At the end of year 1, T enters into a 12-month service contract with X. Under the contract, X will provide services to T until the end of year 2. At the end of year 1, when the contract is executed, T makes a prepayment to X for a portion of the services to be provided in year 2. On its Federal income tax return for year 1, T deducted the prepayment as an expense, citing either the 3½-month rule or the recurring-item exception as authority.
Sec. 461 provides general rules that govern the year of deduction. Regs. Sec. 1.461-1(a)(2) states that, under an accrual method, a liability is incurred, and generally is taken into account for Federal income tax purposes, 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 (the all-events test). Sec. 461(h)(1) provides that, in determining whether an amount has been incurred with respect to any item during any tax year, the all-events test shall not be treated as met any earlier than when economic performance with respect to such item occurs. (This request for advice relates to the economic performance requirement of the all-events test only. It does not address whether the liability for services would be fixed or determinable with reasonable accuracy.)
Sec. 461(h)(2)(A) provides that if a taxpayer’s liability arises out of the provision of services to the taxpayer by another person, economic performance occurs as such person provides such services. Under this general rule, economic performance would occur for the prepaid services as the services are provided to T. Although payment was made in year 1, economic performance generally would not occur until year 2, when the services were provided. However, there are two exceptions to the general economic-performance rule applicable to service liabilities.
One exception is the so-called 3½-month rule in Regs. Sec. 1.461-4(d) (6)(ii), which allows a taxpayer to treat services or property as being provided (i.e., as economic performance) as the taxpayer makes payment to the person providing the services or property, if the taxpayer can reasonably expect the person to provide the services or property within 3½ months after the date of payment.
Thus, T could treat the year 1 prepayment for services as economic performance as long as it can reasonably expect the services to be provided within 3½ months after the payment. The question is whether all of the services must be provided within 3½ months, or whether a taxpayer may accelerate into year 1 a deduction for 3½-months’ worth of services to be provided in year 2.
The liability in the facts set forth relates to services to be provided both before and after the 3½-month period following payment. That liability is not divisible unless different services are required to be provided to T under a single contract, in which case economic performance occurs (and any applicable economic performance exception will apply) separately with regard to each service provided (Regs. Sec. 1.461-4(d)(6)(iv)). If a single contract does not provide for different services, there is no authority in the Sec. 461 regulations allowing taxpayers to use the 3½-month rule for a portion of a liability, even if T can reasonably estimate the amount of services that will be provided to it within 3½ months.
Although Regs. Sec. 1.461-4(d)(6) does not specifically state that all the services must be provided within 3½ months, that conclusion is implicit in the language that requires the services (not a pro-rata amount, or portion of, services) to be provided within 3½ months. The regulation does not provide that taxpayers may use the rule to meet economic performance for a service liability “to the extent of” services provided. Compare Regs. Sec. 1.461-4(d)(6) with Temp. Regs. Sec. 1.404 (b)-1T(b)(1), under which a plan, a method or an arrangement is presumed to defer the receipt of compensation for more than a brief period after the end of an employer's tax year to the extent that compensation is received after the 15th day of the third calendar month after the end of the employer’s tax year in which the related services are rendered.
Unlike the deferred-compensation rule, the 3½-month rule is an “all or nothing” rule with respect to a particular liability. Thus, it does not apply to allow a deduction in year 1 for a prepayment made at the end of year 1 for services to be performed in the first 3½ months of year 2 under a contract that extends beyond that 3½-month period.
AM 2007-009 (5/11/07)REFLECTIONS. The Sec. 461(h)(3) recurring-item exception is also an “all or nothing” rule with respect to a specific liability, and the same rationale would apply. Because all of the services must be provided within 8½ months of year end, this exception is also not available, and the costs of these contracts would not be deductible in year 1.