for
2024. D uses the full inclusion method
for advance payments.
(B) Taxable year 2021. Under the all
events test in § 1.451–1(a), D is required
to include $25x in gross income in 2021
as $25x is due under the terms of the
contract and received by D during 2021.
D does not have a fixed right to receive
any portion of the remaining $75 as
such amount is not due under the terms
of the contract until future years and is
also contingent on D’s completion of the
nonseverable services. Under the AFS
income inclusion rule, because D has an
enforceable right to recover all $50x
reported as AFS revenue for 2021 if the
customer were to terminate the contract
on the last day of such year, all $50x is
treated as ‘‘taken into account as AFS
revenue’’ in 2021. Accordingly, D is
required to include $50x in gross
income in 2021.

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(C) Taxable year 2022. Under the all
events test in § 1.451–1(a), D is required
to include $50x in gross income through
the end of 2022 as $50x is due under the
terms of the contract and received by D
as of the end of 2022. D does not have
a fixed right to receive any portion of
the remaining $50 as such amount is not
due under the terms of the contract until
future years and is also contingent on
D’s completion of the nonseverable
services. Under the AFS income
inclusion rule, because D has an
enforceable right to recover all $50x
reported as AFS revenue through the
end of 2022 if the customer were to
terminate the contract on the last day of
such year, all $50x is treated as ‘‘taken
into account as AFS revenue’’ as of the
last day of 2022. Under the cumulative
rule in paragraph (e)(1)(ii) of this
section, D compares the cumulative all
events test amount of $50x with the
cumulative AFS revenue amount of
$50x and selects the larger of the two
amounts (or if the two amounts are
equal, the equal amount). From this
equal amount of $50x, D subtracts the
prior income inclusion amount of $50x.
Accordingly, under the cumulative rule
D is not required to include any amount
in gross income in 2022.
(D) Taxable year 2023. The payment
received during 2023 meets the
definition of an advance payment under
§ 1.451–8(a)(1). Accordingly, pursuant
to paragraph (e)(1)(ii) of this section, D
must determine the amount that is
required to be included in gross income
in 2023 under the rules in § 1.451–8.
Because D uses the full inclusion
method under § 1.451–8(b), D is
required to include the $25x that was
due and received during 2023 in gross
income in 2023.
(E) Taxable year 2024. Under the all
events test in § 1.451–1(a), D is required
to include $100x in gross income
through the end of 2024 as $100x is due
under the terms of the contract and
received by D as of the end of 2024.
Under the AFS income inclusion rule,
because D has an enforceable right to
recover all $100x reported as AFS
revenue through the end of 2024 if the
customer were to terminate the contract
on the last day of such year, all $100x
is treated as ‘‘taken into account as AFS
revenue’’ through the last day of 2024.
Under the cumulative rule in paragraph
(e)(1)(ii) of this section, D compares the
cumulative all events test amount of
$100x with the cumulative AFS revenue
amount of $100x and selects the larger
of the two amounts (or, if the two
amounts are equal, the equal amount).
From this equal amount of $100x, D
subtracts the prior income inclusion
amount of $75x ($50x from 2021 plus

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$0x from 2022 plus $25x from 2023).
Accordingly, under the cumulative rule

D is required to include $25 in gross
income in 2024. The example in this

849

paragraph (e)(2)(i)(E) is summarized in
the following table:

TABLE 2 TO PARAGAPH (e)(2)(i)(E)
2021
All Events/Full Inclusion Income ..........................................
AFS Revenue .......................................................................
Cumulative rule income .......................................................

(ii) Example 2: Provision of services
included in AFS revenue with deferral
method for advance payments—(A)
Facts. The facts are the same as in
paragraph (e)(2)(i) of this section
(Example 1), except D elects to use the
deferral method under § 1.451–8(c) to
account for advance payments.
(B) Taxable years 2021 and 2022. The
analysis for tax years 2021 and 2022 is
the same as in paragraph (e)(2)(i) of this
section (Example 1).
(C) Taxable year 2023. The payment
received during 2023 meets the
definition of an advance payment under
§ 1.451–8(a)(1). Accordingly, pursuant
to paragraph (e)(1)(ii) of this section, D
must determine the amount that is
required to be included in gross income

2022
$25x
50x
50x

2023
$25x
0
0

in 2023 under the rules in § 1.451–8.
Because D uses the deferral method
under § 1.451–8(b), D is required to
include $20x of the $25x payment in
gross income in 2023 as $20x of such
payment was treated as ‘‘taken into
account as AFS revenue’’ as of the end
of 2023.
(D) Taxable year 2024. Under the all
events test in § 1.451–1(a), D is required
to include $100x in gross income
through the end of 2024. Under the AFS
income inclusion rule, because D has an
enforceable right to recover all $100x
reported as AFS revenue through the
end of 2024 if the customer were to
terminate the contract on the last day of
such year, all $100x is treated as ‘‘taken
into account as AFS revenue’’ through

2024
$25x
20x
25x

Total
$25x
30x
25x

$100x
100x
100x

the last day of 2024. Under the
cumulative rule in paragraph (e)(1)(ii) of
this section, D compares the cumulative
all events test amount of $100x, which
includes the full amount of the $25
advance payment received in 2023, with
the cumulative AFS revenue amount of
$100x and selects the larger of the two
amounts (or, if the two amounts are
equal, the equal amount). From this
equal amount of $100x, D subtracts the
prior income inclusion amount of $70x
($50x from 2021 plus $0x from 2022
plus $20x from 2023). Accordingly,
under the cumulative rule D is required
to include $30x in gross income in 2024.
The example in this paragraph
(e)(2)(ii)(D) is summarized in the
following table:

TABLE 3 TO PARAGRAPH (e)(2)(ii)(D)
2021
All Events Test/Deferral Method Income .............................
AFS Revenue amount .........................................................
Cumulative rule income .......................................................

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1 $5x

2022
$25x
50x
50x

2023

2024

1 $20x

$25x
0
0

20x
20x

Total
$30x
30x
30x

$100x
100x
100x

of the advance payment in 2023 is deferred and taken into income in 2024.

(f) No change in the treatment of a
transaction. Except as provided in
paragraph (j) of this section and
§ 1.1275–2(l), the AFS income inclusion
rule does not change the treatment of a
transaction or the character of an item
for Federal income tax purposes. The
following are examples of transactions
where the treatment or character for
AFS purposes does not change the
treatment of the transaction or character
of the item for Federal income tax
purposes:
(1) A transaction treated as a lease,
license, or similar transaction for
Federal income tax purposes that is
treated as a sale or financing for AFS
purposes, and vice versa;
(2) A transaction or instrument that is
not required to be marked-to-market for
Federal income tax purposes but that is
marked-to-market for AFS purposes;
(3) Asset sale and liquidation
treatment under section 336(e) or
338(h)(10);
(4) A distribution of a corporation or
the allocable share of partnership items

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or an income inclusion under section
951, 951A, or 1293(a) for Federal
income tax purposes that is accounted
for under the equity method for AFS
purposes;
(5) A distribution of previously taxed
earnings and profits of a foreign
corporation; and
(6) A deposit, return of capital, or
conduit payment that is not gross
income for Federal income tax purposes
that is treated as AFS revenue.
(g) No change to exclusion provisions
and the treatment of non-recognition
transactions—(1) In general. The AFS
income inclusion rule accelerates the
time at which the all events test under
§ 1.451–1(a) is treated as satisfied, and
therefore does not change the
applicability of any exclusion provision,
or the treatment of non-recognition
transactions, in the Code, the
regulations in this part, or other
guidance published in the Internal
Revenue Bulletin (see § 601.601(d) of
this chapter). The following are
examples of exclusion provisions and

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non-recognition transactions that are not
affected by the AFS income inclusion
rule:
(i) Any non-recognition transaction,
within the meaning of section
7701(a)(45), including, for example, a
liquidation described in sections 332
and 337, an exchange described in
section 351, a distribution described in
section 355, a reorganization described
in section 368, a contribution described
in section 721, or transactions described
in sections 1031 through 1045; and
(ii) Items specifically excluded from
income under sections 101 through 140.
(2) Example: Non-recognition
provisions not changed for Federal
income tax purposes—(i) Facts.
Taxpayer (Distributing) is a calendaryear accrual method C corporation with
an AFS. On December 31, 2021,
Distributing:
(A)(1) Contributes assets to a wholly
owned subsidiary (Controlled) in
exchange for Controlled stock and
$100x; and

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(2) Distributes all the Controlled stock
pro rata to its shareholders.
(B) The transaction qualifies as a
reorganization under section
368(a)(1)(D) and a distribution to which
section 355 applies (D reorganization).
Distributing’s realized gain on the
transferred assets for book and tax
purposes is $150x. On January 15, 2022,
in pursuance of the plan of
reorganization, Distributing distributes
the $100x to its shareholders.
Consequently, no gain to Distributing is
recognized under section 361(b)(1)(A).
On Distributing’s 2021 AFS,
Distributing recognizes revenue of
$150x related to the D reorganization.
(ii) Analysis. For Federal income tax
purposes, under section 361,
Distributing does not recognize gain on
Distributing’s:
(A)(1) Contribution of assets to
Controlled;
(2) Receipt of Controlled stock and
cash; and
(3) Distribution of Controlled stock
and cash to Distributing’s shareholders.
(B) Pursuant to paragraph (g) of this
section, the AFS income inclusion rule
does not change the result of this
paragraph (g)(2).
(h) Additional AFS issues—(1) AFS
covering groups of entities—(i) In
general. If a taxpayer’s financial results
are reported on the AFS for a group of
entities (consolidated AFS), the
taxpayer’s AFS is the consolidated AFS.
However, if the taxpayer’s financial
results are also reported on a separate
AFS that is of equal or higher priority
to the consolidated AFS under
paragraph (a)(5) of this section, then the
taxpayer’s AFS is the separate AFS.
(ii) Example. Taxpayer B, a reseller of
computers and electronics, is a
calendar-year accrual method taxpayer.
In 2021, B’s financial results are
included in P’s consolidated financial
statement, which is certified as being
prepared in accordance with GAAP, and
is a Form 10–K filed with the SEC. B
also has a separate audited financial
statement prepared in accordance with
GAAP that is used for credit purposes.
B must use its parent corporation’s
consolidated Form 10–K as its AFS.
(2) Separately listed items. If a
consolidated AFS is treated as the
taxpayer’s AFS, the taxpayer must
include the amount of any items listed
separately in the consolidated AFS,
including any notes or other
supplementary data that is considered
part of the consolidated AFS, in
determining the amount of AFS revenue
allocated to the taxpayer.
(3) Non-separately listed items. If a
consolidated AFS does not separately
list items for the taxpayer, the portion

