Recurring-Item Exception Clarified

By Alistair M. Nevius, J.D.

From the IRS

The IRS clarified the application of the all-events test’s recurring-item exception under Sec. 461(h)(3) to certain fact patterns involving liabilities that accrue over more than one year and service contracts (Rev. Rul. 2012-1). The ruling addresses four questions:

  1. Is the amount of a taxpayer’s liability material for purposes of the recurring-item exception if the liability accrues over more than one year for financial accounting purposes?
  2. Does the accrual of the taxpayer’s liability over more than one tax year result in better matching of the liability with related income if the taxpayer generates the related income in its trade or business over more than one tax year and the liability accrues over more than one tax year for financial accounting purposes?
  3. If the taxpayer’s liability arises under a service contract, is it properly characterized as a “liability arising out of the provision of services” under Regs. Sec. 1.461-4(d)(2), rather than a “liability arising out of the provision of a warranty or service contract” under Regs. Sec. 1.461-4(g)(5)?
  4. Does the recurring-item exception apply to a taxpayer’s liability to provide services under a service contract that is characterized as a “liability arising out of the provision of services” under Regs. Sec. 1.461-4(d)(2)?

The ruling discusses a fact pattern in which a corporation uses an accrual accounting method, including the recurring-item exception. The corporation enters into a lease and into a service contract to maintain the leased property. The corporation expects to enter into similar leases and service contracts on a recurring basis in the future.

The ruling says that, to apply the recurring-item exception to its lease liability, the corporation must, in part, demonstrate either that the lease liability is immaterial or that recognizing the liability in a year prior to the ratable use of the property results in a better matching of the expense to the related income. Under the facts of the ruling, the IRS says that, for purposes of the recurring-item exception, the accrual of the taxpayer’s lease liability over more than one tax year results in better matching of the liability with related income. Thus, the taxpayer cannot use the recurring-item exception for the lease.

Similarly, to apply the recurring-item exception to its service contract liability, the corporation must, in part, demonstrate either that its liability is not material or that recognizing the liability in a year prior to the performance of the services results in a better matching of the expense to the related income.

Under the facts of the ruling, the IRS says the corporation’s service contract liability is properly characterized as a liability arising out of the provision of services to the corporation rather than as a liability arising out of the provision to the taxpayer of a warranty or service contract because the services under the contract will be provided on an ongoing or recurring basis. As such, the accrual of the service contract liability in a year prior to the satisfaction of economic performance will not result in a better matching of the liability with the related income as compared to accruing the liability for the tax year in which economic performance occurs. Therefore, the recurring-item exception does not apply to the corporation’s service contract liability.

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