IRS Details Contract Liability Guidelines for Accrual Basis Taxpayers

Spring 2007

Taxpayers using the accrual method of accounting face many challenges when determining whether or not a liability meets the "all-events test" and is deductible in a particular year. New Revenue Ruling 2007-3 from the IRS provides significant insight into the agency’s view of contractual liability, and may provide taxpayers with an opportunity to possibly restructure a contract so that it may provide for an accrual in the year in which the contract is entered into.

Internal Revenue Code Section 461(a) states that a deduction must be taken for the taxable year that is the proper taxable year under the method of accounting used by the taxpayer to compute taxable income. For the accrual method of accounting, a liability is incurred, and is generally taken into account for federal income tax purposes, in the year in which all of the events have occurred that establish the fact of the liability—the earlier of either the occurrence of the event fixing liability or payment due—the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. This is the so-called "all-events test." There is, however, a recurring item exception, in which a liability is treated as incurred for a taxable year under certain circumstances.¹

For taxpayers using this accrual method of accounting, the recently issued Revenue Ruling 2007-3 states that those using the accrual method cannot deduct a liability under a contract when the contract is executed, if economic performance is to occur in the following year.

The ruling presents two examples in this regard for a taxpayer using the accrual method of accounting. In both situations, X is a corporation that uses the accrual method of accounting and files its federal income tax returns on a calendar basis:

• On Dec. 15, 2006, X executes a contract with Y for the provision of services. The contract provides for services to begin on Jan. 15, 2007, and end on Jan. 31, 2007. Under the terms of the contract, payment for the services is due to Y on Jan. 15, 2007, and X pays Y for the services on that date.
• On Dec. 15, 2006, X executes a contract with W for the provision of insurance. The insurance contract covers the period from Jan. 15, 2007, through Dec. 31, 2007. Under the terms of the contract, payment of the insurance premium is due to W on Jan. 15, 2007, and X pays the premium to W on that date.

Through its 2007-3 ruling, the IRS has determined that in both situations, the fact of a liability is not established in 2006, even though X executed the contract on Dec. 15, 2006. The IRS held that in both situations the mere execution of a contract, without more, does not establish the fact of a taxpayer’s liability for services or insurance. The conclusion, therefore, is that under Section 461, the all-events test has not been met since the fact of a liability has not been established.

Ruling 2007-3 goes on to state that, with regard to the insurance example, even if federal or state regulations impose certain legal obligations on taxpayers, those requirements, without more, do not necessarily establish the fact of a taxpayer’s liability under Section 461.

Those taxpayers that are facing these kinds of issues as outlined under this Revenue Ruling, have the ability to change their method of accounting and obtain automatic IRS consent for such a change by following Revenue Procedure 2007-14.

¹ According to Reg. Sec. 1.461-5, under the recurring item exception, a liability is treated as incurred for a taxable year if at the end of the taxable year, all events have occurred to establish the fact of the liability and the amount can be determined with reasonable accuracy; economic performance occurs on or before the earlier of the date the taxpayer files a return, or the fifteenth day of the ninth calendar month after the close of the tax year; the liability is recurring in nature; and either the amount of the liability is not material or accrual of the liability in the taxable year better matches the liability against the income to which it relates that would result from accrual of the liability in the taxable year in which economic performance occurs.

Larry S. Blair, CPA, JD, is a partner with the law firm of Metz Lewis LLC in Pittsburgh, and is a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at lblair@metzlewis.com.

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