AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Comments on Proposed Regulations under Section 6655
Relating to Corporate Estimated Tax [REG-107722-00]
Developed by the
Estimated Tax Task Force
Jennifer D. Kennedy, Task Force Chair
Robert Baird
William B. Creps
David P. Culp
J. Knox Teague
Christine Turgeon
George White, AICPA Technical Manager
April 11, 2006
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Comments on
Proposed Regulations on Corporate Estimated Tax
under Section 6655 (REG-107722-00)
I. General Comments
On December 7, 2005, the Internal Revenue Service and Treasury Department released proposed regulations under Section 6655 of the Internal Revenue Code relating to corporate estimated tax. In releasing these regulations, the IRS and Treasury have outlined two primary purposes for updating the existing regulations under section 6655. First, the IRS and Treasury wanted to update the current regulations to reflect significant changes to the tax law since 1984, most notably the economic performance rules under section 461(h). Secondly, the IRS and Treasury desire to provide rules that will prevent taxpayers from using certain "techniques" to compute their estimated tax liability, thereby resulting in a more accurate computation of annualized income.
The AICPA applauds the IRS and Treasury for providing comprehensive rules that will assist taxpayers in calculating their estimated tax payments and agrees with the stated purposes for updating the existing proposed regulations. The AICPA also believes that the IRS and Treasury should strive to provide rules that generally allow for a more accurate computation of annualized taxable income. However, as explained in our comments below, we are concerned that the rules are too mechanical, and as a result, distort annualized taxable income and create traps for the unwary. Taxpayers who are not well-versed in these rules could easily run afoul of the regulations and miscalculate taxable income for the annualization period, which could result in unwarranted penalties. Finally, as illustrated in greater detail below, similarly situated taxpayers will be treated differently under these proposed regulations. Accordingly, the AICPA recommends that the IRS and Treasury modify the regulations to eliminate potential pitfalls, provide equitable results for similarly situated taxpayers, and relieve administrative burden.
Our comments below, primarily related to the determination of annualized taxable income, appear in the same general order as the related provisions in the proposed regulations.
II. Background
A. General Overview
Section 6655 of the Code imposes an addition to tax (i.e., a penalty) in the event of an underpayment of estimated tax by a corporation if the corporation’s income tax liability for the year exceeds $500. See sections 6655(a) and (d). The amount of the underpayment is the excess of the required installment of estimated tax over the amount (if any) of the installment paid on or before the due date for the installment. Section 6655(b)(1).
There are four required installments of estimated tax for each taxable year. In the case of a calendar year corporation, the required installments are due on or before April 15th, June 15th, September 15th and December 15th of the taxable year. Section 6655(c). In the case of a fiscal year corporation, the required installments are due on or before the 15th day of the fourth, sixth, ninth and twelfth months of the taxable year. Section 6655(i)(1).
In general, the amount of the required installment of estimated tax is equal to 25 percent of the required annual payment. Section 6655(d)(1)(A). For a “large corporation,” the required annual payment is 100 percent of the tax shown on the return for the taxable year. Sections 6655(d)(1)(B) and 6655(d)(2)(A). A “large corporation” for this purpose is a corporation that had taxable income of at least $1 million for any of the three taxable years immediately preceding the taxable year at issue. Section 6655(g)(2). For a corporation other than a large corporation, the required annual payment is the lesser of (i) 100 percent of the tax shown on the return for the taxable year, or (ii) 100 percent of the tax shown on the return for the preceding taxable year provided that the return covered a period of 12 months and showed a liability for tax. Section 6655(d)(1)(B).
B. Annualized Income Installment
In the case of any required installment of estimated tax by a corporation, the amount of such installment shall be the corporation’s annualized income installment if such amount is less than the installment otherwise determined under the rules described above (i.e., 25 percent of the required annual payment). Section 6655(e)(1).
The amount of any annualized income installment is the excess, if any, of the “applicable percentage” of the tax for the taxable year based on the corporation’s annualized taxable income for the annualization period (or, if applicable, alternative minimum taxable income or modified alternative minimum taxable income), over the aggregate amount of all prior required installments for the taxable year. Section 6655(e)(2)(A). For this purpose, the “applicable percentage” is 25 percent for the first required installment, 50 percent for the second, 75 percent for the third, and 100 percent for the last required installment for the taxable year. Section 6655(e)(2)(B)(ii).
