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

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 

AGENCY: Internal Revenue Service (IRS), 

Treasury. 

ACTION: Final regulations. 

SUMMARY: 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: 

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 

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 

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 

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 

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. 

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 

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 

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 

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 

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

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 

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 

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 

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– 

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. 

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. 

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 

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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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 

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)). 

F. Proposed § 1.451–3(i): Special 

Ordering Rule for Certain Items of 

Income for Debt Instruments 

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 

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. 

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 


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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 

satisfies the all events test under 

§ 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 

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 

date and expects to fulfill the contract 

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 

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. 

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 

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 

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 

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 

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

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 

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.’’ 

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 

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 

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 

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 

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 

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 

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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1Cost offsets are not reported on current tax 

returns and will not be separately reported on 

future tax returns. 

(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. 

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 

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 

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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2 Data are based on estimates from the IRS’s 

Research, Applied Analytics and Statistics Division 

using data from the Compliance Data Warehouse. 

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 

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 

Entities with gross receipts 

greater than $26 million 

E-filed Paper-filed Total E-filed Paper-filed Total 

Returns ................................................................. 2,503 307 2,810 73 4 77 

Returns with a Schedule M–3 ............................. 288 * 35 * 323 62 * 3 * 65 

Returns with a Schedule M–3 and an audited income statement ................................................ 113 * 14 * 127 45 * 2 * 47 

Returns without a Schedule M–3 ........................ 2,215 * 272 * 2,487 11 * 1 * 12 

Returns without a Schedule M–3, but with an 

audited income statement (estimated) ............. ** 111 ** 13 ** 124 ** 1 ** 0 ** 1 

Returns with an audited income statement ......... ** 224 ** 27 ** 251 ** 46 ** 2 ** 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 

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 


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

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 

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 

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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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 

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. 

2021 2022 2023 2024 Total 

Payments ............................................................................. $25x $25x $25x $25x $100x 

AFS Revenue ....................................................................... 50x 0x 20x 30x 100x 

Gross Income (cumulative approach) .................................. 50x 0x 25x 25x 100x 

Gross Income (annual approach) ........................................ 50x 25x 25x 0x 100x 

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 

these two alternative regulatory 

approaches. 

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 

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 

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 

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. 

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. 

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 

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

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 

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 

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) .................. Application of AFS income inclusion rule by making all AFS revenue adjustments. 

§ 1.451–3(b)(2)(ii) ................. Application of AFS income inclusion rule by making certain AFS revenue adjustments (Alternative AFS Revenue 

method). 

§ 1.451–3(c) .......................... AFS cost offset method. 

§ 1.451–3(i)(4) ...................... Computing revenue when the AFS and taxable years are mismatched. 

§ 1.451–3(l) ........................... Change in the method of recognizing revenue in an AFS. 

§ 1.451–8(c) .......................... Deferral method for taxpayers with an AFS. 

§ 1.451–8(d) ......................... Deferral method for taxpayer without an AFS. 

§ 1.451–8(e) ......................... Advance payment cost offset method. 

§ 1.451–8(f) .......................... Election for the specified goods exception to not apply. 

§ 1.451–8(g) ......................... Change in the method for recognizing advance payments on an AFS. 

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. 

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 

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 833 

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 

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 

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. 

Form/ 

revenue 

procedure 

Type of filer OMB no.(s) Status 

Form 3115 ............................... All other Filers (mainly trusts 

and estates) (Legacy system).

1545–2070 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. 

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 

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 

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

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 

Entity Total returns 

(thousands) 

Returns using 

an accrual 

method of 

accounting 

(thousands) 

Percent of 

returns 

using accrual 

method of 

accounting 

C corporations ............................................................................................................................. 1,570 691 44 

S corporations .............................................................................................................................. 4,684 1,146 24 

Partnerships ................................................................................................................................. 3,884 912 23 

Sole proprietors and LLCs ........................................................................................................... 26,425 379 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] 

Entities with gross receipts not greater than $26 million 

E-filed 

returns 

Paper-filed 

returns 

Total 

returns 

Returns ........................................................................................................................................ 2,503 307 2,810 

Returns with a Schedule M–3 ..................................................................................................... 288 * 35 * 323 

Returns with a Schedule M–3 and an audited income statement .............................................. 113 * 14 * 127 

Returns without a Schedule M–3 ................................................................................................ 2,215 * 272 * 2,487 

Returns without a Schedule M–3, but with an audited income statement ................................. ** 111 ** 13 ** 124 


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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 

Paper-filed 

returns 

Total 

returns 

Returns with an audited income statement ................................................................................. ** 224 ** 27 ** 251 

* 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 

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. 

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

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. 

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: 

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 Method of accounting for 

interest. 

(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), 

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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(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). 

(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 

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 

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 

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 

$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 

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 Calculation Total rent 

2021 ................................................................................................................................................................. $30,000 $30,000 

2022 ................................................................................................................................................................. 30,000 * 1.05 31,500 

2023 ................................................................................................................................................................. 31,500 * 1.05 33,075 

2024 ................................................................................................................................................................. 33,075 * 1.05 34,729 

2025 ................................................................................................................................................................. 34,729 * 1.05 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 

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. 

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 

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, 

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 

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 

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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(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 

(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 

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: 

(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 

$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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(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 

$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 

$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; 

$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 

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 

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 

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, 

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. 

(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 

paragraph (e)(2)(i)(E) is summarized in 

the following table: 

TABLE 2 TO PARAGAPH (e)(2)(i)(E) 

2021 2022 2023 2024 Total 

All Events/Full Inclusion Income .......................................... $25x $25x $25x $25x $100x 

AFS Revenue ....................................................................... 50x 0 20x 30x 100x 

Cumulative rule income ....................................................... 50x 0 25x 25x 100x 

(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 

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 

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 2022 2023 2024 Total 

All Events Test/Deferral Method Income ............................. $25x $25x 1 $20x $30x $100x 

AFS Revenue amount ......................................................... 50x 0 20x 30x 100x 

Cumulative rule income ....................................................... 50x 0 20x 30x 100x 

1 $5x 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 

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 

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 

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 

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. 

(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 

(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: 

§ 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 

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 

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. 

(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 

increased or decreased, as applicable, by 

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 

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. 

(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. 

(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, 

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 

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 10- 

day 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 2- 

year 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 

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, 

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 

include any remaining amount in 

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 2- 

year 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 

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 

taxable year described in paragraph 

(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 

section. 

(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 

additional rules and limitations in 

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 

(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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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 

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 

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. 

(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 

$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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862 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 

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. 

* * * * * 

§ 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 863 

(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 

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] 

BILLING CODE 4830–01–P 


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