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of the AFS revenue allocable to the
taxpayer is determined by relying on the
taxpayer’s separate source documents
that were used to create the
consolidated AFS and includes amounts
subsequently eliminated in the
consolidated AFS. Whether a taxpayer
that changes the source documents it
uses for this purpose from one taxable
year to another taxable year has changed
its method of accounting is determined
under the rules of section 446.
(4) Computation of AFS revenue for
the taxable year when the AFS covers
mismatched reportable periods—(i) In
general. If a taxpayer’s AFS is prepared
on the basis of a financial accounting
year that differs from the taxpayer’s
taxable year, the taxpayer must use one
of the following permissible methods of
accounting described in paragraph
(h)(4)(i)(A) through (C) of this section to
determine the AFS income inclusion
amount for the taxable year:
(A) The taxpayer computes AFS
revenue as if its financial reporting
period is the same as its taxable year by
conducting an interim closing of its
books using the accounting principles it
uses to prepare its AFS.
(B) The taxpayer computes AFS
revenue by including a pro rata portion
of AFS revenue for each financial
accounting year that includes any part
of the taxpayer’s taxable year. If the
taxpayer’s AFS for part of the taxable
year is not available by the due date of
the return (with extension), the taxpayer
must make a reasonable estimate of AFS
revenue for the pro rata portion of the
taxable year for which an AFS is not yet
available. See § 1.451–1(a) for
adjustments after actual amounts are
determined.
(C) If a taxpayer’s financial accounting
year ends five or more months after the
end of its taxable year, the taxpayer
computes AFS revenue for the taxable
year based on the AFS revenue reported
on the AFS prepared for the financial
accounting year ending within the
taxpayer’s taxable year. For this
paragraph (h)(4)(i)(C), if a taxpayer uses
a 52–53 week year for financial
accounting or Federal income tax
purposes, the last day of such year shall
be deemed to occur on the last day of
the calendar month ending closest to the
end of such year.
(ii) Examples. The following
examples illustrate the principles of
paragraph (j)(4) of this section.
(A) Example 1: Interim closing of the
books. A is a calendar year taxpayer. For
its AFS, A’s financial results are
reported on a June 30 fiscal year. Using
the method described in paragraph
(h)(4)(i)(A) of this section, for the
taxable year 2021, A uses the financial

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results reported on its June 30, 2021
AFS to determine whether an item of
gross income is treated as ‘‘taken into
account as AFS revenue’’ from January
1, 2021, through June 30, 2021, and uses
financial data and accounting
procedures from its June 30, 2022 AFS
to prepare an interim closing of the
books as of December 31, 2021 to
determine whether an item of gross
income is treated as ‘‘taken into account
as AFS revenue’’ from July 1, 2021,
through December 31, 2021.
(B) Example 2: Pro rata approach. A
is a calendar year taxpayer. For its AFS,
A’s financial results are reported on a
June 30 fiscal year. Using the method
described in paragraph (h)(4)(i)(B) of
this section, for the taxable year 2021,
A computes AFS revenue for the 2021
tax year by taking the AFS revenue for
the financial accounting year ending
June 30, 2021 and multiplying it by a
ratio equal to the number of days in the
financial accounting year that are part of
the 2021 tax year/365 and then adding
to that amount the AFS revenue for the
financial accounting year ending June
30, 2022 multiplied by the number of
days in the financial accounting year
that are part of the 2021 tax year/365.
(C) Example 3: AFS revenue for the
taxable year based on AFS ending in
taxpayer’s taxable year. The same facts
as in paragraph (h)(4)(ii)(B) of this
section (Example 2) apply, except that A
uses the method described in paragraph
(h)(4)(i)(C) of this section. For the
taxable year 2021, A uses the financial
results reported on its June 30, 2021
AFS to determine whether an item of
gross income is treated as ‘‘taken into
account as AFS revenue’’ as of the end
of its 2021 taxable year. Accordingly,
any AFS revenue reported on the
taxpayer’s June 30, 2022 AFS is
disregarded when determining whether
an item of gross income is treated as
‘‘taken into account as AFS revenue’’ as
of the end of the 2021 taxable year.
(i) [Reserved]
(j) Special ordering rule for certain
items of income for debt instruments—
(1) In general. If an item of income, or
portion thereof, with respect to a debt
instrument is described in paragraph
(j)(2) of this section, the rules of this
section apply before the rules in
sections 1271 through 1275 and
§§ 1.1271–1 through 1.1275–7 (OID
rules). Therefore, an item of income, or
portion thereof, described in paragraph
(j)(2) of this section may not be included
in income later than when that item, or
portion thereof, is treated as taken into
account as AFS revenue, as determined
under paragraph (b)(2) of this section,
regardless of whether the timing of
income inclusion for that item is

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normally determined using a special
method of accounting. See also
§ 1.1275–2(l) for the treatment of the
items described in paragraph (j)(2) of
this section under the OID rules.
(2) Specified fees. Paragraph (j)(1) of
this section applies to fees (specified
fees) that are not spread over a period
of time as discount or as an adjustment
to the yield of a debt instrument (such
as points) in the taxpayer’s AFS and, but
for paragraph (j) of this section and
§ 1.1275–2(l), would be treated as
creating or increasing OID for Federal
income tax purposes. For example, the
following specified fees (specified credit
card fees) are described in this
paragraph (j)(2):
(i) A payment of additional interest or
a similar charge provided with respect
to amounts that are not paid when due
on a credit card account (for example,
credit card late fees);
(ii) Amounts charged under a credit
card agreement when the cardholder
uses the credit card to conduct a cash
advance transaction (for example, credit
card cash advance fees); and
(iii) Amounts a credit or debit card
issuer is entitled to upon a purchase of
goods or services by one of its
cardholders (for example, interchange
fees, which are sometimes labeled
merchant discount in certain private
label credit card transactions).
(3) Example. C, a credit card issuer, is
a calendar-year accrual method taxpayer
with a calendar year AFS. In 2021, a
cardholder uses C’s credit card to
purchase $100 of merchandise from a
merchant and the cardholder earns a
reward of 1% of the purchase price of
$100 ($1) as part of C’s cardholder
loyalty program. Upon purchase, C
becomes entitled to an interchange fee
equal to 2% of the purchase price of
$100 ($2). For its AFS, C reports the $2
of interchange fees as AFS revenue for
2021. C’s $2 of interchange fees is
described in paragraph (j)(2)(iii) of this
section. Under paragraph (j)(1) of this
section, C must apply the rules in this
section before applying the OID rules.
See also § 1.1275–2(l). Therefore, C’s $2
of interchange fees is included in gross
income in 2021, the year it is treated as
‘‘taken into account as AFS revenue.’’
Under paragraph (b)(2)(i)(A) of this
section, the $2 of interchange revenue is
not reduced by the $1 reward. Even if
C reports interchange fees net of
rewards in its AFS for 2021 ($2 of
interchange fee minus $1 reward
liability), under paragraph (b)(2)(i)(A) of
this section, C includes $2 of
interchange revenue in gross income in
2021. See sections 162 and 461(h) for
the treatment of the reward by C.

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(k) Treatment of adjustments to
deferred revenue in an AFS—(1) In
general. If a taxpayer treats an item of
gross income as 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, AFS revenue
for that subsequent taxable year is
increased or decreased, as applicable by
the amount of that item, or portion
thereof, that is written down or
adjusted. See § 1.451–8(c)(5).
(2) Example—(i) Facts. D, a
remanufacturer of industrial equipment,
is a calendar-year, accrual method
taxpayer with a calendar year AFS. On
January 1, 2021, D enters into a contract
with a customer and receives a payment
of $100x to remanufacture equipment in
2021 and 2022. The contract is not a
long-term contract under section 460.
For its AFS 2021, D performs
remanufacturing services and reports
$40x of the $100x payment as AFS
revenue for 2021, and treats $60x of the
$100x payment as deferred revenue.
(ii) Facts for taxable year 2022. On
January 1, 2022, all of the stock of D is
acquired by an unrelated third party and
D adjusts deferred AFS revenue to $50x
(the expected cost to provide the
services) by charging $10x ($60x¥$50×
= $10x) to retained earnings. In
addition, for 2022, D performs
remanufacturing services and reports
$50x of the deferred revenue as AFS
revenue.
(iii) Analysis for taxable year 2022.
Under paragraph (k)(1) of this section,
D’s $10x write down to deferred
revenue for 2022 is treated as ‘‘taken
into account as AFS revenue’’ for 2022.
(l) Methods of accounting—(1) In
general. Except as otherwise provided
in this section, a change to comply with
this section is a change in method of
accounting to which the provisions of
sections 446 and 481 and the
regulations in this part under sections
446 and 481 of the Code apply. A
taxpayer seeking to change to a method
of accounting permitted in this section
must secure the consent of the
Commissioner in accordance with
§ 1.446–1(e) and follow the
administrative procedures issued under
§ 1.446–1(e)(3)(ii) for obtaining the
Commissioner’s consent to change its
accounting method. For example, the
use of the AFS income inclusion rule
under paragraph (b)(1) of this section
under which the taxpayer determines
the amount of the item of gross income
that is treated as ‘‘taken into account as
AFS revenue’’ by making the
adjustments provided in paragraph

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851

(b)(2)(i) of this section, the use of the
AFS income inclusion rule under
paragraph (b)(1) of this section under
which the taxpayer determines the
amount of the item of gross income that
is treated as ‘‘taken into account as AFS
revenue’’ by making only the
adjustments provided in paragraph
(b)(2)(ii) of this section (the alternative
AFS revenue method), the AFS cost
offset method under paragraph (c) of
this section, the use of a method of
determining AFS revenue under
paragraph (i)(4) of this section, are
methods of accounting under section
446 and the regulations in this part
under section 446 of the Code. In
addition, a change in the manner of
recognizing revenue in an AFS that
changes or could change the timing of
the inclusion of income for Federal
income tax purposes is generally a
change in method of accounting under
section 446 and the regulations in this
part under section 446 of the Code.
However, a change resulting from the
restatement of AFS revenue may not
always constitute a change in method of
accounting under section 446 and the
regulations in this part under section
446 of the Code. For example, a
restatement of AFS revenue to correct
an error described in § 1.446–
1(e)(2)(ii)(b) does not constitute a
change in method of accounting under
section 446.
(2) Transition rule for changes in
method of accounting—(i) In general.
Except as provided in paragraph
(l)(2)(ii) of this section, a taxpayer that
makes a qualified change in method of
accounting for the taxpayer’s first
taxable year beginning after December
31, 2017, is treated as making a change
in method of accounting initiated by the
taxpayer under section 481(a)(2). A
taxpayer obtains the consent of the
Commissioner to make the change in
method of accounting by using the
applicable administrative procedures
that govern changes in method of
accounting under section 446(e). See
§ 1.446–1(e)(3).
(ii) Special rules for OID and specified
credit card fees. The rules of paragraph
(l)(2)(i) of this section apply to a
qualified change in method of
accounting for the taxpayer’s first
taxable year beginning after December
31, 2018, if the change relates to a
specified credit card fee as defined in
paragraph (j)(2) of this section. For
paragraph (l) of this section, the section
481(a) adjustment period for any
adjustment under section 481(a) for a
change in method of accounting
described in the preceding sentence is
six taxable years.