In the case of the first and second required installments, the corporation’s annualized taxable income generally is determined by annualizing the taxable income for the first three months of the taxable year. In the case of the third and fourth required installments, the corporation’s annualized taxable income generally is determined by annualizing the taxable income for the first six and nine months, respectively, of the taxable year. Section 6655(e)(1)(A).
Alternatively, a corporation can elect to use one of two other annualization period options for purposes of determining its four required installments. Section 6655(e)(1)(C).
Under the first alternative, the corporation’s annualized taxable income for the four required installments is determined by annualizing its taxable income for the first two, four, seven and ten months, respectively. Section 6655(e)(1)(C)(i).
Under the second alternative, the corporation’s annualized taxable income for the four required installments is determined by annualizing its taxable income for the first three, five, eight and eleven months, respectively. Section 6655(e)(1)(C)(ii).
III. Simplification of 52/53 week taxable year rules
The IRS and Treasury specifically requested comments on whether the 52-53 week year rules under §1.6655-2(e) should be simplified. It is the view of the AICPA that the current rules that have been restated in the proposed regulations are too complex and thus administratively burdensome. The IRS and Treasury should consider eliminating the detailed rules contained in the proposed regulations and instead rely on the general concept of annualization, which is not defined for non-52/53 week taxpayers. In our experience, 52/53 week taxpayers know how to annualize their applicable annualization period (e.g., 3, 3, 6, 9) without reference to (or knowledge of) these proposed rules.
IV. Revenue Recognition
Prop. Reg. §1.6655-2(f)(1)(i) provides that in determining the applicable gross income for an annualization period, gross income is included in accordance with section 451. However, the proposed regulations do not address how a taxpayer that defers revenue either under Rev. Proc. 2004-34 or Treas. Reg. §1.451-5(c) should account for advance payments in determining their annualized taxable income. That is, under both of these provisions, a taxpayer generally is allowed to defer the recognition of qualifying advance payments to the extent that financial statements defer recognition, but only for a limited time (i.e., one year in the case of Rev. Proc. 2004-34 and two years following the receipt of substantial advance payments under §1.451-5(c)). To the extent income is deferred for financial statement purposes beyond this limited time, it is unclear when the remaining portion of income should be taken into account in determining annualized taxable income for the year the remaining amount must be recognized (i.e., should the remaining amount be recognized in full on the first day of the inclusion year, in full at the end of the inclusion year, ratable throughout the inclusion year, etc.).
The AICPA recommends that the IRS and Treasury include a rule in the final regulations that would allow taxpayers using a deferral method either under Treas. Reg. §1.451-5(c) or Rev. Proc. 2004-34 to recognize advance payments as revenue in the annualization period to the extent the advance payment is recognized in the taxpayer's applicable financial statements in that annualization period. To the extent any portion of the advance payment has not otherwise been recognized in the taxpayer's applicable financial statements, it should be recognized at the end of the next succeeding taxable year in the case of revenue deferred under Rev. Proc. 2004-34. Similarly, substantial advance payments for inventoriable goods that are deferred under Treas. Reg. §1.451-5(c) should be recognized based on financial statement recognition during the annualization periods with any remaining amount recognized in full at the end of the second taxable year.
In the case of revenue that is deferred under Rev. Proc. 2004-34, if the taxpayer does not have an applicable financial statement, or if the taxpayer is unable to determine, as required by the revenue procedure, the extent to which advance payments are recognized in revenues in its applicable financial statements, the IRS and Treasury should consider a rule that would require a taxpayer using the Deferral Method under Rev. Proc. 2004-34 to include the advance payment in gross income to the extent earned as determined under section 5.02(3)(b) in the applicable annualization periods for the taxable year of receipt and the next succeeding taxable year. Any remaining amount should be recognized at the end of the next succeeding taxable year. Such a rule would be consistent with Section 5.02(2) of Rev. Proc. 2004-34, which provides special rules for short taxable years. The AICPA does not believe that multi-year contracts should be treated differently than contracts of one year or less. To require taxpayers to account for multi-year contracts differently than contracts for a period of one year or less would result in a distortion of annualized taxable income.
The examples below illustrate how the rules should be applied in the case of revenue that is deferred under Rev. Proc. 2004-34. The AICPA envisions that similar principles would apply to revenue that is deferred under Treas. Reg. §1.451-5(c).
