2012 - Issue 51 — In addition to the accounting method changes that accompany the new tangible property regulations, one of the more significant developments in tax accounting this year is a quiet change in the interpretation of the recurring item exception that has for the most part flown under the radar. In Revenue Ruling 2012-1, the Internal Revenue Service outlines a highly detailed interpretation of the recurring item exception that will effectively narrow the ability of many taxpayers to rely on this common timing rule for deducting many prepaid items in the year of payment.
The new revenue ruling is a more restrictive view of how the recurring item exception should be applied to determine when prepaid items can be deducted. Because many accrual-method taxpayers rely on the recurring item exception, the ruling likely will have wide-ranging impact. Taxpayers should review their tax accounting treatment of any items that rely on the recurring item exception in order to determine if any changes need to be made in light of the analysis and conclusions set out in Rev. Rul. 2012-1.
Background — Economic Performance Requirement
For accrual-basis taxpayers, under Section 461(h) of the Internal Revenue Code, an accrued expense can be deducted when all of the events that determine the fact of the liability have occurred, the amount of the liability can be determined with reasonable accuracy, and "economic performance" has occurred with respect to the liability.
Congress added the economic performance requirement to the Internal Revenue Code with the Deficit Reduction Act of 1984. This requirement was a major modification of the all-events test for tax deduction of accrued expenses. It delays the tax deduction of many accrued items until the time of economic performance. In contrast, there is no economic performance requirement in determining when an item of income accrual must be recognized for tax.
Economic performance is determined differently for different types of expenses, as outlined in Treasury Regulations Section 1.461-4:
In the case of liabilities owed for the provision of services or property to the taxpayer, economic performance generally occurs as the services or property is provided to the taxpayer. For this purpose, the regulation allows a taxpayer to treat services or property as provided to the taxpayer as of the time of payment if the taxpayer can reasonably expect the services or property to be provided within 3.5 months after the date of payment (Reg. Section 1.461-4(d)(6)(ii)).
If the liability of a taxpayer arises out of the use of property (e.g., lease of rental property), economic performance generally occurs as the taxpayer uses the property.
There are a variety of expenses where economic performance is deemed to happen as payments are made. These payment liabilities include, among other things, any liability that arises under a workers' compensation act or out of any tort, breach of contract or violation of law; liabilities that are owed to another person for the provision to the taxpayer of insurance or a warranty or services contract; liabilities for making rebates, refunds and similar payments to other persons; etc.
There are also special rules for specific types of expenses (e.g., property tax expense).
Hence, an essential first step in applying the economic performance requirement is for a taxpayer to classify the type of accrued expense or liability in question so that the right yardstick of economic performance can be applied. While this is generally not a problem, one area of uncertainty is how to distinguish between a liability for services to be provided to the taxpayer (a "service liability," where economic performance happens as the services are provided) and a liability owed under a warranty or services contract (which is treated as a "payment liability," where economic performance is determined by payment).
The IRS resolves some of this uncertainty as part of its analysis in Rev. Rul. 2012-1. In the ruling, the IRS considers a one-year maintenance service contract that a taxpayer signed in conjunction with a one-year lease agreement for property to be used in the taxpayer's trade or business. The service contract is with a maintenance company unrelated to the lessor of the property, and covers the same period as the lease (July 1, 2011 through June 30, 2012). The service contract requires the maintenance company to provide general services to the taxpayer on an ongoing and recurring basis. Specifically, under the terms of the service contract, the maintenance company is required to inspect and clean the leased property monthly and provide any necessary repair and maintenance services relating to the normal wear and tear or routine maintenance of the property.
Rev. Rul. 2012-1 concludes that for a service liability to be treated as payment liability under the rule for warranty and service contracts, the liability must be "characterized by the occurrence of unique or irregular circumstances necessitating the repair or replacement of property." Because the service contract discussed in the revenue ruling involves general services to be provided on an ongoing and recurring basis rather than services provided only in specified circumstances, the IRS concluded that any payment owed under the service contract is a form of service liability, whose economic performance happens as the service is performed.
In addition, Rev. Rul. 2012-1 also clarifies how to interpret the recurring item exception to the economic performance requirement, in a way that would generally restrict the ability of many taxpayers to rely on the recurring item exception to accelerate the tax deduction of an accrued expense.
Background — Recurring Item Exception
Although IRC Section 461(h) generally requires economic performance to occur before an accrued expense may be deducted, Section 461(h)(3) provides an exception to this general rule for certain recurring items. If the recurring item exception applies, an item may be treated as incurred and hence deducted in the taxable year before economic performance occurs.