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(iii) Qualified change in method of
accounting. For paragraph (l)(2) of this
section, a qualified change in method of
accounting means any change in
method of accounting that is required by
section 13221 of Public Law 115–97,
131 Stat. 2054 (2017) (TCJA), or was
prohibited under the Internal Revenue
Code of 1986 prior to TCJA section
13221 and is now permitted as a result
of TCJA section 13221.
(m) Applicability date—(1) In general.
Except as provided in paragraph (m)(2)
of this section, this section applies for
taxable years beginning on or after
January 1, 2021.
(2) Delayed application with respect
to certain fees. Notwithstanding
paragraph (m)(1) of this section,
paragraph (j) of this section applies to
specified fees (as defined in paragraph
(j)(2) of this section) that are not
specified credit card fees (as defined in
paragraph (j)(2) of this section) for
taxable years beginning on or after
January 6, 2022.
(3) Early application of this section—
(i) In general. Except as provided in
paragraph (m)(3)(ii) of this section,
taxpayers and their related parties,
within the meaning of sections 267(b)
and 707(b), may apply both the rules in
this section and, to the extent relevant,
the rules in § 1.451–8, in their entirety
and in a consistent manner, to a taxable
year beginning after December 31, 2017,
and before January 1, 2021, provided
that, once applied to a taxable year, the
rules in this section and, to the extent
relevant, the rules in § 1.451–8, are
applied in their entirety and in a
consistent manner to all subsequent
taxable years. See section 7508(b)(7) and
§ 1.451–8(h).
(ii) Certain fees—(A) Specified credit
card fees. In the case of specified credit
card fees, a taxpayer and its related
parties, within the meaning of sections
267(b) and 707(b), may apply both the
rules in this section and the rules in
§ 1.1275–2(l), in their entirety and in a
consistent manner, to a taxable year
beginning after December 31, 2018, and
before January 1, 2021, provided that,
once applied to a taxable year, the rules
in this section and § 1.1275–2(l) that
apply to specified credit card fees are
applied in their entirety and in a
consistent manner to all subsequent
taxable years (other than the rules
applicable to specified fees that are not
specified credit card fees). See section
7508(b)(7) and § 1.1275–2(l)(2).
(B) Specified fees. Paragraphs (m)(3)(i)
and (m)(3)(ii)(A) of this section do not
apply to specified fees that are not
specified credit card fees.
■ Par. 6. Section 1.451–8 is added to
read as follows:

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§ 1.451–8 Advance payments for goods,
services, and certain other items.

(a) Definitions. Except as otherwise
provided in this section, the following
definitions apply for 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
taken into account as AFS revenue for
a subsequent taxable year, or, if the
taxpayer does not have an applicable
financial statement any portion of the
payment is earned by the taxpayer in a
subsequent taxable year. To determine
the amount of the payment that is
treated as ‘‘taken into account as AFS
revenue,’’ the taxpayer must adjust AFS
revenue for any amounts described in
§ 1.451–3(b)(2)(i)(A), (C), and (D);
(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 (a)(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 (a)(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
(a)(1)(i)(C)(8);
(9) An eligible gift card sale;
(10) Any other payment identified by
the Secretary of the Treasury or his
delegate (Secretary) under section
451(c)(4)(A)(iii), including in guidance
published in the Internal Revenue

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Bulletin (see § 601.601(d)(2) of this
chapter); or
(11) Any combination of items
described in paragraphs (a)(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 for
an item or items described in paragraph
(a)(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 of the
Internal Revenue Code;
(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 C.B. 479 (see § 601.601(d)(2) of
this chapter);
(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;
(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 (specified good
exception) unless the taxpayer uses the
method under paragraph (f) of this
section;
(I) Any other payment identified by
the Secretary under section
451(c)(4)(B)(vii), including in guidance
published in the Internal Revenue
Bulletin (see § 601.601(d)(2) of this
chapter); and
(J) Any combination of items
described in paragraphs (a)(1)(ii)(A)
through (I) of this section.
(2) Advance payment income
inclusion amount. The term advance
payment income inclusion amount
means the amount of the advance
payment that is required to be included
in gross income for the taxable year
under the applicable rules in this
section.
(3) Advance payment inventory
inclusion amount. The term advance
payment inventory inclusion amount
means the amount of the advance
payment from the sale of an item of

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inventory that, but for the cost of goods
in progress offset, would be includable
in gross income under paragraph (b), (c),
or (d) of this section, as applicable, for
the taxable year.
(4) AFS revenue. The term AFS
revenue has the same meaning as
provided in § 1.451–3(a)(4).
(5) Applicable financial statement.
The term applicable financial statement
(AFS) has the same meaning as
provided in § 1.451–3(a)(5).
(6) Contractual delivery date. The
term contractual delivery date means
the month and year of delivery listed in
the original written contract to the
transaction entered into between the
parties prior to initial receipt of any
payments.
(7) Cost of goods. The term cost of
goods means the costs that are properly
capitalized and included in inventory
under sections 471 and 263A or any
other applicable provision of the
Internal Revenue Code and that are
allocable to an item of inventory for
which an advance payment inventory
inclusion amount is calculated. See
paragraph (e)(6) of this section for
specific rules for a taxpayer using the
simplified methods under section 263A.
(8) Cost of goods in progress offset.
The term cost of goods in progress offset
has the meaning provided in paragraph
(e)(4) of this section.
(9) Cumulative cost of goods in
progress offset. The term cumulative
cost of goods in progress offset means
the cumulative cost of goods in progress
offset amounts under paragraph (e) of
this section for a specific item of
inventory that have reduced an advance
payment inventory inclusion amount
attributable to such item of inventory in
prior taxable years.
(10) Eligible gift card sale. The term
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,
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
(a)(1)(i)(C)(1) through (11) of this
section.
(11) Enforceable right. The term
enforceable right has the same meaning
as provided in § 1.451–3(a)(9).
(12) Performance obligation. The term
performance obligation has the same
meaning as provided in § 1.451–3(a)(11).
(13) Prior income inclusion amounts.
The term prior income inclusion
amounts means the amount of an item
of gross income that was included in the

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taxpayer’s gross income under this
section or § 1.451–3 in a prior taxable
year.
(14) 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.
(15) Specified good. The term
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.
(16) Transaction price. The term
transaction price has the same meaning
as provided in § 1.451–3(a)(14).
(b) 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.
(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 can
determine the extent to which the
advance payment is taken into account
as AFS revenue as of the end of the
taxable year of receipt and, if applicable,
a short taxable year described in
paragraph (c)(6) of this section. Except
as otherwise provided in this section, a
taxpayer that uses the deferral method
described in this paragraph (c) must:
(i) Include the advance payment, or
any portion thereof, in gross income in
the taxable year of receipt to the extent
taken into account as AFS revenue as of
the end of such taxable year, as
determined under paragraph (c)(2) of
this section; 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
(next succeeding year).
(2) Adjustments to AFS revenue. The
amount of an advance payment that is
treated as ‘‘taken into account as AFS
revenue’’ as of the end of the taxable
year of receipt under paragraph (c)(1)(i)
of this section is determined by
adjusting AFS revenue by amounts
described in § 1.451–3(b)(2)(i)(A), (C),
and (D), as applicable.

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(3) Examples. The following examples
demonstrate the rules in paragraphs
(c)(1) and (2) of this section.
(i) Example 1: Gift cards not eligible
for deferral method. 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 may not be
redeemed for cash and have no
expiration date. E does not track the sale
date of the gift cards and includes
advance payments for gift cards in AFS
revenue when redeemed. Because E is
unable to determine the extent to which
advance payments are taken into
account as AFS revenue for the taxable
year of receipt, E cannot use the deferral
method for these advance payments.
(ii) Example 2: Gift cards eligible for
deferral method. The same facts as in
paragraph (c)(3)(i) of this section
(Example 1) apply, 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 AFS revenue
for the taxable year in which the cards
expire. Because E tracks the sale date
and the expiration date of the gift cards
for its AFS, E can determine the extent
to which advance payments are taken
into account as AFS revenue for the
taxable year of receipt. Therefore, E
meets the requirement of paragraph
(c)(1) of this section and may elect the
deferral method for these advance
payments.
(4) 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, 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
for 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 § 1.1502–1(h).