A. Example 1. On November 1, 2007, A, in the business of giving dancing lessons, receives an advance payment for a 1-year contract commencing on that date and providing for up to 48 individual, 1-hour lessons. A provides eight lessons in 2007 and another 35 lessons in 2008. In its applicable financial statement, A recognizes 1/6 of the payment in revenues for 2007, and 5/6 of the payment in revenues for 2008. A uses the Deferral Method under Rev. Proc. 2004-34. For federal income tax purposes, A must include 1/6 of the payment in gross income for 2007, and the remaining 5/6 of the payment in gross income for 2008.
For estimated tax purposes, the taxpayer in Example 1 should be permitted to recognize revenue in 2007 and 2008 in the annualization period in which the advance payment is recognized in its applicable financial statements. To require the taxpayer to recognize the remaining portion of the advance payment in the first annualization period of 2008 would result in a distortion of annualized taxable income, which would be inconsistent with one of the stated purposes for updating the existing regulations.
B. Example 2. Assume the same facts as in Example 1, except that the advance payment is received for a 2-year contract under which up to 96 lessons are provided. A provides eight lessons in 2007, 48 lessons in 2008, and 40 lessons in 2009. In its applicable financial statement, A recognizes 1/12 of the payment in revenues for 2007, 6/12 of the payment in revenues for 2008, and 5/12 of the payment in gross revenues for 2009. For federal income tax purposes, A must include 1/12 of the payment in gross income for 2007, and the remaining 11/12 of the payment in gross income for 2008.
For estimated tax purposes, the taxpayer in Example 2 should be permitted to recognize revenue for 2007 in an annualization period to the extent the advance payment is recognized in its applicable financial statements (i.e., 1/12 will follow the financial statements). In 2008, the taxpayer should recognize revenue in the annualization period to the extent the advance payment is recognized in its applicable financial statements (i.e., 6/12 of the revenues will be recognized in 2008 when the applicable financial statements recognize the revenue). The remaining portion of the advance payment should be recognized on the last day of the taxable year (i.e., 5/12 of the payment will be recognized on the last day of the taxable year).
V. Timing of Expenses
A. Definition of Incurred
The proposed regulations provide rules for determining when an expense is considered incurred in an annualization period for purposes of section 461 and thus may be taken into account in that period. Specifically, Prop. Reg. §1.6665-2(f)(1)(iii) provides that, in the case of an accrual method taxpayer, only items of deduction which have been incurred under Reg. §1.461-1(a)(2) may be taken into account in computing taxable income in the annualization period. Prop. Reg. §1.6655-2(f)(1)(iii) further provides that the provisions of section 170(a)(2) and Reg. §1.170A-11(b), Reg. §1.461-4(d)(6)(ii), Reg. §1.461-5, and any other provision that has a similar effect cannot be used in determining whether the item has been incurred. To avoid uncertainty and controversy as to what other provisions could be interpreted as having a "similar effect," the AICPA recommends that the IRS and Treasury provide an exhaustive list of rules that taxpayers may not take into account when determining whether an expense is incurred in an annualization period.
B. Expenses Incurred at the End of the Year or After Year-end
Prop. Reg. §1.6655-2(f)(2)(i) allows taxpayers to consider certain expenses incurred at the end of a tax year or after year-end as incurred ratably throughout the year. The objective of this rule appears consistent with the principle of matching revenue with related expenses and providing for a more accurate computation of annualized taxable income. However, the expenses qualifying for this exception are restricted to only those expenses incurred between the 15th day of the last month of the taxable year and the last day of the taxable year, or for expenses incurred after year-end. This arbitrary period creates significant administrative burdens, as well as a trap for unwary taxpayers who may incur the expense before this period. Moreover, this mechanical rule will treat similarly situated taxpayers differently depending upon when they incur a recurring expense, even if such expense is incurred only one day later. Accordingly, the AICPA recommends that the IRS and Treasury allow a pro rata portion of a taxpayer's recurring expenses to be taken into account during the annualization period so long as the expense will be incurred during the taxable year (or within 8 1/2 months of year-end). As explained below, such a rule would be more consistent with financial accounting principles, avoid traps for the unwary, and allow similar treatment for similarly situated taxpayers.