Press Room: Tax Release

April 10, 2012

Limitation on Use of Recurring Item Exception Explained

Section 461 of the Internal Revenue Code governs the timing of when taxpayers are permitted to claim a tax deduction for various liabilities. Under the rules detailed in the regulations, a liability is generally deducted when all events have occurred establishing the fact of the liability, the amount can be determined with reasonable accuracy and economic performance has occurred. “Economic performance,” which is also defined in the regulations, depends on the type of liability and various other factors.

One of those other factors is an exception to the general economic performance rule which is termed the “recurring item exception.” Under that exception, a liability may be treated as being incurred before economic performance actually occurs if: (i) economic performance occurs on or before the earlier of the date the taxpayer files a timely return, or the 15th day of the ninth month after the close of the taxable year; and (ii) either (a) the amount of the liability is not material, or (b) the accrual of the liability in the taxable year results in a better matching with the income to which it relates. It is the application of this rule that has been troublesome to taxpayers and practitioners and has led to controversy in IRS examinations. 

IRS in a recent ruling (Rev. Rul. 2012-1) discussed the application of the recurring item exception to two liabilities incurred by the taxpayer: 1) a one-year lease agreement for property; and 2) a service liability for the regular and continuous service of the property. The taxpayer was required to pay for both liabilities at the onset of the contracts (the term was from July 1, 2011 to June 30, 2012), and accrued the expenses for both on its Generally Accepted Accounting Principles (GAAP) financial statements over the period of the contract.

IRS considered the liabilities and determined that:

  1. Because the lease expense was accrued over more than one year under GAAP, it was deemed to be material, and therefore was material for tax. Also, deducting in the year of payment did not result in better matching because the taxpayer used the property in its trade or business to generate income over the full life of the lease. Therefore, the lease did not qualify for the recurring item exception.
     
  2. The service contract was a “service liability” (Reg. Sec. 1.461-4(d)(2)) and was also held to be material because it was accrued under GAAP over more than one year. Similarly, because the services provided to the taxpayer are used in the ongoing operation of its trade or business to generate income over the period of the contract, better matching was not obtained by deducting the expense in the year of payment. Therefore, the service contract did not qualify for the recurring item exception.

This ruling is significant because taxpayers may have taken contrary positions on these items, arguing that lease payments and service payments are not material and that service contracts are in fact insurance arrangements that are deductible upon payment. Taxpayers that have taken positions contrary to this ruling have exposure to penalties and interest upon IRS examination. This risk may be avoided by filing an automatic method change.

If you believe you may be affected by this notice or need assistance with this filing, please contact your WTAS advisor or Pat Anderson at pat.anderson@wtas.com or 571.382.0056.