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(ii) Examples. The following
examples illustrate the rules in
paragraph (c)(4) of this section. In each
of the following examples, the taxpayer
is a C corporation, uses an accrual
method of accounting for Federal
income tax purposes and files its returns
on a calendar year basis. In addition, the
taxpayer has an AFS and uses the
deferral method in paragraph (c) of this
section.
(A) Example 1: Ceasing to exist. A is
in the business of selling and licensing
off the shelf, fully customized, and
semi-customized computer software and
providing customer support. On July 1,
2021, 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, 2021, in a transaction that
does not involve a section 351(a)
transfer described in paragraph
(c)(4)(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
2021 taxable year.
(B) Example 2: Satisfaction of
obligation—(1) Facts. On November 1,
2021, J, a travel agent, receives payment
from a customer for an airline flight that
will take place in April 2022. J
purchases and delivers the airline ticket
to the customer on November 14, 2021.
J retains the excess of the customer’s
payment over the cost of the airline
ticket as its commission. 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 2022.
(2) Analysis. The payment for
commission income is an advance
payment. Because J is not required to
provide any services after the ticket is
delivered to the customer on November
14, 2021, J satisfies its obligation to the
customer for its commission when the
airline ticket is delivered. Thus, for
Federal income tax purposes, J must
include the commission in gross income
for 2021.
(5) Financial statement adjustments—
(i) In general. 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 such as retained
earnings, or otherwise writes-down or
adjusts that item of deferred revenue in
a subsequent taxable year, AFS revenue
for that subsequent taxable year is
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the amount that is written down or
adjusted. See § 1.451–3(k).
(ii) Examples. The following
examples illustrate the rules in
paragraph (c)(5) of this section. In each
of the following examples, the taxpayer
is a C corporation, uses an accrual
method of accounting for Federal
income tax purposes and files its returns
on a calendar year basis. In addition, the
taxpayer has an AFS and uses the
deferral method in paragraph (c) of this
section.
(A) Example 1—(1) Facts. On May 1,
2021, A 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 ($25) of the advance payment
in AFS revenue for 2021, 1⁄2 ($50) for
2022, and 1⁄4 ($25) for 2023. On August
31, 2021, C, an unrelated corporation
that files its Federal income tax return
on a calendar year basis and that is a
member of a consolidated group,
acquired all of the stock of A, and A
joined C’s consolidated group. A’s short
taxable year ended on August 31, 2021,
and, as of that date, A had included 1⁄4
($25) of the advance payment in AFS
revenue. On September 1, 2021, 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 is included in
revenue on A’s AFS in accordance with
the method of accounting A uses for
financial accounting purposes.
(2) Analysis. 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,
2021 and must include the remainder of
the advance payment ($75) ($65 write
down + $10 future financial statement
revenue) in income for its next
succeeding taxable year.
(B) Example 2—(1) Facts. On May 1,
2021, B received $100 as an advance
payment for a contract to be performed
in 2021, 2022, and 2023. On August 31,
2021, D, a corporation that is not a
member of a consolidated group for
Federal income tax purposes, acquired
all of the stock of B. Before the stock
acquisition, for 2021, B included $40 of
the advance payment in AFS revenue,
and $60 as a deferred revenue liability.
On September 1, 2021, after the stock
acquisition and in accordance with
purchase accounting rules, B, at D’s
direction, 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 take into account
as AFS revenue any of the $10 deferred
revenue liability in its 2021 AFS. B does

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include $5 in revenue in 2022, and $5
in revenue in 2023.
(2) Analysis. For Federal income tax
purposes, B must include $40 of the
advance payment into income in 2021
and must include the remainder of the
advance payment ($60) ($50 write down
plus $10 future financial statement
revenue) in income for the 2022 taxable
year.
(6) 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 taken into account as
AFS revenue as of the end of such
taxable year, as determined under
paragraph (c)(2) of this section. Any
amount of the advance payment not
included in gross income in the taxable
year of receipt or the short taxable year,
must be included in gross income for
the taxable year immediately following
the short taxable year.
(ii) Example 1—(A) Facts. A is a
calendar year taxpayer and is in the
business of selling and licensing off the
shelf, fully customized, and semicustomized computer software and
providing customer support. On July 1,
2021, A enters into a 2-year software
maintenance contract and receives an
advance payment of $240 under the
contract. Under the contract, A will
provide software updates if it develops
an update within the contract period, as
well as provides online and telephone
customer support. A changes its taxable
period to a fiscal year ending March 31.
As a result, A has a short taxable year
beginning January 1, 2022, and ending
March 31, 2022. In its AFS, A includes
6/24 ($60) of the payment in revenue for
the taxable year ending December 31,
2021 to account for the six-month
period July 1 through December 31,
2021; 3/24 ($30) in revenue for the short
taxable year ending March 31, 2022 to
account for the three-month period
January 1 through March 31, 2022; 12/
24 ($120) in revenue for the taxable year
ending March 31, 2023; and 3/24 ($30)
in revenue for the taxable year ending
March 31, 2024.
(B) Analysis. Because the taxable year
ending March 31, 2021, is 92 days or
less, A must include 6/24 ($60) of the
payment in gross income for the taxable
year ending December 31, 2021, 3/24
($30) in gross income for the short

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taxable year ending March 31, 2022, and
15/24 ($150), the remaining amount, in
gross income for the taxable year ending
March 31, 2023.
(iii) Example 2—(A) Facts. On May 1,
2021, B received $100 as an advance
payment for a contract to be performed
in 2021, 2022, and 2023. On October 31,
2021, C, an unrelated corporation that
files its federal income tax return on a
calendar year basis and that is a member
of a consolidated group, acquired all the
stock of B and B joined C’s consolidated
group. Before the stock acquisition, for
2021, B included $40 of the advance
payment in AFS revenue, and $60 as a
deferred revenue liability. On November
1, 2021, after the stock acquisition and
in accordance with purchase accounting
rules, C wrote down B’s $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 2021 AFS. B includes $5
in revenue in 2022, and $5 in revenue
in 2023.
(B) Analysis. For Federal income tax
purposes, B must take $40 of the
advance payment into income in its
short tax year ending October 31, 2021.
B’s subsequent tax year, the short tax
year ending December 31, 2021, is a tax
year that is 92 days or less. Therefore,
under paragraph (c)(6)(i) of this section,
B generally will include the portion of
the advance payment not included in
the taxable year of receipt in gross
income for this short taxable year to the
extent taken into account as AFS
revenue. Although for AFS purposes, no
amount is recognized in revenue for the
short period beginning November 1,
2021 and ending on December 31, 2021,
under paragraph (c)(5)(i) of this section,
B must treat the amount of the writedown as AFS revenue in the taxable
year in which the write-down occurs.
Therefore, B must include $50 of the
advance payment into income in the
short tax year ending December 31, 2021
(equal to the $50 write down plus $0
recognized in B’s AFS for the period
beginning on November 1, 2021 and
ending December 31, 2021), and must
include the remainder of the advance
payment ($10) in income for the 2022
taxable year.
(7) Financial statement conformity
requirement. A taxpayer that uses an
AFS to apply the rules under § 1.451–
3 must use the same AFS and, if
applicable, the same method of
accounting under § 1.451–3(h)(4), to
apply the deferral method in paragraph
(c) of this section. Additionally, the AFS
rules under § 1.451–3(h) also apply for
purposes of this section.

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(8) Contracts with multiple
performance obligations—(i) General
rule. If a taxpayer is using the deferral
method under this paragraph (c) and the
taxpayer’s contract with a customer has
more than one performance obligation,
then any payments received under the
contract are allocated to the
corresponding item of gross income in
the same manner as such payments are
allocated to the performance obligations
in the taxpayer’s AFS.
(ii) Example: Computer software
subscription with multiple performance
obligations—(A) Facts. P is in the
business of licensing off the shelf, fully
customized, and semi-customized
computer software and providing
customer support. P uses an accrual
method of accounting for Federal
income tax purposes, files its returns on
a calendar year basis, and has an AFS.
On July 1, 2021, P receives an advance
payment of $100 for a 2-year software
subscription comprised of:
(1)(i) A 1-year ‘‘software maintenance
contract’’ under which P will provide
software updates within the contract
period; and
(ii) A ‘‘customer support agreement’’
for online and telephone customer
support.
(2) P reflects the software
maintenance contract and the customer
support agreement as two separate
performance obligations in its AFS and
allocates $80 of the payment to the
software maintenance contract and $20
to the customer support agreement. P
includes the $80 allocable to the
software maintenance payment in AFS
revenue as follows: 1⁄4 ($20) in AFS
revenue for 2021; 1⁄2 ($40) in AFS
revenue for 2022; and the remaining 1⁄4
($20) in AFS revenue for 2023.
Regarding the $20 allocable to the
customer support payment, P includes
1⁄2 ($10) in AFS revenue for 2021, and
the remaining 1⁄2 ($10) in AFS revenue
for 2022 regardless of when P provides
the customer support.
(B) Analysis. Since the software
maintenance contract and the customer
support agreement are two separate
performance obligations, each yielding a
separate item of gross income,
paragraph (c)(8) of this section requires
P to allocate the $100 payment to each
item of gross income in the same
manner as the payment is allocated to
each performance obligation in P’s AFS.
For Federal income tax purposes, P
must include $30 in gross income for
2021 ($20 allocable to the software
maintenance contract and $10 allocable
to the customer support agreement) and
the remaining $70 is included in gross
income for 2022.

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(iii) Contracts with advance payments
that include items subject to a special
method of accounting—(A) In general.
The portion of the payment allocable to
the items of gross income described in
paragraph (a)(1)(i)(C) of this section
from a contract that includes one or
more items of gross income subject to a
special method of accounting and one or
more items of gross income described in
paragraph (a)(1)(i)(C) of this section
must be determined based on objective
criteria.
(B) Allocation deemed to be based on
objective criteria. A taxpayer’s
allocation method is based on objective
criteria if an allocation of the payment
to each item of gross income is in
proportion to the amounts determined
in § 1.451–3(d)(5) or as otherwise
provided in guidance published in the
Internal Revenue Bulletin (see
§ 601.601(d) of this chapter).
(iv) Example—(A) Facts. B is a
calendar-year accrual method taxpayer
with an AFS. In 2020, B enters into a
$100x contract to design, build, operate
and maintain a toll road and receives an
up-front payment of $100x. The contract
meets the definition of a long-term
contract under § 1.460–1(b)(1). B
properly determines that the obligations
to design and build the toll road are
long-term contract activities under
§ 1.460–1(d)(1) and accounts for the
gross income from these activities under
section 460. In addition, B properly
determines that the obligations to
operate and maintain the toll road are
non-long-term contract activities under
§ 1.460–1(d)(2) and that the gross
income attributable to these activities is
accounted for under section 451(b). B
allocates $60x of the transaction price
amount to the long-term contract
activities and the remaining $40x to the
non-long-term contract activity pursuant
to § 1.451–3(d)(5). For AFS purposes, B
allocates $55x of the transaction price
amount to the performance obligations
that are long-term contract activities and
$45x to the non-long-term contract
activities. B uses the deferral method of
accounting.
(B) Analysis. For Federal income tax
purposes, a method of accounting under
section 460 is a special method of
accounting under paragraph (c)(8)(iv) of
this section. Pursuant to paragraph
(c)(8)(iv) of this section, B must allocate
the payment among the item(s) of gross
income that are subject to section 460
and the item(s) of gross income
described in paragraph (a)(1)(i)(C) of
this section based on objective criteria.
B’s allocation is deemed to be based on
objective criteria if it allocates the
payment in proportion to the amounts
determined under § 1.451–3(d)(5). That

