Tax Court Clarifies the All-Events Test for Prepaid and Accrued Liabilities

By Kathleen Meade, CPA, Woodbridge, N.J.

Editor: Kevin D. Anderson, CPA, J.D.

Tax Accounting

The Tax Court recently held in VECO Corp. , 141 T.C. No. 14 (2013), that an accrual-method corporation was not permitted to change its method of accounting to accelerate the timing of various deductions because the items failed to satisfy all the requirements of the all-events test in Sec. 461.


VECO Corp. was an accrual-method taxpayer engaged in various business activities, including oil and gas field services, manufacturing, construction, and equipment leasing. For the fiscal year ended March 31, 2005, VECO attached a Form 3115, Application for Change in Accounting Method , to its federal income tax return proposing to change its accounting method to accelerate deductions for prepaid and accrued expense liabilities attributable to periods after the close of its fiscal year that were incurred in connection with service contracts, insurance premiums, and real property and equipment leases. The IRS rejected the taxpayer's proposed accounting method change and denied the majority of the accelerated deductions, contending that the amounts did not meet the requirements of the all-events test outlined in Sec. 461. The taxpayer challenged the IRS's determination in Tax Court.

All-Events Test and Recurring-Item Exception

Under the three-part all-events test, a liability is generally taken into account by an accrual-basis taxpayer in the tax year in which (1) all the events have occurred that establish the fact of the liability; (2) the amount of the liability can be determined with reasonable accuracy; and (3) economic performance has occurred with respect to the liability.

Sec. 461(h)(3) allows an exception, called the recurring-item exception, to the economic performance requirement of the all-events test where (1) the item meets the all-events test during the tax year without regard to economic performance; (2) economic performance occurs within the shorter of a reasonable period after the close of the tax year or 8½ months after the close of the tax year; (3) the item is recurring in nature, and the taxpayer consistently treats such items as incurred in the tax year in which the all-events test is met without regard to economic performance; and (4) either the item is not material or the item's accrual in the tax year results in a more proper match against income than in the year in which economic performance occurs.

The IRS agreed that VECO met the second part of the all-events test with regard to the accelerated deductions at issue but argued that it failed to meet the first part for any of them and did not meet the third part for the majority of them. VECO claimed that the first requirement was satisfied upon execution of the relevant agreements and associated assumption of binding legal obligations, and that the recurring-item exception applied to satisfy the third requirement (economic performance).

Fact of the Liability

The Tax Court first examined VECO's argument that the first requirement of the all-events test, that the fact of the liability was established, was satisfied upon execution of the relevant agreements and associated assumption of binding legal obligations. Based on numerous Tax Court and appellate opinions, the Tax Court found that the execution of a contract was not sufficient to fix a liability. The court also noted that none of the cases VECO cited as authority for its claim actually supported the proposition that execution of a contract, without more, establishes the fact of the taxpayer's liability for the entire amount due under the contract.

Instead, citing Rev. Rul. 2007-3 and two earlier revenue rulings, the Tax Court found that the first requirement of the all-events test is generally satisfied upon the earlier of (1) the event fixing the liability, such as the required performance, or (2) the date the payment is unconditionally due. To evaluate whether the liabilities were established during the tax year, the court examined the terms of the taxpayer's service agreements, insurance contracts, and real property and equipment leases that gave rise to the liabilities for which VECO had claimed accelerated deductions.

Based on case law, the court determined that the fact of a liability attributable to a bilateral service contract or an insurance contract is established when performance occurs and that the fact of a liability for a rental expense is established as each rent payment becomes due under the contract. After reviewing the evidence that had been presented, the court found that neither the required performance nor the payment due dates had occurred as of the end of the tax year for most of the liabilities for which the taxpayer sought to take accelerated deductions. The court therefore held that these liabilities were not fixed (and were not deductible) for that year.

Third Prong of All-Events Test Not Met

For the accelerated deductions that met the first requirement of the all-events test, the Tax Court then considered whether, as VECO claimed, they met the third requirement of the test, economic performance, through the recurring-item exception. The court determined that they did not meet all the requirements for the recurring-item exception, so the all-events test was not met and the expenses could not be deducted.