Specifically, under Reg. Section 1.461-5(b), the recurring item exception allows a taxpayer to deduct an accrued expense at the end of a taxable year in advance of economic performance if the following four conditions are satisfied:
(i) As of the end of the taxable year, all events have occurred that establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy (i.e., the "all-events test").
(ii) Economic performance with respect to the item must occur within 8.5 months after the close of the taxable year, or the date the taxpayer files a timely return (including extensions) for that taxable year, if earlier.
(iii) The item is recurring in nature.
(iv) Either (a) the item is not a material item or (b) the accrual of the item for that taxable year results in a better matching of the item with the income to which it relates (compared with accruing the liability in the year of economic performance). For certain payment liabilities, such as liabilities under an insurance, warranty or service contract, the matching requirement is deemed satisfied automatically.
Some types of liabilities are not eligible for the recurring item exception. As specified in Reg. Section 1.461-5(c), these ineligible expenses include, among other things, liabilities for legal exposure such as tort, breach of contract and violation of law.
Hence, the recurring item exception allows an accrual-method taxpayer to deduct certain types of recurring expenses in Year 1 if (assuming a calendar-year corporate taxpayer who files a timely return on September 15 of Year 2):
(i) The fact and the amount of liability are fixed by December 31 of Year 1;
(ii) Economic performance with respect to the expense occurs by September 15 of Year 2;
(iii) The liability is recurring in nature; and
(iv) Either the amount of the liability is immaterial or accruing the full liability in Year 1 results in better matching of expenses to related income.
The recurring item exception is a very common tax accounting rule that many accrual-method taxpayers rely on to deduct prepaid expenses for rent and services in the year of payment (to the extent that the payment covers liability owed for rent or services through 8.5 months after the close of the taxable year).
In determining whether an expense is material for purposes of applying the recurring item exception, Reg. Section 1.461-5(b)(4)(ii) provides that considerations shall be given to the absolute and relative size of the amount (relative to other items of income and expense attributable to the same activity). Moreover, anything that is material for financial statement purposes under generally accepted accounting principles is also deemed material for the recurring item exception. (However, an expense that is immaterial for financial statement purposes under GAAP may still be deemed material for purposes of the recurring item exception, under Reg. Section 1.461-5(b)(4)(iii).)
Most taxpayers do not pay much attention to the materiality test, assuming that as long as the expenses in question are not substantial in absolute or relative terms and are not enough to be treated as material for audit purposes, the expenses should qualify for the recurring item exception. However, Rev. Rul. 2012-1 has changed that working assumption.
The case considered in Rev. Rul. 2012-1 involves an accrual-method taxpayer on a calendar taxable year. The taxpayer signed a one-year lease for property to be used in that taxpayer's trade or business to generate income over the period of the lease (July 1, 2011 through June 30, 2012). As required by the lease agreement, the taxpayer prepaid the entire lease payment of $50,000 at the beginning of the lease. The taxpayer's financial statements account for the lease agreement by recognizing the $50,000 expense ratably over the one-year period of the lease.
In this hypothetical fact pattern, the taxpayer reasonably expects that it will enter into similar leases on a recurring basis in the future. The IRS reviews the requirements of the recurring item exception to determine if the taxpayer could deduct the entire lease payment in 2011 (Year 1), rather than half in 2011 (Year 1) and half in 2012 (Year 2) in accordance with the economic performance requirement.
The taxpayer in this case meets the first three requirements of the recurring item exception. The only remaining question is whether it also meets the fourth and last requirement, namely that either the lease payment is not a material item, or that deducting the full lease payment in 2011 would result in better matching between related income and expense.
The revenue ruling refers back to an example in the legislative history of the recurring item exception, which indicates that if a maintenance expense is prorated between two taxable years for financial statement purposes, then the expense should also be prorated for tax purposes. In contrast, if the expense is deducted in the first year for financial statement purposes because it is immaterial under GAAP, then it may (or may not) be immaterial for purposes of applying the recurring item exception.
- Relying on the example in the legislative history, the ruling concludes that the lease payment in this case is a material item because the lease liability accrues ratably over more than one taxable year for financial statement purposes under generally accepted accounting principles.
- Moreover, because (i) the lease liability accrues over more than one taxable year for financial accounting purposes, (ii) the income from the leased property is generated over the term of the lease and (iii) there are no other overriding facts or circumstances, the ruling also concludes that accruing the lease liability in this case over two years results in better matching than accrual in the first year alone.