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is, $60x to the items of gross income
subject to section 460 and $40x to the
items of gross income described in
paragraph (a)(1)(i)(C) of this section.
(9) Special rule relating to eligible gift
card sales. For paragraphs (a)(1)(i)(B)
and (c)(1) of this section, if an eligible
gift card is redeemable by an entity
described in paragraph (a)(10)(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 its AFS revenue to the
extent the gift card is redeemed by such
entity during the taxable year.
(10) Examples. The following
examples illustrate the rules of
paragraph (c) of this section. In each of
the following examples, the taxpayer
uses an accrual method of accounting
for Federal income tax purposes and
files its returns on a calendar year basis.
In addition, the taxpayer in each
example has an AFS and uses the
deferral method under paragraph (c) of
this section. Further, the taxpayer does
not use the advance payment cost offset
method in paragraph (e) of this section.
(i) Example 1: Services. On November
1, 2021, A, in the business of giving
dancing lessons, receives an advance
payment of $480 for a 1-year contract
commencing on that date and providing
for up to 48 individual, 1-hour lessons.
A provides eight lessons in 2021 and
another 35 lessons in 2022. A takes into
account 1⁄6 ($80) of the payment as AFS
revenue for 2021, and 5⁄6 ($400) of the
payment as AFS revenue for 2022. For
Federal income tax purposes, under the
deferral method in paragraph (c) of this
section, A must include 1⁄6 ($80) of the
payment in gross income for 2021, and
the remaining 5⁄6 ($400) of the payment
in gross income for 2022.
(ii) Example 2: Services. The same
facts as in paragraph (c)(10)(i) of this
section (Example 1) apply. A receives
an advance payment of $960 for a 3-year
contract under which A provides up to
96 lessons. A provides eight lessons in
2021, 48 lessons in 2022, and 40 lessons
in 2023. A takes into account 1/12 ($80)
of the payment as AFS revenue for 2021,
1⁄2 ($480) of the payment as AFS
revenue for 2022, and 5/12 ($400) of the
payment as AFS revenue for 2023. For
Federal income tax purposes, under the
deferral method in paragraph (c) of this
section, A must include 1/12 ($80) of
the payment in gross income for 2021,
and the remaining 11/12 ($880) of the
payment in gross income for 2022.
(iii) Example 3: Services. On June 1,
2021, B, a landscape architecture firm,
receives an advance payment of $100 for
landscape services that, under the terms
of the agreement, must be provided by
December 2022. On December 31, 2021,

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B estimates that 3⁄4 of the work under
the agreement has been completed. B
takes into account 3⁄4 ($75) of the
payment as AFS revenue for 2021, and
1⁄4 ($25) of the payment as AFS revenue
for 2022. For Federal income tax
purposes, under the deferral method in
paragraph (c) of this section, B must
include 3⁄4 ($75) of the payment in gross
income for 2021, and the remaining 1⁄4
($25) of the payment in gross income for
2022, regardless of whether B completes
the job in 2022.
(iv) Example 4: Repair contracts. On
July 1, 2021, C, in the business of selling
and repairing television sets, receives an
advance payment of $100 for a 2-year
contract under which C agrees to repair
the customer’s television set. C takes
into account 1⁄4 ($25) of the payment as
AFS revenue for 2021, 1⁄2 ($50) of the
payment as AFS revenue for 2022, and
1⁄4 ($25) of the payment as AFS revenue
for 2023. For Federal income tax
purposes, under the deferral method in
paragraph (c) of this section, C must
include 1⁄4 ($25) of the payment in gross
income for 2021 and the remaining 3⁄4
($75) of the payment in gross income for
2022.
(v) Example 5: Online website design.
On July 20, 2021, D, a website designer,
receives an online payment of $75 to
design a website for Customer to be
completed on February 1, 2023. D
designs and completes Customer’s
website on February 1, 2023. D takes
into account the $75 payment for
Customer’s website as AFS revenue for
2023. The $75 payment D receives for
Customer’s website is an advance
payment. For Federal income tax
purposes, under the deferral method in
paragraph (c) of this section, D must
include the $75 payment for the website
in gross income for 2022.
(vi) Example 6: 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, 2021, G receives an
advance payment from a subscriber for
1 year of access to its online database,
beginning on that date. G takes into
account 1⁄3 of the payment as AFS
revenue for 2021 and the remaining 2⁄3
as AFS revenue for 2022. For Federal
income tax purposes, under the deferral
method in paragraph (c) of this section,
G must include 1⁄3 of the payment in
gross income for 2021 and the
remaining 2⁄3 of the payment in gross
income for 2022.
(vii) Example 7: Membership fees. On
December 1, 2021, H, in the business of
operating a chain of ‘‘shopping club’’
retail stores, receives advance payments
for membership fees. The membership

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fees are not prepaid dues income subject
to section 456. 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. H
takes into account 1/12 of the payment
as AFS revenue for 2021 and 11/12 of
the payment as AFS revenue for 2022.
For Federal income tax purposes, under
the deferral method in paragraph (c) of
this section, H must include 1/12 of the
payment in gross income for 2021, and
the remaining 11/12 of the payment in
gross income for 2022.
(viii) Example 8: Cruise. In 2021, I, in
the business of operating tours, receives
$20x payments from customers for a 10day cruise that will take place in April
2022. 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. I takes
into account the $20x payments as AFS
revenue for 2022. For Federal income
tax purposes, I must include the $20x
payments in gross income for 2022.
(ix) Example 9: Broadcasting rights—
(A) Facts. 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 league entered into a 2year broadcasting contract beginning
October 1, 2021. K receives two
payments of $100x on October 1 of each
contract year, beginning in 2021. K
estimates that for each contract year,
25% of the broadcasting rights are
transferred by December 31 of the year
of payment, and the remaining 75% of
the broadcasting rights are transferred in
the following year. K takes into account
1⁄4 ($25x) of the first installment
payment as AFS revenue for 2021 and
3⁄4 ($75x) as AFS revenue for 2022. K
takes into account 1⁄4 ($25x) of the
second payment as AFS revenue for
2022 and 3⁄4 ($75x) as AFS revenue for
2023.
(B) Analysis. Each installment
payment is an advance payment under
paragraph (a)(1) of this section because
a portion of each payment is included
in AFS revenue for a subsequent taxable
year and the payment relates to the use
of intellectual property. For Federal
income tax purposes, under the deferral
method in paragraph (c) of this section,
K must include 1⁄4 ($25x) of the first
$100x installment payment in gross
income for 2021 and 3⁄4 ($75x) of the
first installment payment in gross
income for 2022. In addition, K must
include 1⁄4 ($25x) of the second $100x
payment in gross income for 2022 and
3⁄4 ($75x) of the second installment
payment in gross income for 2023.

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(x) Example 10: Insurance claims
administration—(A) Facts. L is in the
business of negotiating, placing, and
servicing insurance coverage and
administering claims for insurance
companies. On December 1, 2021, 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,
2022. 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. Since L does not perform any
services related to the payment prior to
the service year, L does not meet the
requirements of § 1.451–1(a) for the
payment prior to the service year. For
example, L is paid on December 1, 2021,
for the service year beginning January 1,
2022. L takes into account the first
payment as AFS revenue for 2022; the
second payment as AFS revenue for
2023; the third payment as AFS revenue
for 2024; and the fourth payment as AFS
revenue for 2025.
(B) Analysis. Each annual payment is
an advance payment under paragraph
(a)(1) of this section because each
payment is taken into account as AFS
revenue for a subsequent taxable year
and the payment relates to services. For
Federal income tax purposes, under the
deferral method in paragraph (c) of this
section, L must include: The first
payment in gross income for 2022; the
second payment in gross income for
2023; the third payment in gross income
for 2024; and the fourth payment in
gross income for 2025.
(xi) Example 11: internet services—
(A) Facts. M is a cable internet service
provider that enters into contracts with
subscribers to provide internet services
for a monthly fee that is 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, that is 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 2021, M receives $100x
payments from subscribers for January
2022 internet service and cable modem
use. M takes into account the entire
$100x payments as AFS revenue for
2022.
(B) Analysis. For Federal income tax
purposes, the $100x payments are
advance payments. Because M uses the
deferral method in paragraph (c) of this
section, M must include $100x in gross
income for 2022.
(xii) Example 12: License agreement—
(A) Facts. On January 1, 2021, N

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receives a payment of $250 for entering
into a 3-year license agreement for the
use of N’s trademark throughout the
term of the agreement. The $250
payment reflects the first year (2021)
license fee of $100 and the third year
(2023) license fee of $150. The fee of
$125 for the second year is payable on
January 1, 2022. N takes into account
$100 of the $250 upfront payment as
AFS revenue for 2021, $125 as AFS
revenue for 2022, and $150 of the $250
payment as AFS revenue for 2023.
(B) Analysis. For Federal income tax
purposes, N received an advance
payment of $150, the 2023 license fee,
in 2021. Because N uses the deferral
method in paragraph (c) of this section,
N must defer the $150 payment and
include it in gross income for 2022.
(xiii) Example 13: Computer software
subscription with one performance
obligation—(A) Facts. On July 1, 2021,
O, in the business of licensing off the
shelf, fully customized, and semicustomized computer software and
providing customer support, receives a
payment of $100 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. O determines that its
obligations under the software
subscription contract are one
performance obligation for financial
accounting purposes, which yields one
item of gross income. O takes into
account 1⁄4 ($25) of the payment as AFS
revenue for 2021, 1⁄2 ($50) as AFS
revenue for 2022, and the remaining 1⁄4
($25) as AFS revenue for 2023,
regardless of when O provides updates
or customer support.
(B) Analysis. For Federal income tax
purposes, the $100 payment is an
advance payment. Because O uses the
deferral method in paragraph (c) of this
section, O must include 1⁄4 ($25) of the
payment in gross income for 2021 and
3⁄4 ($75) in gross income for 2022.
(xiv) Example 14: Gift cards
administered by another—(A) General
facts. Q is a corporation that operates
department stores and is the common
parent of a consolidated group (the Q
group). U, V, and W are domestic
corporations wholly owned by Q and
members of the Q group. X is a foreign
corporation wholly owned by Q and not
a member of the Q group. 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
members of the Q 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,