The court focused on the fourth requirement of the recurring-item exception—"immateriality or better matching"—and concluded that the items could not satisfy the requirement as of year end because the taxpayer conceded that the proposed treatment did not result in better matching and that it failed to prove that the amounts were immaterial within the meaning of Regs. Sec. 1.461-5(b)(4).

Regs. Sec. 1.461-5(b)(4) provides the following general principles:

(i) In determining whether a liability is material, consideration shall be given to the amount of the liability in absolute terms and in relation to the amount of other items of income and expense attributable to the same activity.

(ii) A liability is material if it is material for financial statement purposes under generally accepted accounting principles.

(iii) A liability that is immaterial for financial statement purposes under generally accepted accounting principles may be material for purposes of this paragraph (b).

From these principles, the court found that although a liability is material for purposes of the recurring-item exception if it is material for financial statement purposes, a liability that is not material for financial statement purposes may still be material for purposes of the recurring-item exception.

The court noted that Sec. 461 does not define when an item is material under the recurring-item exception and that the general principles outlined in Sec. 461(h)(3)(B) and Regs. Sec. 1.461-5(b)(4) simply provide that the taxpayer's financial statement treatment is taken into account in determining the materiality of an item for purposes of the recurring-item exception. The court found that these general principles, in conjunction with an example in the legislative history of the recurring-item exception, led to the conclusion that a liability is material if a taxpayer prorates the liability over two or more tax years for financial statement purposes but takes an inconsistent position on its tax returns. With respect to the remaining liabilities at issue, the court found that the liabilities were material because the liabilities were prorated over two years for financial reporting purposes but deducted in a single year for tax purposes.

The court further stated that, even if the liabilities were immaterial for financial statement purposes, they would have been material for purposes of the recurring-item exception. The liabilities would have been material because:

  • They arose from a change in accounting method that was disclosed on VECO's financial statement;
  • They were treated inconsistently for financial accounting and tax purposes; and
  • They were accrued over more than one tax year.

Given the prevalence of executory contract liabilities and materiality of their amounts for many accrual-method businesses, as well as the widespread use of the recurring-item exception to accelerate deductions, taxpayers would be wise to review their current treatment of prepaid and accrued expenses that are subject to the all-events test, for consistency with the Tax Court's decision. The court's holding essentially follows IRS guidance on determining when executory contract liabilities become fixed under the all-events test (see Rev. Rul. 2007-3) and interprets the immaterial-or-better-matching requirement under the recurring-item exception (see Rev. Rul. 2012-1). Based on these holdings, as well as the complexity surrounding the timing of deductions and the history of controversy in this area, it appears likely that the IRS will closely scrutinize a taxpayer's eligibility for the recurring-item exception for accrued liabilities that are prorated over more than one tax year for financial reporting purposes, regardless of whether the amounts are deemed immaterial for financial reporting purposes.

If the IRS chooses that approach and prevails, the opportunity to accelerate deductions under the recurring-item exception may largely be restricted to liabilities eligible under the limited better-matching safe harbor in Regs. Sec. 1.461-5(b)(5)(ii), such as rebates, refunds, insurance, warranties, and taxes. Similarly, prepaid liabilities for goods or services reasonably expected to be provided within 3½ months of the prepayment may continue to qualify for accelerated deduction under the 3½-month rule in Regs. Sec. 1.461-4(d)(6), which is not subject to the immaterial-or-better-matching requirement.

Taxpayers affected by the Tax Court decision may want to consider filing a Form 3115 to comply with the case holdings. Changes described in Rev. Ruls. 2007-3 and 2012-1 may generally be filed using the automatic consent procedures under Rev. Proc. 2011-14, provided the scope limitations outlined in Section 4.02 of that revenue procedure are met. Nonautomatic change applications may generally be filed under the advance consent procedures outlined in Rev. Proc. 97-27.


Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Bethesda, Md.

For additional information about these items, contact Mr. Anderson at 301-634-0222 or

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.

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