Many companies that offer warranties for their products or services are required to accrue a warranty liability at the end of the year when preparing the companies' financial statements. Practitioners must carefully consider several tests under Sec. 461 to determine the deductibility of accrued warranty expense for tax purposes, paying particular attention to whether a fixed liability actually exists at the end of the year. The practitioner must analyze and document whether the all-events test has been met and economic performance has occurred before considering whether the recurring item exception applies to the accrued warranty liability.
Sec. 461(h): The All-Events Test and Economic Performance
Taxpayers can deduct an accrued expense for tax purposes only after the all-events test has been met and economic performance has occurred.
Under Sec. 461(h), a three-prongall-events test is met when (1) all 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.
Sec. 461(h)(2)(A) and Regs. Sec. 1.461-4(d)(3) state that economic performance occurs when the taxpayer receives services or property or uses property another party provided. Sec. 461(h)(2)(B) states that economic performance also occurs when the taxpayer provides property or services to another party.
A company's liability for warranties provided to its customers is deductible for tax purposes when the all-events test has been met and economic performance has occurred. The expense must fulfill the first prong of the all-events test, and it is essential that all facts have occurred that establish the liability. It must be clear that the taxpayer has incurred an obligation to render the warranty service. The expense is not currently deductible if it is subject to contingencies. The obligation to provide warranty service must be fixed and determinable, but the service does not need to be performed by the end of the year to be deductible.
Sec. 461(h)(3): Recurring Item Exception
Sec. 461(h)(3) provides for an exception as to when economic performance occurs. Sec. 461(h)(3) states that an expense is incurred and deductible in the tax year if the all-events test is met during the year, and 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. Additionally, the item must be recurring, and the taxpayer must consistently treat similar items as incurred in the tax year. The expense must also not be material, or the accrual of the expense in the tax year must result in a better match against income than accruing the item in the tax year when economic performance occurs.
Taxpayers may think that the recurring item exception alone will secure a current deduction for warranty work. However, the courts make it clear that the recurring item exception in Sec. 461(h)(3) requires taxpayers to prove that they have satisfied the all-events test and have a deductible expense that is fixed in amount and can be determined with reasonable accuracy. Sec. 461(h)(3) is an exception to the timing of economic performance and does not excuse taxpayers from satisfying the test's other two prongs.
IRS and Courts' Interpretation of Sec. 461(h)
The question of when a taxpayer can deduct an accrual for warranty work can affect taxpayers of all sizes. In Chrysler Corp., 436 F.3d 644 (6th Cir. 2006), the taxpayer accrued the entire amount of warranty claims for vehicles sold to dealers during the year. Chrysler included the warranty liability on its balance sheet and deducted the warranty expense in arriving at both book and taxable income.
The IRS challenged the taxpayer on the deductibility of the warranty liability expense, and the court ultimately held that the auto manufacturer did not meet the first prong of the all-events test under Regs. Sec. 1.461-1(a)(2)(i), which requires a definite liability to exist by the end of the tax year. The court found that the liability was contingent at the end of the year and was not fixed in amount, and it denied the auto manufacturer a deduction for accrued warranty expense in the year the manufacturer sold the automobiles to the dealerships. Even though the taxpayer could estimate the future claims with reasonable accuracy, the claims were only anticipated in amount because the customers had not yet filed any claims. The court further emphasized that it was irrelevant whether Chrysler could determine the amount of the claim with reasonable accuracy under the second prong of the all-events test because it failed to meet the test's first prong and prove that the liability was fixed in amount.
The tax years in the Chrysler case predate the recurring item exception. However, the first prong of the all-events test, which establishes the fact of the liability, is just as relevant and important today as it was before the addition of the recurring item exception to the Code.
Chrysler's liability was contingent even though the company provided a warranty that was partially defined by statute and a contract between the parties. A statute, such as a lemon law, does not establish a fixed liability by itself. The customer still needs to submit a valid claim, which will define the true liability. The statute simply requires the manufacturer to stand behind its work and repair the faulty product, but the existence of the statute is not evidence that there is or will be a valid warranty claim.
The court focused on the last event fixing the liability, which is either the customer's filing a claim for warranty service or a dealer's request for reimbursement of a customer claim. The liability was not fixed because the taxpayer failed to identify the recipient of the economic benefit, which is the warranty service. Therefore, the court disallowed the warranty liability expense deduction on the taxpayer's current-year tax return because it was estimated and was based on contingent events that had not occurred by the close of the tax year.
The court in Massachusetts Mutual Life Ins. Co., 782 F.3d 1354 (Fed. Cir. 2015), discussed the fixation-of-liability issue under the first prong of the all-events test. The court allowed the insurance company to deduct dividends payable to policyholders before the tax year when they were paid and before the insurance company knew the exact recipient of the dividend.
The court found that the insurance company guaranteed the dividend to a class of policyholders. Even though some policyholders had the right to terminate their policy before the dividend was paid, many paid-up policies had no risk of lapse and had an absolute right to receive the dividend. Therefore, even though the insurance company did not know the exact dividend recipients and the amount they would receive by the end of the tax year, the liability was fixed because the insurance company was obligated to pay a group of policyholders the guaranteed dividend amount the following year.
