What Happened to Reg 1.451-5 for Advance Payments?

The Tax Cuts and Jobs Act (TCJA) significantly shifted the rules for reporting advance payments for goods and services. For many years, businesses relied on Treasury Regulation §1.451-5 to defer this income, but the TCJA made this rule obsolete.

This overhaul replaced the old regulation with new rules in Internal Revenue Code (IRC) Section 451(c). This change fundamentally altered how and when accrual-basis taxpayers must account for advance payments. Understanding the transition is necessary for proper tax compliance.

Understanding the Repealed Advance Payment Rule

Before its repeal, Treasury Regulation §1.451-5 provided a framework for accrual-basis taxpayers to defer including advance payments in their gross income. This rule was relevant for businesses that received payments for goods before delivery, as it allowed income deferral until the tax year the payments were recognized for financial reporting purposes.

Under these rules, an advance payment was defined as any amount received for the future sale of goods held for sale to customers in the ordinary course of business. The regulation permitted a deferral that could, for inventoriable goods, extend for up to two years following the year of receipt. The deferral could not extend beyond the year the payments were included in gross receipts for the taxpayer’s financial reports.

The Current Deferral Method for Advance Payments

IRC Section 451(c) establishes that income is recognized for tax purposes no later than when it is recognized on a business’s applicable financial statement (AFS). An AFS typically refers to a certified financial statement prepared according to Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).

Under the new law, taxpayers have two main options for handling advance payments. The first is the “full inclusion method,” which requires including the entire advance payment in gross income in the year it is received. The second is the “deferral method,” which allows a taxpayer to include a portion of the advance payment in income in the year of receipt to the extent it is recognized as revenue in their AFS for that year.

The remaining portion of the payment must then be included in gross income in the following taxable year. This creates a strict one-year deferral limit, a significant departure from the potentially longer deferral period allowed under the former Reg. §1.451-5. The definition of an advance payment was also broadened to include payments for services and other specified items, not just goods.

Required Change in Accounting Method

Transitioning from the repealed deferral method to the new one under IRC Section 451(c) is a change in accounting method. Taxpayers must obtain consent from the IRS for this change by filing Form 3115, Application for Change in Accounting Method.

Filing Form 3115 is a procedural requirement to ensure the taxpayer is properly transitioning. The form requires detailed information about the old method being changed and the new method being adopted, and it ensures that income is not omitted or duplicated during the transition year.

To facilitate this widespread change, the IRS established automatic consent procedures. This means that for this specific change, taxpayers who properly file Form 3115 by the deadline are granted automatic approval without needing to wait for a specific letter of consent from the IRS National Office. These procedures streamline the compliance process for the many businesses affected by the repeal of the old regulation.