Editor: Mary Van Leuven, J.D., LL.M.
Taxpayers generating revenues from services may now be able to use the nonaccrual-experience (NAE) book safe-harbor method to exclude qualifying uncollectible revenues from taxable income. As this item explains, qualifying for this recently established book safe-harbor method is easier than qualifying for other safe-harbor methods, but other complexities still face taxpayers using the safe harbor.
In September 2011, the IRS released Rev. Proc. 2011-46, which provided a book safe-harbor method for taxpayers accounting for revenues using the NAE method. The safe harbor allows eligible taxpayers to compute uncollectible revenues by applying a factor of 95% to their allowance for doubtful accounts as determined through the taxpayer’s applicable financial statements.
The NAE Method
Sec. 448(d)(5) allows accrual-method taxpayers to use the NAE method to account for the noncollectibility of certain service-related revenues based on the taxpayer’s experience. If applicable, the NAE method allows taxpayers to exclude amounts from income when collection is not expected. The NAE method is available only to taxpayers performing services and either qualifying under an annual $5 million gross receipts test or delivering those services in health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting.
Generally, the gross receipts test is satisfied for any prior tax year if the average annual gross receipts for the three-tax-year period ending with the prior tax year does not exceed $5 million. The gross receipts of all entities treated as a single employer are aggregated for the purposes of the test. Taxpayers may not use the NAE method for overdue amounts on which the taxpayer charges interest or penalties.
In 2006, Treasury finalized Regs. Sec. 1.448-2, which contains four specific safe harbors related to the NAE method. These safe-harbor methods are often cumbersome for taxpayers. For certain computations, the methods require taxpayers to track financial information for six years. Acquisition of a new company or business can produce additional issues, as taxpayers might have difficulty finding necessary historical information. In many instances, eligible taxpayers do not use the NAE method because of the complexity surrounding the safe harbors.
The NAE Book Safe-Harbor Method
Rev. Proc. 2011-46 establishes an additional NAE book safe-harbor method, which appears somewhat simpler than the existing safe harbors, as it does not require extensive tracking of data. Qualified taxpayers may compute the amount excluded from revenue under Sec. 448(d)(5) by multiplying 95% by the portion of the year-end allowance for doubtful accounts on the taxpayer’s applicable financial statement that is attributable to current-year NAE-eligible accounts receivable.
The book safe-harbor method may not be applied to an allowance for doubtful accounts related to accounts receivable to which a taxpayer is prohibited from applying the NAE method, such as receivables not earned through the performance of NAE-eligible services or receivables where interest or penalties are charged for failure to timely pay. In addition, eligible accounts receivable are only those receivables that a taxpayer has earned in the current tax year.
The revenue procedure allows taxpayers to use any reasonable method to determine the amount of the allowance for doubtful accounts that is attributable to current-year NAE-eligible accounts receivable. The methodology generally must take into account relevant information that is readily available to the taxpayer. Taxpayers must use an applicable financial statement to determine the amount of eligible allowance for doubtful accounts. Rev. Proc. 2011-46 lists the applicable financial statements, in descending priority:
- A financial statement required to be filed with the SEC (the Form 10-K or the Annual Statement to Shareholders);
- A certified audited financial statement that is accompanied by the report of an independent CPA (or in the case of a foreign corporation, by the report of a similarly qualified independent professional) that is used for:
- Credit purposes;
- Reporting to shareholders; or
- Any other substantial nontax purpose; and
- A financial statement (other than a tax return) required to be provided to a federal or a state government or any federal or state agency (other than the SEC or IRS).
Without an applicable financial statement, a taxpayer is not eligible to apply the NAE book safe-harbor method when determining its taxable income.
Although the NAE book safe-harbor method appears simpler, complexities are still present for taxpayers applying it, including:
Determining whether a qualified service generates the receivable: For taxpayers exceeding the annual $5 million gross receipts test, the NAE method is available only if the taxpayers perform services in the fields listed earlier. Determining that a company is involved in a qualifying service is often difficult. For example, a large manufacturer may provide certain consulting services, which could generate revenues that qualify for the NAE method. Or a bank may provide financial consulting services, which could generate qualifying revenues. The service revenues of both these businesses might be overlooked because the amounts are relatively small in comparison to other revenues.
