Deducting executory contract expenses.
On Dec. 21, 2006, the IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws. released Rev. Rul. 2007-3, which provides guidance on whether the execution of a contract for services or insurance (an executory contract An executory contract is a contract in which a party has material unperformed obligations. Although material, an obligation to pay money does not usually make a contract executory.
The term executory contract assumes a specialized meaning in some areas of law. liability) establishes the "fact of the liability" under Sec. 461. The determination of whether a contract for services or insurance establishes the fact of the liability is key in determining the timing for deducting such expenditures for an accrual-basis taxpayer under Regs. Sec. 1.461-1(a)(2)(i).
In general, an accrual-basis taxpayer is allowed a deduction deduction, in logic, form of inference such that the conclusion must be true if the premises are true. For example, if we know that all men have two legs and that John is a man, it is then logical to deduce that John has two legs. for an otherwise deductible That which may be taken away or subtracted. In taxation, an item that may be subtracted from gross income or adjusted gross income in determining taxable income (e.g., interest expenses, charitable contributions, certain taxes). expense in the period in which the following three-pronged Adj. 1. three-pronged - having three prongs
divided - separated into parts or pieces; "opinions are divided" test is met (the first two prongs are referred to collectively as the "all-events test"; see Sec. 461(h)(4)):
1. All events have occurred that determine the fact of the liability.
2. The amount of the liability can be determined with reasonable accuracy.
3. Economic performance has occurred with respect to the liability.
Because the all-events test is based on the facts and circumstances CIRCUMSTANCES, evidence. The particulars which accompany a fact.
2. The facts proved are either possible or impossible, ordinary and probable, or extraordinary and improbable, recent or ancient; they may have happened near us, or afar off; they are public or as to the nature and extent of the taxpayer's liability, the terms of a contract that may give rise to a liability generally will determine the events that establish the fact of the liability; see, e.g., Decision, Inc., 47TC 58 (1966), acq., 1967-2 CB 2.
The general rule under Regs. Sec. 1.461-4(d)(2) provides that economic performance occurs for a liability arising out of the provision of property or services to the taxpayer by another person as the property or services are provided. Regs. Sec. 1.461-4(g) generally provides that for certain types of liabilities, including those arising out of the provision of insurance to the taxpayer, economic performance occurs as payment is made to the person to whom the liability is owed.
The recurring-item exception of Sec. 461(h) and Regs. Sec. 1.461-5 provides an exception to the general rules of economic performance. If a taxpayer is eligible to use the recurring-item exception for a particular liability and meets all of the requirements, economic performance will be deemed to occur at year-end year-end also year·end
The end of a year.
Occurring or done at the end of the year: a year-end audit.
Noun 1. , to the extent that it actually occurs within 8 1/2 months of year-end.
Thus, if a liability for services or insurance is considered fixed and determinable Liable to come to an end upon the happening of a certain contingency. Susceptible of being determined, found out, definitely decided upon, or settled.
determinable adj. at year-end, a taxpayer may be able to accelerate economic performance through use of the recurring-item exception, to the extent that economic performance (i.e., payment of the insurance premium or provision of the services) occurs within 8 1/2 months of year-end. The main purpose of Rev. Rul. 2007-3 was to set forth the IRS's position as to when the first prong of the all-events test is met with respect to executory contract liabilities, specifically when these types of liabilities are considered fixed, including whether the execution of a binding contract is sufficient to fix the liability. For this purpose, an executory contract liability is one for which there are unperformed Adj. 1. unperformed - not performed; "the author of numerous unperformed plays"
unstaged - not performed on the stage obligations, by either or both parties.
Rev. Rul. 2007-3
In the ruling, the Service considers two situations. Situation 1 involves a calendar-year-end, accrual-method taxpayer who enters into a contract for the provision of services on Dec. 15, 2006. The contract provides for services to begin on Jan. 15, 2007 and end on Jan. 31, 2007. Payment is due and paid on January January: see month. 15, and the taxpayer uses the recurring-item exception.
Situation 2 involves a calendar-yearend, accrual-method taxpayer who enters into a contract for the provision of insurance on Dec. 15, 2006. The contract provides for an insurance coverage period of Jan. 15, 2007-Dec. 31, 2007. Payment is due and paid on January 15; the taxpayer uses the recurring-item exception.
