Timing Is Everything

The IRS celebrates the holiday season a bit differently than the rest of us. Rather than spreading joy, the Government Grinch has presented taxpayers with a stocking full of coal in the form of Revenue Ruling 2012-1.

The ruling deals with the timing of certain deductions for expenses that recur eternally, concluding that the deductions can only be taken ratably over time, rather than when the expenses are paid. Two situations are posited:

1. Corporation X uses the accrual method of accounting. In the middle of Year 1, X enters into a one-year lease for property it will use in its business to generate income over the period of the lease. X pays all of the rent due at the beginning of the lease term.

2. At the same time, X also enters into a one-year service contract with a maintenance company to inspect, clean, repair and maintain the leased property. The entire amount due on the contract is payable at the inception of the contract.

Normally, accrual method taxpayers may take deductions when all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred. Because X actually pays the liability in Year 1, the first two tests are met. The general rule, however, is that economic performance does not occur until the services or property are provided (or, in the case of a lease, used).

There is an exception that allows an earlier deduction for recurring items. To qualify for this exception, the liability must be recurring in nature and either (1) not material, or (2) a better matching of the liability with the income to which it relates than accruing the liability in the year in which economic performance occurs. If the payments meet these tests, they would be deductible in Year 1 rather than ratably over the terms of the contracts.

The IRS concluded that both the lease and the service contract were material. Materiality exists if the liability is material for financial statement purposes, and the IRS viewed the fact that the liabilities accrued over more than one taxable year for financial accounting purposes demonstrated materiality.

The ruling states that the matching requirement is met if (1) the liability accrues over more than one taxable year for financial accounting purposes; (2) the liability relates to income that a taxpayer generates in its trade or business over more than one taxable year; and (3) there are no overriding facts or circumstances that indicate accrual of the full liability in the earlier year results in a better match with the income. With respect to both the lease and the service contract, the IRS ruled that (1) the liabilities accrue over more than one year for financial accounting purposes; (2) X uses the property and the services in its business to generate income over the entire term of the lease and the contract, respectively; and (3) the accrual of the liabilities in Year 1 would not result in a better matching of the liabilities with the income. So even though the lease and service contract liabilities recurred annually, the IRS concluded that the recurring item exception was not met. As a result, X could not deduct the entire amounts paid under the lease and the contract in Year 1.

There may be a gem hidden in the coal, however. The ruling clarifies the previously murky application of the materiality and matching tests, so there may be some taxpayers who can benefit from this clarification. Those taxpayers may wish to consider filing a request for an automatic change of accounting method.

Any tax advice contained herein was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding U.S. federal, state, or local tax penalties.

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