In addition to overlooking the possibility of applying the NAE method, companies otherwise eligible to use it could have ineligible revenue streams. Taxpayers should remember that revenues generated from wholly owned finance, management, or rental companies might not qualify for the NAE method.
Determining the amount of receivables from revenues generated in the current year: Again, the NAE book safe-harbor method applies only to the taxpayer’s receivables generated in the current year. Thus, for a calendar-year taxpayer, an allowance established in June for a receivable generated in the previous December would not be eligible for the NAE book safe-harbor method. A taxpayer could analyze its receivables individually; however, this may be impractical for a company with a large number of receivables. The revenue procedure allows a taxpayer to use a reasonable method that takes into account readily available data. Thus, for example, the taxpayer might use data generated from its accounts receivable aging report to determine the amount of the allowance related to accounts receivable generated in the current year.
Determining whether a taxpayer has an applicable financial statement: Most privately held companies do not issue a Form 10-K and might not have an audit performed as described in the revenue procedure. However, these companies could have filings with state or federal governmental agencies (other than the IRS or the SEC). Taxpayers should not overlook these filings, which might qualify for purposes of the NAE book safe-harbor method. Additionally, complex legal structures could create instances in which some legal entities within a taxpayer’s structure are audited, while other legal entities are not audited. Taxpayers should consider this when determining the amount of eligible accounts receivable.
Procedures for Changing to the NAE Book Safe-Harbor Method
Rev. Proc. 2011-46 provides the necessary procedures for taxpayers that want to change their method of accounting to the NAE book safe-harbor method. Barring any scope limitations, a change to the NAE book safe-harbor method is an automatic change in method of accounting. A change to the NAE book safe-harbor method allows taxpayers either not using an NAE method or applying a different safe harbor to change accounting methods to the NAE book safe-harbor method.
To change its method, a taxpayer must apply the rules of Rev. Proc. 2011-14. Thus, taxpayers should attach Form 3115, Application for Change in Accounting Method, to their timely filed tax returns and file a copy with the IRS National Office. Note that the scope limitations of Rev. Proc. 2011-14, Section 4.02, do not apply for a taxpayer’s first tax year ending on or after Sept. 28, 2011; however, if a taxpayer’s NAE method is an issue under consideration in an IRS exam, before an IRS Appeals office, or before a federal court, then the audit protection of Rev. Proc. 2011-14, Section 7, does not apply.
Other Method Changes in Rev. Proc. 2011-46
Rev. Proc. 2011-46 also identifies two additional method changes:
Change in applicable financial statements and allowance for doubtful accounts: The revenue procedure states that a change to a taxpayer’s method for determining its allowance for doubtful accounts for its applicable financial statements is a change in method of accounting.
Change in method of determining the NAE-eligible amount: The revenue procedure states that a change to a taxpayer’s method for determining the portion of its applicable financial statement allowance for doubtful accounts that is attributable to current-year NAE-eligible accounts receivable is a change in method of accounting.
To change its method for these two items, the taxpayer must apply the rules of Rev. Proc. 2011-14. However, the manner in which a taxpayer makes either of these two method changes is to attach a statement to its original return for the year of change. The information to be contained in such statements is described in Rev. Proc. 2011-46, Sections 5.02 and 5.03. No duplicate copy of this statement is required to be filed with the IRS National Office. A change to either of these two items is made on a cutoff basis.
The NAE book safe-harbor method described in Rev. Proc. 2011-46 can provide taxpayers with a less cumbersome safe harbor than those presently provided in the regulations. In general, this new safe harbor allows taxpayers to compute uncollectible revenues as 95% of their allowance for doubtful accounts related to receivables generated in the current year.
Although the method is less cumbersome than the existing safe harbors, difficulties still can arise. They include (1) determining whether a qualified service generates the receivable; (2) determining the amount of receivables from revenues generated in the current year; or (3) determining whether a taxpayer has an applicable financial statement. Taxpayers wishing to change their method of accounting to the NAE book safe-harbor method should follow the procedures of Rev. Proc. 2011-46 and Rev. Proc. 2011-14.
Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or email@example.com.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.