Editor: Mary Van Leuven, J.D., LL.M.
In Technical Advice Memorandum (TAM) 200903079, the IRS applied the all-events test for income recognition to service contacts that were subject to the Federal Acquisition Regulations (FAR), 48 CFR Chapter 1. This article discusses the IRS’s interpretation and application of the Sec. 451 rules for determining the event establishing the taxpayer’s right to income. Although the TAM does not seem to reflect any new IRS positions, it does apply the income recognition rules to a wide variety of FAR contractual arrangements.
Contract Types and Terms
In the TAM, the taxpayer’s contracts with the U.S. government were fixed price, cost plus, and time and materials. Those contracts were subject to the FAR, under which different types of contracts have different rights to bill.
- Fixed-price contracts with milestones (specific tasks the taxpayer must per form): Right to bill conditioned on completion of the milestone and acceptance by the customer.
Nonmilestone fixed-price contracts:
Right to bill monthly, regardless of completion of performance.
- Cost-plus contracts (both fixed and variable fee terms): Right to bill allowable costs every two weeks as work progresses.
- Time-and-materials contracts: Time portion of contract payable at least monthly on submission of a voucher, and materials portion of contract billable every two weeks as work progresses.
Fixed Right to Income
Regs. Sec. 1.451-1(a) includes income in gross income under an accrual method of accounting when (1) all the events have occurred that fix the right to receive the income and (2) the amount can be determined with reasonable accuracy.
Satisfaction of the test for determining when the right to income is fixed occurs upon the earliest of: UÊ The date payment is made to the taxpayer;
- The date the taxpayer’s required performance occurs (i.e., the amount is earned); or
- The date the payment to the taxpayer is due (Schlude, 372 U.S. 128 (1963); Rev. Rul. 2004-52; Rev. Rul. 2003-10; and Rev. Rul. 84-31).
The terms of a contract are relevant in determining when the all-events test is satisfied (Decision, Inc., 47 T.C. 58 (1966), acq. 1967-2 C.B. 2).
The main issue in the TAM was whether the taxpayer’s method of accounting for unbilled receivables complied with Sec. 451. The taxpayer asserted that its right to income for the unbilled receivables was not fixed until the government paid those amounts. The IRS pointed out that although acceptance of the invoice is a prerequisite to payment, “[i]f income for the unbilled receivables is ‘earned’ or ‘due’ prior to being ‘paid,’ then the event that first occurs [either performance or payment due] fixes the taxpayer’s right to receive income.” The IRS considered whether the taxpayer should have recognized its unbilled receivables before receiving payment either because of the taxpayer’s performance or because the taxpayer was due payment.
With respect to performance as the event that establishes the taxpayer’s right to income under Sec. 451, the IRS differentiates contracts that require performance of severable services from contracts that do not have severable services. For nonseverable-services contracts, income “generally accrues when performance is complete, not as the taxpayer engages in the activity.” For severable-services contracts, performance occurs “as each severable portion of the contracts is performed . . . and Taxpayer’s right to receive income from those services is fixed under §451 no later than such performance.” The right to income is not deferred until the government accepts each milestone, as the taxpayer argued; instead the taxpayer earns the right to income through performance of the severable service.
With respect to payment due as the event that establishes the taxpayer’s right to income under Sec. 451, the IRS notes that the FAR rules allow the taxpayer to submit invoices at specified intervals—e.g., every two weeks or once a month. The taxpayer’s failure to bill as frequently as allowed does not delay the right to the income. In this instance, the IRS appears to equate the submission of an invoice with a minor or ministerial act that does not delay accrual. However, when the government’s acceptance of a milestone is a condition precedent to the right to bill (as in the case of nonseverable, milestone contracts), the right to the income is fixed when the condition precedent is satisfied and the right to bill arises. With contracts that are nonseverable, and severable contracts when amounts are due before the performance is complete, the right to income is fixed no later than when payment is due, the IRS asserts.
TAM Conclusions and Application to Contract Terms
The IRS concluded that:
- “[F]or Taxpayer’s severable contracts, the amounts allocable to each severable portion of a contract are fixed no later than when performance of the severable portion is complete”;
- “[F]or Taxpayer’s contracts that are not severable, amounts under the contracts are fixed no later than when due”; and
- “[I]n the case of fixed-price contracts with milestones that must be accepted by the Government prior to billing, the amounts with respect to those milestones are not fixed until acceptance by the Government (i.e., when Taxpayer’s right to bill occurs).”
general provisions relating to all the taxpayer’s FAR contracts at issue—such as the government’s acceptance of the billed amounts before payment is made, invoice audits that may change the amounts due, or other subsequent modifications of the contract—are not conditions precedent or substantial contingencies to the establishment of the taxpayer’s right to income under such contracts.
The interpretation and application of the Sec. 451 rules for determining the event that establishes the taxpayer’s right to income in the TAM do not seem to reflect any new IRS positions. The TAM is instructive because it provides a very detailed application of the income recognition rules to a wide variety of FAR contractual arrangements and makes explicit the IRS’s views on several issues.
For nonseverable-service contracts the completed performance likely occurs later than the taxpayer’s right to bill arises (no less than once a month as work progresses on the contracts), and the right to the invoice amount due for such billing period (whether or not the invoice was actually submitted) is fixed when payment for that billing period is due. For severable contracts, if performance of the severable portion is complete before the right to bill arises, then the taxpayer’s right to income for such service is fixed upon completion of performance of the severable portion.
If the right to bill arises before the performance of the severable portion is complete, the right to the invoice amount due for such billing period (whether or not the invoice was actually submitted) is fixed when payment for that billing period is due. If a contract contains milestones that the taxpayer must achieve and the government must approve before the taxpayer can bill, its right to income related to the achievement of the milestone is fixed upon the approval of the milestone.
The TAM does not consider whether any particular contract addressed in the TAM was for severable services, which was an area of disagreement between the IRS and the taxpayer. The identification of contracts as containing severable services, milestones, or other intervening events, and the contingencies that attach to such provisions, will likely be an area of ongoing debate between taxpayers and the IRS. As such, a practical operational implication of the TAM for taxpayers providing services to the government subject to the FAR is to have in place processes and controls to identify contracts (and their payment terms and other relevant conditions) as service contracts or nonservice contracts. Service contracts should further be classified as severable or nonseverable and then as fixed-price, cost-plus, and time and materials contracts. Having a well-thought-out framework in place should provide a good starting point to begin analyzing service contracts for the earliest occurrence of events that fix a taxpayer’s right to income for tax purposes.
Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.
This article represents the views of the author or authors only, and does not necessarily rep-resent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
© 2009 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved.
For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or email@example.com.