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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.
(B) Facts for taxable year 2021. In
2021, W sells gift cards with a total
value of $900, and, at the end of 2021,
the unredeemed balance of the gift cards
is $100. In Q group’s AFS, the group
includes revenue from the sale of a gift
card when the gift card is redeemed.
Accordingly, of the $900 of gift cards
sold in 2021, $800 were redeemed and
taken into account as AFS revenue for
2021. W tracks sales and redemptions of
gift cards electronically, determines the
extent to which advance payments are
taken into account as AFS revenue in Q
group’s AFS for the taxable year of
receipt and meets the requirements of
paragraph (c)(1) of this section.
(C) Analysis. The payments W
receives from the sale of gift cards are
advance payments because they are
payments for eligible gift cards. Under
the deferral method, W must include
$800 of the payments from gift card
sales in gross income in 2021 and the
remaining $100 of the payments in gross
income in 2022.
(xv) Example 15: Gift cards of
affiliates—(A) Facts. 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 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

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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
taken into account as AFS revenue for
the taxable year of receipt and meet the
requirements of paragraph (c)(1) of this
section.
(B) Analysis. The payments R receives
from the sale of gift cards are advance
payments because they are payments for
eligible gift card sales. For Federal
income tax purposes, R is eligible to use
the deferral method. Using the deferral
method, in the taxable year of receipt,
R must include the advance payment in
income to the extent taken into account
as AFS revenue and must include any
remaining amount in income in the
taxable year following the taxable year
of receipt. Under paragraph (c)(9) of this
section, R is treated as taking into
account revenue from the sale of a gift
card as AFS revenue when a gift card is
redeemed at a participating restaurant.
(xvi) Example 16: Gift cards for
domestic and international hotels—(A)
Facts. S is a corporation that operates
for the benefit of its franchisee
members, who own and operate
domestic and international individual
member hotels. S 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,
determines the extent to which advance
payments are included in AFS revenue
for the taxable year of receipt and meets
the requirements of paragraph (c)(1) of
this section.
(B) Analysis. 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. Under the deferral
method, in the taxable year of receipt,
S must include in income the advance
payment to the extent taken into
account as AFS revenue and must
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income in the taxable year following the
taxable year of receipt.
(xvii) Example 17: Discount
voucher—(A) Facts. On December 10,
2021, 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% 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 takes into account
$12 of the amount allocated to the
discount voucher as AFS revenue for
2021 and includes $18 of the discount
voucher as AFS revenue for 2022.
(B) Analysis. For Federal income tax
purposes, the $30 payment allocated to
the discount voucher is an advance
payment. Using the deferral method, T
must include the $12 allocable to the
discount voucher in gross income in
2021 and the remaining $18 allocated to
the discount voucher in gross income in
2022.
(xviii) Example 18: Rewards—(A)
Facts. On December 31, 2021, 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 2year expiration date. U tracks the issue
date, redemption date, and expiration
date of each customer’s reward points.
Under the terms of U’s reward program,
when the customer redeems reward
points they are deemed to use the
earliest issued points first. In its AFS, U
treats the rewards points as a separate
performance obligation and allocates
$50 of the $1,000 sales price to the
rewards points. U is able to determine
the extent to which a payment that is
allocated to a reward point is taken into
account in AFS revenue in the year of
receipt. U does not take any of the
amount allocated to the reward points
into account as AFS revenue for 2021.
U takes into account $25 of the reward
points as AFS revenue for 2022 and $25
of the reward points as AFS revenue for
2023.
(B) Analysis. For Federal income tax
purposes, U’s treatment of the reward
points as a separate performance
obligation for AFS purposes yields an
item of gross income that must be
accounted for separately. The $50
payment allocated to the reward points
item is an advance payment as the full
inclusion of the payment in gross
income in the year of receipt is a
permissible method of accounting
without regard to this section, a portion

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of the payment is taken into account as
AFS revenue in a subsequent taxable
year, and the reward points are
redeemable for an item described in
paragraph (a)(1)(i)(C) of this section
(goods). Because the entire amount of
the $50 advance payment is taken into
account as AFS revenue in tax years
following the year of receipt, U defers
the payment and includes the $50
payment in gross income in 2022.
(xix) Example 19: Credit card
rewards—(A) Facts. V issues credit
cards and has a loyalty program under
which cardholders earn reward points
when they use V’s credit card to make
purchases. Each reward point is
redeemable for $1 on any future
purchases.
(B) Analysis. Payments under credit
card agreements, including rewards for
credit card purchases, are excluded
from the definition of an advance
payment under paragraph (a)(1)(ii)(C) of
this section. Accordingly, V cannot use
the deferral method for these amounts.
(xx) Example 20: Airline reward
miles—(A) Facts. On January 1, 2021,
W, a passenger airline company, sells a
customer a $700 airline ticket to fly
roundtrip in 2021. As part of the
purchase, the customer receives 7,000
reward points (air miles) from W to be
used for future air travel. The reward
points are not redeemable for cash and
have a 2-year expiration date. W tracks
the issue date, redemption date, and
expiration date of each customer’s
reward points. Under the terms of U’s
reward program, when the customer
redeems reward points they are deemed
to use the earliest issued points first. In
its AFS, W treats the rewards points as
a separate performance obligation and
allocates $35 of the $700 ticket price to
the reward points. W is able to
determine the extent to which a
payment that is allocated to a reward
point is taken into account in AFS
revenue in the year of receipt. W takes
into account all $35 as AFS revenue in
2023 when the customer redeems the air
miles.
(B) Analysis. For Federal income tax
purposes, W’s treatment of the reward
points as a separate performance
obligation for AFS purposes yields an
item of gross income that must be
accounted for separately. The $35
allocated to the reward points item is an
advance payment as the full inclusion of
the payment in gross income in the
taxable year of receipt is a permissible
method of accounting without regard to
this section, a portion of the payment is
taken into account as AFS revenue in a
subsequent taxable year, and the reward
points are redeemable for an item
described in paragraph (a)(1)(i)(C) of

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this section (services). Because the
entire amount of the $35 advance
payment is taken into account as AFS
revenue in a tax year following the year
of receipt, W defers the payment and
includes the $35 payment in gross
income in 2022.
(xxi) Example 21: Chargebacks—(A)
Facts. In 2021, X, a manufacturer of
pharmaceuticals, enters into a contract
to sell 1,000 units to W, a wholesaler,
for $10 per unit, totaling $10,000 (1,000
× $10 = $10,000). The contract also
provides that X will credit W $4 per
unit (chargeback) for sales W makes to
qualifying customers. X delivers 600
units to W on December 31, 2021, and
bills W $6,000 under the contract. X
anticipates that all of W’s sales will be
to qualifying customers and subject to
chargeback. For AFS purposes, X
adjusts its 2021 AFS revenue of $6,000
by $2,400, the anticipated chargebacks,
and reports $3,600 of AFS revenue.
(B) Analysis. For Federal income tax
purposes, under paragraph (a)(1)(i)(B) of
this section, for a payment to qualify as
an advance payment, a portion of the
payment must be taken into account as
AFS revenue for a subsequent taxable
year. Under paragraph (a)(1)(i)(B) of this
section, the amount of the payment
included in AFS revenue for a
subsequent taxable year is $0, calculated
as the $6,000 payment reduced by
$6,000 that is treated as taken into
account as AFS revenue for 2021
($3,600 of AFS revenue for 2021 +
$2,400 of anticipated chargebacks
(section 461 liabilities) which had
reduced AFS revenue for 2021). Because
no portion of the $6,000 is taken into
account as AFS revenue in a subsequent
taxable year (that is, on an AFS after
2021), the $6,000 payment received in
2021 is not an advance payment under
paragraph (a)(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 nonAFS deferral method of accounting
described in paragraph (d)(4) of this
section.
(2) Taxpayers eligible to use the nonAFS deferral method. A taxpayer is
eligible to use the non-AFS deferral
method if the taxpayer does not have an
applicable financial statement and can
determine the extent to which advance
payments are earned in the taxable year
of receipt and, if applicable, a short
taxable year described in paragraph
(d)(6) of this section. The determination
whether the advance payment is earned
in the taxable year of receipt, or a short
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(d)(6) of this section, if applicable, is
determined on an item by item basis.
(3) Deferral of advance payments
based on when payment is earned—(i)
In general. Except as otherwise
provided in this section, a taxpayer that
uses the non-AFS deferral method of
accounting includes the advance
payment in gross income for the taxable
year of receipt to the extent that it is
earned in that taxable year and includes
the remaining portion of the advance
payment in gross income in the next
succeeding taxable year.
(ii) When payment is earned. Under
the non-AFS deferral method, a
payment is earned when the all events
test described in § 1.451–1(a) is met,
without regard to when the amount is
received, as defined under paragraph
(a)(14) 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, or a short
taxable year described in paragraph
(d)(6) of this section, if applicable, the
taxpayer may calculate the amount:
(A) On a statistical basis if adequate
data are available to the taxpayer;
(B) On a straight-line basis over the
term of the agreement if the taxpayer
receives the advance payment under a
fixed term agreement and if it is
reasonable 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) Using any other method that may
be provided in guidance published in
the Internal Revenue Bulletin (see
§ 601.601(d) of this chapter).
(4) Contracts with multiple items of
gross income—(i) In general. If a
taxpayer receives a payment that is
attributable to one or more items
described in paragraph (a)(1)(i)(C) of
this section, the taxpayer must
determine the portion of the payment
that is allocable to such item(s) by using
an allocation method that is based on
objective criteria.
(ii) Objective criteria. A taxpayer’s
allocation method for a payment
described in paragraph (d)(4)(i) of this
section is deemed to be based on
objective criteria if the allocation
method is based on payments the
taxpayer 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 § 601.601(d) of
this chapter).
(5) Acceleration of advance payments.
The acceleration rules in paragraph
(c)(4) of this section also apply to a
taxpayer that uses the non-AFS deferral
method under paragraph (d) of this
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(6) Short taxable year rule. 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 non-AFS 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
earned in such taxable year. Any
amount of the advance payment not
included in gross income in the taxable
year of receipt, or the short taxable year,
must be included in gross income for
the taxable year immediately following
the short taxable year.
(7) Eligible gift card sale. For
paragraphs (a)(1)(i)(B) and (d)(3) of this
section, if an eligible gift card is
redeemable by an entity described in
paragraph (a)(10)(ii) of this section,
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 such entity during the
taxable year.
(8) Examples. The following examples
illustrate the rules of paragraph (d) of
this section. In the examples in this
paragaph (d)(8), the taxpayer is a
calendar year taxpayer that uses the
non-AFS deferral method described in
paragraph (d) of this section. None of
the taxable years are short taxable years.
(i) Example 1—(A) Facts. A, a video
arcade operator, receives payments in
2021 for tokens that customers use to
play A’s arcade games. The tokens
cannot be redeemed for cash, are
imprinted with the name of the arcade,
but 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 2021, 70% of
tokens are expected to be used in 2021,
20% of tokens are expected to be used
in 2022, and 10% of tokens are expected
to never be used. Based on the study,
under paragraph (d)(3)(ii)(A) of this
section, A determines that 80% of the
advance payments are earned for 2021
(70% for tokens expected to be used in
2021 plus 10% for tokens that are
expected to never be used).
(B) Analysis. For Federal income tax
purposes, A must include 80% of the
advance payments in gross income for
2021 and 20% of the advance payments
in gross income for 2022.
(ii) Example 2—(A) Facts. B is in the
business of providing internet services.
On September 1, 2021, B receives an