Citing Rev. Ruls. 80-230 and 79410, the IRS first sets forth the basic premise that the fact of a liability is established (i.e., the liability is considered fixed) when (1) the event fixing the liability (whether that be the required performance or other event) occurs or (2) payment therefore is due, whichever happens earliest. Based on this premise, the Service concludes that the first event that occurs to establish the fact of the taxpayer's liability for services in Situation 1 is the date that payment is due under the contract (Jan. 15, 2007). Further, the fact of the liability is not established in 2006 on the date the contract is executed, because
[i]t is well established that an accrual basis A method of accounting that reflects expenses incurred and income earned for Income Tax purposes for any one year.
Taxpayers who use the accrual method must include in their taxable income any money that they have the right to receive as payment for services, once it obligor The individual who owes another person a certain debt or duty.
The term obligor is often used interchangeably with debtor.
obligor (ah-bluh-gore) n. is not permitted to deduct de·duct
v. de·duct·ed, de·duct·ing, de·ducts
1. To take away (a quantity) from another; subtract.
2. To derive by deduction; deduce.
v.intr. an expense stemming from a bilateral bilateral /bi·lat·er·al/ (-lat´er-al) having two sides, or pertaining to both sides.
1. Having or formed of two sides; two-sided.
2. contractual arrangement, that is, mutual promises, prior to the performance of the contract for services by the obligee The individual to whom a particular duty or obligation is owed.
The obligation might be to pay a debt or involve the performance or nonperformance of a particular act.
The term obligee is often used synonymously with creditor. .
In other words Adv. 1. in other words - otherwise stated; "in other words, we are broke"
put differently , a promise by the taxpayer to pay for services rendered under the terms of a contract in exchange for the service provider's promise to perform the services stipulated in the contract is not sufficient, by itself, for the taxpayer in Situation 1 to establish the tact of the liability for purposes of the all-events test.
Similarly, the IRS concludes that the first event that occurs to establish the fact of the taxpayer's liability for insurance in Situation 2 is the date the premium is due under the contract (Jan. 15, 2007). Thus, it concludes in Situation 2 that the taxpayer has not incurred a liability for insurance until 2007. In reaching this conclusion, it explains that although Federal and state regulations may impose certain legal obligations (i.e., the insurance company must provide coverage), such obligation, by itself, does not establish the fact of the liability for purposes of the all-events test. In both situations, the Service notes that the recurring-item exception does not apply, as the fact of the liability is not established in 2006.
In summary, in both Situations 1 and 2, the Service concludes that the mere execution of a contract does not establish the fact of the taxpayer's liability. Thus, in applying the general principle that the fact of a liability is established on the earlier of the event fixing the liability occurring or payment being due, the IRS, in both situations, concludes that the "event fixing the liability, whether that be the required performance or other event" is the required performance, i.e., the provision of services or insurance coverage. There is no discussion, and it is not clear from the ruling, as to what "other event" could occur that would fix the liability. In addition, because the ruling addresses only two tact patterns (both of which involve the execution of a contract in year 1 under which payment is not due until year 2, and the related services or insurance coverage is not provided until year 2), it is uncertain whether a liability for services or insurance would be considered fixed in year 1 if the contract begins, and partial performance occurs, in year 1.
Finally, because the ruling specifies that a liability is fixed when "payment therefore is due," if earlier than the required performance, it appears that the IRS's position is that payment must be due and required under the contract; in other words, a voluntary prepayment Prepayment
1. The payment of a debt obligation prior to its due date.
2. The excess payment over a scheduled debt repayment amount.
1. Examples include deferred expenses such as rent and early loan repayments.
2. is not sufficient to fix a liability.
A taxpayer's treatment of liabilities for services and insurance is an accounting method within the meaning of Sec. 446. Thus, any change in the treatment of such liabilities by a taxpayer is an accounting-method change within the meaning of Sec. 446(e), requiring the Service's consent before implementation. Rev. Proc. 2007-14 was issued simultaneously with Rev. Rul. 2007-3 to provide automatic-consent procedures for a taxpayer that is currently treating the mere execution of a contract for services or insurance as establishing the fact of the liability under Sec. 461, and wants to change its accounting method to comply with Rev. Rul. 2007-3. The method change is subject to the automatic-change provisions, including the scope limits, of Rev. Proc. 2002-9 (as modified by Rev. Proc. 2002-19). Thus, a taxpayer who has requested a method change as to the same item within the past five years (including the year of change) will not be eligible to use the automatic provisions.
FROM NATHAN K. SMITH, CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. , MBA MBA
Master of Business Administration
Noun 1. MBA - a master's degree in business
Master in Business, Master in Business Administration , AND CATHY FITZPATRICK, CPA, MST See micro systems technology. , WASHINGTON, DC