The Massachusetts Mutual fact pattern is in contrast to manufacturer warranty liabilities where the warranty provider often does not have a fixed group of customers that are definitely owed service under a warranty contract at the end of the tax year. The customers usually have not submitted a valid warranty claim before the end of the tax year.
In Technical Advice Memorandum (TAM) 200037004, the IRS provided additional guidance on the first prong of the all-events test, whether a fixed liability existed for accruing and deducting repairs made under a product warranty, as well as the timing of economic performance. Under these facts, the taxpayer was a manufacturer that recorded an estimated warranty liability expense each year by including warranty payments made during the year, adding payments made during the first 8½ months of the following year under the recurring item exception of Sec. 461(h)(3)(A)(ii)(II), and subtracting payments made during the current year that were included in the prior-year warranty liability.
The taxpayer provided warranty protection to its customers and proposed that it met the first prong of the all-events test, and liability was established at the time the sale occurred because defects in workmanship covered by the warranty were present at that time. The taxpayer cited several court cases that further supported its position that the liability is fixed by its contractual obligation under the warranty.
The IRS agent examining the taxpayer disagreed, stating that the mere existence of the warranty and the defect did not fix the warranty liability. The IRS agent claimed that the liability was not fixed because other conditions had to occur to establish an actual liability. These conditions included the sale of the product, substantiation of the defect during the warranty period, the filing of a claim, and a reporting of the defect within the warranty period, along with a repair of the defective product.
In the TAM, the IRS National Office advised that filing and approval of the warranty claim was not necessary to establish a liability but rather was a ministerial act because the taxpayer had a history of servicing all customers with valid warranty claims. The National Office concluded that the manufacturer should accrue and deduct the warranty liability expense when it performed the repair service because, at that time, the amount of the liability can be calculated with reasonable accuracy and economic performance has occurred. It also noted that because the all-events test and economic performance occur at the same time, the recurring item exception did not apply. The recurring item exception simply extends the time for economic performance to occur, and the extra time was not necessary in this case.
The court in VECO Corp., 141 T.C. 440 (2013), further clarified the first prong of the all-events test. The court analyzed payments on several contracts to determine whether all events had occurred to establish the fact of the liability under Regs. Sec. 1.461-1(a)(2)(i), which provides that a liability is established on the earlier of the event fixing the liability such as the required performance or the date that payment is unconditionally due. Although VECO is not about warranty work performed by the product's seller, the concepts and analysis related to the all-events test and fixed liability are relevant and can be used to determine the deductibility of accrued warranty claims.
The taxpayer argued that the execution of contracts that established a binding legal obligation fixed the fact of the liabilities under the contracts and allowed a current deduction for the expense. The IRS contended that wile a statute or regulation may sometimes fix a taxpayer's liability, the execution of the contracts did not fix the taxpayer's liability for the entire obligation under the contract.
The court sided with the IRS and held that the execution of a contract proposing payment, without more, is not an event that fixes liability. In particular, the court stated, where a contract contains mutually dependent promises, liability is contingent until performance occurs, and thus liability is not fixed by the existence of the contract. According to the court, the fact of the liability was fixed by either the occurrence of performance under the contract or the payment due date. The terms of the contracts were, however, relevant in determining when the liabilities became fixed.
Accordingly, the court reviewed the individual contracts in question. Most of the contracts were service contracts containing mutually dependent promises for performance. Under the contracts, the taxpayer was required to make payments in exchange for goods and services that were provided over future tax years. The court held the liability was not established and fixed for the majority of the expenses under the service contracts contested by the IRS because under the contracts, the payments were not due until after the end of the tax year, and the taxpayer did not prove that the performance of the services occurred before that time. However, the court held that some of the contested expenses under the taxpayers' real estate and equipment rental contracts were deductible because the contracts provided that the taxpayer had an unconditional liability to pay a lease payment as it accrued each month, even though the payments were not made until a later date. Therefore, the payments that were due before the end of the tax year were required and certain, and the liability for them was fixed.
The concepts discussed in VECO can be applied to accrued warranty liability claims. The company offering the warranty has agreed to be bound by a contractual arrangement. However, the contractual arrangement alone does not establish a fixed liability. Additional acts must occur for the company to incur a deductible liability expense. There must be a defective product within the warranty period and, in many cases, the customer must file a claim reporting the defect. Each party has a duty to perform before the liability is considered fixed and determined.
When a taxpayer accrues a warranty expense liability for book purposes, tax practitioners should gather facts from the client to determine its deductibility and avoid overstating deductible warranty expenses for tax purposes. This includes reviewing the warranty agreement and inquiring whether any customers have actually filed warranty claims by year end.
It is important to remember that a warranty claim must be fixed and determinable and not contingent upon future events to qualify as a deduction on the current-year tax return. However, the warranty repair does not necessarily need to be performed by the end of the tax year.
While the recurring item exception may provide an avenue to deduct the warranty claims in the current tax year, it does not excuse the taxpayer from meeting the other elements of the all-events test, including economic performance. The recurring item exception simply provides additional time for economic performance to occur.
Michael Koppel is with Gray, Gray & Gray LLP in Canton, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or email@example.com.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.