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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. However, at the close of the
2021 taxable year, it is reasonable for B
to anticipate that the advance payment
will be earned ratably over the term of
the agreement.
(B) Analysis. For Federal income tax
purposes, pursuant to paragraph
(d)(3)(ii)(B) of this section, B determines
the extent to which the payment is
earned in tax year 2021 on a straightline basis over the term of the agreement
and takes that amount into income in
2021. The remaining amount of the
advance payment is taken into gross
income in the 2022 taxable year.
(e) Advance payment cost offset
method—(1) In general. This paragraph
(e) provides an optional method of
accounting for advance payments from
the sale of inventory (advance payment
cost offset method). A taxpayer that
chooses to use the advance payment
cost offset method for a trade or
business must use the method of
accounting for all advance payments
received by that trade or business that
meet the criteria in this paragraph (e).
Additionally, a taxpayer that chooses to
use this method for a trade or business
and that has an AFS must also use the
AFS cost offset method described in
§ 1.451–3(c). A taxpayer that uses the
AFS cost offset method and the advance
payment cost offset method to account
for gross income, including advance
payments, from the sale of an item of
inventory, determines the
corresponding AFS income inclusion
amount, as defined in § 1.451–3(a)(1),
and the advance payment income
inclusion amount for a taxable year by
following the rules in § 1.451–3(c)(2)
rather than the rules under this
paragraph (e). However, if all payments
received for the sale of item of inventory
meet the definition of an advance
payment under paragraph (a)(1) of this
section, a taxpayer that uses the advance
payment cost offset method determines
the corresponding advance payment
income inclusion amount for a taxable
year by:
(i) Following the rules in paragraph
(e)(2) of this section, subject to the
additional rules and limitations in
paragraphs (e)(5) through (8) of this
section, if the taxable year is a taxable
year prior to the taxable year in which
ownership of the item of inventory is
transferred to the customer; and
(ii) Following the rules in paragraph
(e)(3) of this section, subject to the
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paragraphs (e)(5) through (8) of this
section, if the taxable year is the taxable
year in which ownership of the item of
inventory is transferred to the customer.
(2) Determining the advance payment
income inclusion amount in a year prior
to the year of sale. To determine the
advance payment income inclusion
amount for a taxable year prior to the
year in which ownership of the item of
inventory is transferred to the customer,
the taxpayer must first determine the
advance payment inventory inclusion
amount for such item for such year. This
advance payment inventory inclusion
amount is then reduced by the cost of
goods in progress offset for the taxable
year, as determined under paragraphs
(e)(4), (5), and (8) of this section. This
net amount is the advance payment
income inclusion amount for the taxable
year.
(3) Determining the advance payment
income inclusion amount in the year of
sale. The advance payment income
inclusion amount for the taxable year in
which ownership of the item of
inventory is transferred to the customer
is equal to the portion of any advance
payment for such item that was not
required to be included in gross income
in a prior taxable year. This amount is
not reduced by a cost of goods in
progress offset under paragraph (e)(4) of
this section. However, the taxpayer is
entitled to recover the costs capitalized
to the item of inventory as cost of goods
sold in accordance with sections 471
and 263A or any other applicable
provision of the Internal Revenue Code.
See § 1.61–3.
(4) Cost of goods in progress offset.
The cost of goods in progress offset for
the taxable year is calculated as:
(i) The cost of goods allocable to the
item of inventory through the last day
of the taxable year; reduced by
(ii) The cumulative cost of goods in
progress offset attributable to the item of
inventory, if any.
(5) Limitations to the cost of goods in
progress offset. The cost of goods in
progress offset is determined separately
for each item of inventory. The cost of
goods in progress offset attributable to
one item of inventory cannot reduce the
advance payment inventory inclusion
amount attributable to a different item
of inventory. Further, the cost of goods
in progress offset cannot reduce the
advance payment inventory inclusion
amount for the taxable year below zero.
(6) Exception for gift cards. The cost
of goods in progress offset in this
paragraph (e) does not apply to eligible
gift card sales or payments received for
customer reward points.
(7) Acceleration of advance payments.
The acceleration rules in paragraph

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(c)(4) of this section also apply to a
taxpayer that uses the advance payment
cost offset method under this paragraph
(e), regardless of whether the taxpayer
uses such method in connection with
the full inclusion method under
paragraph (b) of this section, or the
deferral method under paragraph (c) or
(d) of this section. If an advance
payment is subject to the acceleration
rules, paragraph (e)(2) of this section
does not apply to determine the advance
payment income inclusion amount for
the taxable year described in paragraph
(c)(4) of this section. Further, a taxpayer
that uses the advance payment cost
offset method under this paragraph (e)
applies paragraph (c)(4)(i)(B)(2)(ii) of
this section by substituting ‘‘same
advance payment method as the
transferor’’ for ‘‘deferral method.’’
(8) Inventory costs for the advance
payment cost offset method—(i)
Inventory costs not affected by cost of
goods in progress offset. The cost of
goods comprising the cost of goods in
progress offset does not reduce the costs
that are capitalized to the items of
inventory produced or items of
inventory acquired for resale by the
taxpayer. While the cost of goods in
progress offset reduces the amount of
the advance payment inventory
inclusion amount, the cost of goods in
progress offset does not affect how and
when costs are capitalized to inventory
under sections 471 and 263A or any
other applicable provision of the
Internal Revenue Code or when those
capitalized costs will be recovered.
(ii) Consistency between inventory
methods and advance payment cost
offset method. The costs of goods
comprising the cost of goods in progress
offset must be determined by applying
the taxpayer’s methods of accounting for
inventory for Federal income tax
purposes. A taxpayer using the advance
payment cost offset method must
calculate its cost of goods in progress
offset by reference to all costs that the
taxpayer has permissibly capitalized
and allocated to items of inventory
under its methods of accounting for
inventory for Federal income tax
purposes, but including no more costs
than what the taxpayer has permissibly
capitalized and allocated to items of
inventory.
(iii) Allocation of ‘‘additional section
263A costs’’ for taxpayers using
simplified methods. If a taxpayer uses
the simplified production method as
defined under § 1.263A–2(b), the
modified simplified production method
as defined under § 1.263A–2(c), or the
simplified resale method as defined
under § 1.263A–3(d) to determine the
amount of its ‘‘additional section 263A

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Federal Register / Vol. 86, No. 3 / Wednesday, January 6, 2021 / Rules and Regulations
costs,’’ as defined under § 1.263A–
1(d)(3), to be included in ending
inventory, then solely for computing the
cost of goods in progress offset, the

taxpayer must determine the portion of
additional section 263A costs allocable
to an item of inventory by multiplying
its total additional section 263A costs

861

accounted for under the simplified
method for all items of inventory subject
to the simplified method by the
following ratio:

Section 471 costs allocable to the specific item of inventory

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Total section 471 costs for all items of inventory subject to the simplified method

(9) Additional procedural guidance.
The IRS may publish procedural
guidance in the Internal Revenue
Bulletin (see § 601.601(d) of this
chapter) that provides alternative
procedures for complying with the rules
under this paragraph (e), including
alternative methods of accounting for
cost offsets.
(10) Examples. The following
examples illustrate the rules of
paragraph (e) of this section. In each of
the following examples, the taxpayer is
a C corporation, has an AFS, uses an
accrual method of accounting for
Federal income tax purposes, and uses
a calendar year for Federal income tax
purposes and AFS purposes. In
addition, in each example, the taxpayer
uses the deferral method and the
advance payment cost offset method
under paragraph (e) of this section.
Lastly, the taxpayer does not produce
unique items, as described in § 1.460–
2(a)(1) and (b), or any item that
normally requires more than 12
calendar months to complete, as
determined under § 1.460–2(a)(2) and
(c). Any production period that exceeds
12 calendar months is due to unforeseen
production delays.
(i) Example 1—(A) Facts. In December
2021, A enters into a contract with
Customer to manufacture and deliver a
good in 2024, with a total contract price
of $100x. The costs to produce the good
are required to be capitalized under
sections 471 and 263A as the good is
inventory in the hands of A. On the
same day, A receives a payment of $40x
from the customer. For its AFS, A
reports all of the revenue from the sale
of the good as AFS revenue in the year
of delivery, which is also the year in
which ownership of the good transfers
from A to Customer. As of December 31,
2021, A has not incurred any cost to
manufacture the good. The payment of
$40x does not satisfy the specified good
exception in paragraph (a)(1)(ii)(H) of
this section, and thus qualifies as an
advance payment. During 2022, A does
not receive any additional payments on
the contract and incurs $10x of costs to
manufacture the good. A properly
capitalizes and allocates such costs to
the manufactured good under sections
471 and 263A.

