On Dec. 21, 2006, the IRS released Rev. Rul. 2007-3, which provides guidance on whether the execution of a contract for services or insurance (an executory contract liability) establishes the “fact of the liability” under Sec. 461. The determination of whether a contract for services or insurance establishes the fact of the liability is key in determining the timing for deducting such expenditures for an accrual-basis taxpayer under Regs. Sec. 1.461-1(a)(2)(i).
In general, an accrual-basis taxpayer is allowed a deduction for an otherwise deductible expense in the period in which the following three-pronged test is met (the first two prongs are referred to collectively as the “all-events test”; see Sec. 461(h)(4)):
All events have occurred that deter-mine the fact of the liability.
The amount of the liability can be determined with reasonable accuracy.
Economic performance has occurred with respect to the liability.
Because the all-events test is based on the facts and circumstances as to the nature and extent of the taxpayer’s liability, the terms of a contract that may give rise to a liability generally will determine the events that establish the fact of the liability; see, e.g., Decision, Inc., 47 TC 58 (1966), acq., 1967-2 CB 2.
The general rule under Regs. Sec. 1.461-4(d)(2) provides that economic performance occurs for a liability arising out of the provision of property or services to the taxpayer by another person as the property or services are provided. Regs. Sec. 1.461-4(g) generally provides that for certain types of liabilities, including those arising out of the provision of insurance to the taxpayer, economic performance occurs as payment is made to the person to whom the liability is owed.
The recurring-item exception of Sec. 461(h) and Regs. Sec. 1.461-5 provides an exception to the general rules of economic performance. If a taxpayer is eligible to use the recurring-item exception for a particular liability and meets all of the requirements, economic performance will be deemed to occur at year-end, to the extent that it actually occurs within 8½ months of year-end.
Thus, if a liability for services or insurance is considered fixed and determinable at year-end, a taxpayer may be able to accelerate economic performance through use of the recurring-item exception, to the extent that economic performance (i.e., payment of the insurance premium or provision of the services) occurs within 8½ months of year-end. The main purpose of Rev. Rul. 2007-3 was to set forth the IRS’s position as to when the first prong of the all-events test is met with respect to executory contract liabilities, specifically when these types of liabilities are considered fixed, including whether the execution of a binding contract is sufficient to fix the liability. For this purpose, an executory contract liability is one for which there are unperformed obligations, by either or both parties.
Rev. Rul. 2007-3
In the ruling, the Service considers two situations. Situation 1 involves a calendar-year-end, accrual-method taxpayer who enters into a contract for the provision of services on Dec. 15, 2006. The contract provides for services to begin on Jan. 15, 2007 and end on Jan. 31, 2007. Payment is due and paid on January 15, and the taxpayer uses the recurring-item exception.
Situation 2 involves a calendar-year-end, accrual-method taxpayer who enters into a contract for the provision of insurance on Dec. 15, 2006. The contract provides for an insurance coverage period of Jan. 15, 2007–Dec. 31, 2007. Payment is due and paid on January 15; the taxpayer uses the recurring-item exception.
Citing Rev. Ruls. 80-230 and 79-410, the IRS first sets forth the basic premise that the fact of a liability is established (i.e., the liability is considered fixed) when (1) the event fixing the liability (whether that be the required performance or other event) occurs or (2) payment therefore is due, whichever happens earliest. Based on this premise, the Service concludes that the first event that occurs to establish the fact of the taxpayer’s liability for services in Situation 1 is the date that payment is due under the contract (Jan. 15, 2007). Further, the fact of the liability is not established in 2006 on the date the contract is executed, because
[i]t is well established that an accrual basis obligor is not permitted to deduct an expense stemming from a bilateral contractual arrangement, that is, mutual promises, prior to the performance of the contract for services by the obligee.
In other words, a promise by the taxpayer to pay for services rendered under the terms of a contract in exchange for the service provider’s promise to perform the services stipulated in the contract is not sufficient, by itself, for the taxpayer in Situation 1 to establish the fact of the liability for purposes of the all-events test.
Similarly, the IRS concludes that the first event that occurs to establish the fact of the taxpayer’s liability for insurance in Situation 2 is the date the premium is due under the contract (Jan. 15, 2007). Thus, it concludes in Situation 2 that the taxpayer has not incurred a liability for insurance until 2007. In reaching this conclusion, it explains that although Federal and state regulations may impose certain legal obligations (i.e., the insurance company must provide coverage), such obligation, by itself, does not establish the fact of the liability for purposes of the all-events test. In both situations, the Service notes that the recurring-item exception does not apply, as the fact of the liability is not established in 2006.
In summary, in both Situations 1 and 2, the Service concludes that the mere execution of a contract does not establish the fact of the taxpayer’s liability. Thus, in applying the general principle that the fact of a liability is established on the earlier of the event fixing the liability occurring or payment being due, the IRS, in both situations, concludes that the “event fixing the liability, whether that be the required performance or other event,” is the required performance, i.e., the provision of services or insurance coverage. There is no discussion, and it is not clear from the ruling, as to what “other event” could occur that would fix the liability. In addition, because the ruling addresses only two fact patterns (both of which involve the execution of a contract in year 1 under which payment is not due until year 2, and the related services or insurance coverage is not provided until year 2), it is uncertain whether a liability for services or insurance would be considered fixed in year 1 if the contract begins, and partial performance occurs, in year 1.
Finally, because the ruling specifies that a liability is fixed when “payment therefore is due,” if earlier than the required performance, it appears that the IRS’s position is that payment must be due and required under the contract; in other words, a voluntary prepayment is not sufficient to fix a liability.
A taxpayer’s treatment of liabilities for services and insurance is an ac-counting method within the meaning of Sec. 446. Thus, any change in the treatment of such liabilities by a taxpayer is an accounting-method change within the meaning of Sec. 446(e), requiring the Service’s consent before implementation. Rev. Proc. 2007-14 was issued simultaneously with Rev. Rul. 2007-3 to provide automatic-consent procedures for a taxpayer that is currently treating the mere execution of a contract for services or insurance as establishing the fact of the liability under Sec. 461, and wants to change its accounting method to comply with Rev. Rul. 2007-3. The method change is subject to the automatic-change provisions, including the scope limits, of Rev. Proc. 2002-9 (as modified by Rev. Proc. 2002-19). Thus, a taxpayer who has requested a method change as to the same item within the past five years (including the year of change) will not be eligible to use the automatic provisions.
From Nathan K. Smith, CPA, MBA, and Cathy Fitzpatrick, CPA, MST, Washington, DC
Mary Van Leuven, J.D., LL.M. is a Senior Manager at Washington National Tax KPMG LLP in Washington, DC.
Unless otherwise indicated, contributors are members of or associated with KPMG LLP. The views and opinions are those of the authors and do not necessarily represent the views and opinions of KPMG LLP. The information contained herein is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser.
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