Because the ruling concludes that the lease payment does not meet either the "not material" or the "better matching" requirement, it holds that the recurring item exception does not apply and, therefore, the taxpayer cannot deduct the full amount of the prepaid lease expense in the year of payment.
In conjunction with the lease agreement, the taxpayer also signed a concurrent one-year service agreement with a maintenance company. As noted above in the discussion of the economic performance requirement, the IRS classifies such an arrangement as a service liability rather than payment liability applicable to warranty or service contract. For such a service liability, the taxpayer must meet the "not material" or "better matching" requirement in order to apply the recurring item exception. Applying the same analysis, the ruling concludes that the recurring item exception is inapplicable in this case for similar reasons:
- Because the taxpayer's service contract liability accrues over more than one tax year for financial statement purposes under generally accepted accounting principles, Rev. Rul. 2012-1 concludes that the service contract liability is material for purposes of applying the recurring item exception.
- In addition, because (i) the service contract liability accrues over two years on the taxpayer's financial statements, (ii) the services provided to the taxpayer are used in the ongoing operation of its trade or business to generate income over the period of the contract and (iii) there are no other overriding facts or circumstances, the revenue ruling also concludes that the accrual of the service liability in the year of payment does not result in a better matching of the liability with the related income.
Therefore, the revenue ruling concludes that the recurring item exception also does not apply to the prepayment for services in this case, and the taxpayer cannot deduct the full amount of the prepayment in 2011.
Implications for Taxpayers
The revenue ruling highlights the difference between service liabilities for regular ongoing services and payment liabilities for specified services in irregular circumstances. For service contracts that focus primarily on replacement and repair in unique or irregular circumstances, the revenue ruling should provide more comfort in treating such service contracts as payment liabilities for which the "better matching" test is deemed automatically satisfied. Accordingly, for these service contracts and for other payment liability items that automatically meet the "better matching" test (such as rebates and refunds), Rev. Rul. 2012-1 should not present any hurdle in applying the recurring item exception.
Relying on legislative history of the recurring item exception, Rev. Rul. 2012-1 concludes that if a taxpayer accrues a prepaid expense over more than one taxable year for financial accounting purposes, that expense is also considered material and hence cannot be deducted in full in the year of payment under the recurring item exception. The ruling also relies on such an accrual for financial accounting purposes as evidence that accruing the expense in the taxable year of payment does not result in better matching between the expense and related income. Accordingly, taxpayers can no longer assume that a material item under the recurring item exception is something similar to a material item for audit purposes. In effect, taxpayers must now assume that if any prepaid expense is accrued ratably over different reporting periods on the financial statement, the expense is considered material and hence cannot be deducted in full in the year of payment under the recurring item exception.
In the case of prepaid expenses for services or property, if the recurring item exception does not apply, taxpayers may consider the possibility of relying in part on the 3.5-month grace period, which allows the taxpayer to treat services or property as already provided at the time of payment for purposes of the economic performance requirement, to the extent that the taxpayer can reasonably expect the services or property to be provided within 3.5 months after the date of payment. While such a grace period is not as long as the one under the recurring item exception, it may still help accelerate the timing of some deduction for prepaid year-end expenses.
Many taxpayers may need to implement accounting method changes in their application of the recurring item exception to conform to the revenue ruling. Anticipating that the analysis and conclusions in Rev. Rul. 2012-1 will require many taxpayers to change their tax accounting methods under the recurring item exception, the IRS also provided that a taxpayer who wants to change its tax accounting method to conform to the revenue ruling must follow the automatic change process as provided in Rev. Proc. 2011-14, which outlines the procedures that taxpayers must follow to obtain automatic consent for a change in accounting method.
An automatic accounting method change generally does not require advance consent from the IRS, and hence should not be a costly or burdensome process. Calendar-year taxpayers who implement such a change for the 2012 taxable year should be able to rely on the automatic change procedures outlined in Rev. Proc. 2011-14, subject to normal scope limitations. Rev. Rul. 2012-1 also provides that for taxpayers who want to make such a change for its first taxable year ending on or after December 13, 2011, the normal scope limitations applicable to an automatic method change do not apply as long as the all-events test for the expense in question is not an issue under consideration (under examination, pending review before the IRS appeals division or pending resolution before a federal court).
Alvarez & Marsal Taxand Says:
Rev. Rul. 2012-1 can have a significant impact on the way many accrual-method taxpayers apply the recurring item exception to accelerate deduction for prepaid expenses incurred with respect to services and lease or use or property (rent, royalty payments, etc.) Taxpayers should review their tax accounting methods for recurring items to determine if any change or adjustment is required.
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Nicholas Nguyen, Director, contributed to this article.
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