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(B) Analysis. Because no portion of
the $40x advance payment is taken into
account as AFS revenue as of the end of
2021, A is not required to include any
portion of the advance payment in gross
income for 2021. For 2022, A’s advance
payment inventory inclusion amount is
$40x, which is the amount of the
advance payment that, but for the cost
of goods in progress offset, would be
includable in gross income in 2022
under the deferral method. Pursuant to
paragraph (e)(2) of this section, A
reduces such amount by the $10x cost
of goods in progress offset, determined
as the costs of goods through the end of
2022 ($0 costs incurred in 2021 plus 10x
of costs incurred in 2022 = $10x). A is
required to include this net amount of
$30x in gross income in 2022. The
remaining portion of the payment ($10x)
is deferred and included in gross
income in 2024, the taxable year in
which ownership of the good is
transferred to Customer.
(ii) Example 2—(A) Facts. The same
facts as in paragraph (e)(10)(i) of this
section (Example 1) apply. In addition,
in 2023, A incurs costs of $20x to
manufacture the good but does not
receive any additional payments from
Customer.
(B) Analysis. A includes $0 in gross
income in 2023. A’s cost of goods in
progress offset for 2023 is $20x under
paragraph (e)(4) of this section ($30x
costs of goods through the last day of
2023 ($10x for 2022 plus $20x for 2023
= $30x) less $10x cumulative cost of
goods in progress offset amounts taken
in prior taxable years). However,
because A’s advance payment inventory
inclusion amount for 2023 is $0, which
is the amount of the advance payment
that, but for the cost of goods in progress
offset, would be includable in gross
income in 2023 under the deferral
method, paragraph (e)(5) of this section
limits the cost offset to $0.
(iii) Example 3—(A) Facts. The same
facts as in paragraph (e)(10)(i) of this
section (Example 1) apply, except that
in taxable year 2022, A incurs
additional costs of $25x to manufacture
the good, resulting in total costs of $35x
to manufacture the good in taxable year
2022.
(B) Analysis. For 2022, A’s advance
payment inventory inclusion amount is

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$40x, which is the amount of the
advance payment that, but for the cost
of goods in progress offset, would be
includable in gross income in 2022
under the deferral method. Pursuant to
paragraph (e)(2) of this section A
reduces such amount by the $35x cost
of goods in progress offset, determined
as the costs of goods through the end of
2022 ($0 costs incurred in 2021 plus
$35x costs incurred in 2022 = $35x). A
is required to include this net amount
of $5x in gross income in 2022. The
remaining portion of the payment ($35x)
is deferred and included in gross
income in 2024, the taxable year in
which ownership of the good is
transferred to the customer.
(iv) Example 4—(A) Facts. The same
facts as in paragraph (e)(10)(iii) of this
section (Example 3) apply, except that
for tax year 2023, A receives an
additional advance payment of $60x,
and does not incur any costs to
manufacture the good in 2023. In 2024,
A incurs the remaining $10x to
manufacture the good, and delivers the
good to Customer.
(B) Analysis for 2023. Because no
portion of the $60x advance payment is
taken into account as AFS revenue as of
the end of 2023, A is not required to
include any portion of the $60x advance
payment in gross income for 2023.
(C) Analysis for 2024. In 2024, the
ownership of the good is transferred to
Customer. Accordingly, pursuant to
paragraph (e)(3) of this section, A is
required to include $95x, the remaining
portion of all advance payments that
were not required to be included in
gross income in a prior taxable year
($100x of total advance payments
received less $5x that was required to be
included in gross income in 2022).
Although A does not reduce such
amount by a cost offset, it reduces gross
income in 2024 by recovering the $45x
of costs capitalized to inventory as cost
of goods sold ($35x costs incurred in
2022 plus $10x costs incurred in 2024)
in accordance with sections 471 and
263A. Accordingly, A’s gross income for
2024 is $50x.
(f) Method treating payments
qualifying for the specified goods
exception as advance payments—(1) In
general. A taxpayer may choose to use
the specified good section 451(c)

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Federal Register / Vol. 86, No. 3 / Wednesday, January 6, 2021 / Rules and Regulations

method to treat all payments that
qualify for the specified goods exception
in paragraph (a)(1)(ii)(H) of this section
as advance payments that are eligible to
be accounted for under this section.
Under the specified good section 451(c)
method, an advance payment is a
payment received by the taxpayer in a
taxable year earlier than the taxable year
immediately preceding the taxable year
of the contractual delivery date for a
specified good. A taxpayer that chooses
to use the specified good section 451(c)
method for a trade or business must
apply this method of accounting for all
advance payments that meet the criteria
described in paragraph (a)(1)(ii)(H) of
this section.
(2) Example: Method for the specified
goods exception to not apply. On May
1, 2021, A, a corporation that files its
Federal income tax return on the
calendar year basis, receives a
prepayment for $100x, for a contract to
manufacture and deliver a good in
September of 2023. All of the revenue
from the sale of the good is recognized
in A’s AFS in the year of delivery.
During 2021, A 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. The
payment of $100x satisfies the specified
good exception. A uses the method
under paragraph (f) of this section to
treat all payments that otherwise satisfy
the specified good exception as advance
payments under this section. For
Federal income tax purposes, A must
treat the payment of $100x as an
advance payment and account for such
payment under the full inclusion
method in paragraph (b) of this section,
or the deferral method in paragraph (c)
of this section, as applicable.
Additionally, the taxpayer may choose
to apply the advance payment cost
offset method in paragraph (e) of this
section.
(g) Election and methods of
accounting—(1) Procedures for making
election under section 451(c)(1)(B). An
election to apply the deferral method
under section 451(c)(1)(B) is made by
the taxpayer filing a Federal income tax
return reflecting the deferral method in
computing its taxable income. If the
application of the deferral method
under section 451(c)(1)(B) results in the
taxpayer changing its method of
accounting, the election may only be
made by the taxpayer complying with

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the method change procedures under
this paragraph (g).
(2) Methods of accounting. A change
to comply with this section is a change
in method of accounting to which the
provisions of sections 446 and 481 and
the regulations in this part under
sections 446 and 481 of the Code apply.
A taxpayer seeking to change to a
method of accounting permitted in this
section must secure the consent of the
Commissioner in accordance with
§ 1.446–1(e) and follow the
administrative procedures issued under
§ 1.446–1(e)(3)(ii) for obtaining the
Commissioner’s consent to change its
accounting method. For example, use of
the full inclusion method under
paragraph (b) of this section, the AFS
deferral method under paragraph (c) of
this section, the non-AFS deferral
method under paragraph (d) of this
section, the advance payment cost offset
method under paragraph (e) of this
section, and the specified good section
451(c) method under paragraph (f) of
this section are adoptions of, or changes
in, a method of accounting under
section 446 of the Internal Revenue
Code or the regulations in this part
under section 446 of the Code. 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 regulations in
this part under section 446 of the Code.
(h) Applicability date—(1) In general.
The rules of this section apply to taxable
years beginning on or after January 1,
2021.
(2) Early application. Taxpayers and
their related parties, within the meaning
of sections 267(b) and 707(b), may apply
both the rules in this section and, to the
extent relevant, the rules in § 1.451–3,
in their entirety and in a consistent
manner, to a taxable year beginning after
December 31, 2017, and before January
1, 2021, provided that, once applied to
a taxable year, the rules in this section
and, to the extent relevant, the rules in
§ 1.451–3, are applied in their entirety
and in a consistent manner to all
subsequent taxable years. See section
7805(b)(7) and § 1.451–3(m).
■ Par. 7. Section 1.1271–0 is amended
by adding entries for § 1.1275–2(l) and
(l)(1) and (2) to read as follows:
§ 1.1271–0 Original issue discount;
effective date; table of contents.

*

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*

*

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*

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*

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§ 1.1275–2 Special rules relating to debt
instruments.

*

*
*
*
*
(l) OID rule for income item subject to
section 451(b).
(1) In general.
(2) Applicability dates.
*
*
*
*
*
Par. 8. Section 1.1275–2 is amended
by adding paragraph (l) to read as
follows:

■

§ 1.1275–2 Special rules relating to debt
instruments.

*

*
*
*
*
(l) OID rule for income item subject to
section 451(b)—(1) In general.
Notwithstanding any other rule in
sections 1271 through 1275 and
§§ 1.1271–1 through 1.1275–7, if, and to
the extent, a taxpayer’s item of income
with respect to a debt instrument is
subject to the timing rules in § 1.451–3
because the item of income is a
specified fee described in § 1.451–3(j)
(such as credit card late fees, credit card
cash advance fees, or interchange fees),
then the taxpayer does not take the item
into account to determine whether the
debt instrument has any OID. As a
result, the taxpayer does not treat the
item as creating or increasing any OID
on the debt instrument.
(2) Applicability dates—(i) In general.
Except as provided in paragraph
(l)(2)(ii) and (iii) of this section, for a
specified credit card fee as defined in
§ 1.451–3(j)(2), paragraph (l)(1) of this
section applies for taxable years
beginning on or after January 1, 2021,
and, for a specified fee that is not a
specified credit card fee, paragraph (l)(1)
of this section applies for taxable years
beginning on or after January 6, 2022.
(ii) Early application. For a taxable
year beginning after December 31, 2018,
and before January 1, 2021, a taxpayer
and its related parties, within the
meaning of sections 267(b) and 707(b),
may choose to apply both paragraph
(l)(1) of this section and the rules in
§ 1.451–3, in their entirety and in a
consistent manner, to all specified
credit card fees subject to § 1.451–3,
provided that once applied to a taxable
year the rules in paragraph (l)(1) of this
section and the rules in § 1.451–3 that
apply to specified credit card fees, are
applied in their entirety and in a
consistent manner for all subsequent
taxable years. See section 7508(b)(7).

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Federal Register / Vol. 86, No. 3 / Wednesday, January 6, 2021 / Rules and Regulations
(iii) Applicability date for accounting
method changes. Paragraph (l)(1) of this
section will not apply in applying
section 13221(e) of Public Law 115–97,
131 Stat. 2054 (2017), to determine the
section 481(a) adjustment period for any
adjustment under section 481(a) for a

qualified change in method of
accounting required under section

863

451(b) and § 1.451–3 for a specified
credit card fee.
Sunita Lough,
Deputy Commissioner for Services and
Enforcement.
Approved: December 14, 2020.
David J. Kautter,
Assistant Secretary of the Treasury (Tax
Policy).
[FR Doc. 2020–28653 Filed 12–30–20; 4:15 pm]

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