IRS memo discusses accelerating deductions for recurring liabilities
INSIGHT ARTICLE |
In fall 2014, the IRS released a memorandum (CCA 201442048) ruling that a taxpayer could not use the recurring item exception under Reg. section 1.461-5 in order to deduct a liability to pay for damaged goods. Under the accrual method of accounting, taxpayers may generally deduct a liability in the year the liability has become fixed and determinable and economic performance has occurred. However, if the liability is fixed and determinable at year end and the taxpayer satisfies economic performance within 8 ½ months of year end, the taxpayer may be able to accelerate the deduction under the recurring item exception. The recurring item exception allows taxpayers to deduct certain liabilities in the year prior to economic performance occurring if the taxpayer also meets various other requirements. One such requirement is that the acceleration of the deduction better match the income to which the liability relates (the "matching requirement"). Certain liabilities for which payment is economic performance (such as insurance or warranty liabilities) are deemed to meet this matching requirement. However, certain liabilities are specifically excluded from the recurring item exception. These excluded liabilities include those related to interest, workers' compensation, tort and breach of contract, as well as liabilities for which economic performance is not specifically provided for in published guidance (i.e., "other liabilities").
In the CCA, the accrual-basis taxpayer was a professional moving company. As part of its services, the taxpayer entered into contracts with customers providing for certain maximum amounts the taxpayer would be liable for related to damaged or stolen goods. Such contracts required the customers to file written claims for reimbursement due to lost or damaged goods within a certain time frame. The taxpayer treated the payment of a claim as an insurance or warranty liability and generally recognized a deduction for the liability related to claims received during that year and paid within five months after the end of the year. The taxpayer argued that since this liability was essentially a warranty or insurance liability, acceleration of the liability was proper under the recurring item exception. The IRS agreed that payment constituted economic performance for the liability but ruled that the taxpayer's liability was not a warranty or insurance liability since the taxpayer was not purchasing or making payments for an insurance or warranty contract in the arrangement it entered into with customers. Rather, the IRS stated that these contracts served only to limit the taxpayer's liability to its customers and did not provide the taxpayer itself with any insurance or warranty benefits.
Since neither the economic performance regulations nor other IRS published guidance provides a specific rule with respect to economic performance for a taxpayer's liability for lost or damaged goods, the IRS ruled that the liability constituted an "other liability" for which payment is economic performance. However, since such "other liabilities" are explicitly excluded from the recurring item exception, the IRS ruled that the taxpayer could not rely on the exception to accelerate its deduction. Rather, the taxpayer must deduct the liability in the tax year the related claims were actually paid.
While unfavorable for the taxpayer at issue, the CCA does serve as a reminder for taxpayers currently accelerating liabilities into the year prior to payment to evaluate such treatment to ensure it is consistent with either the recurring item exception or some other provision of the Internal Revenue Code or Treasury regulations. The memorandum also demonstrates that it not always clear how the application of the economic performance rules interacts with certain liabilities. Accrual-method taxpayers should consult with their tax advisors in determining whether any liabilities may be accelerated under the recurring item exception. For certain liabilities, a change in method of accounting to use the recurring item exception may be automatic and, thus, may be filed by the date the taxpayer timely files its tax return for the year of change (including extensions). A change to stop improperly using the recurring item exception will generally be non-automatic, requiring the Form 3115 to be filed by the end of the tax year of change along with a $7,000 user fee. While the non-automatic consent procedures may be burdensome, taxpayers may gain audit protection for the prior years' improper treatment and a four-year spread of any increase in income arising from the change.