IRS releases safe harbor for treatment of certain service liabilities
TAX ALERT |
The IRS recently released Rev. Proc. 201 5-39, providing a safe harbor method of accounting under which an accrual method taxpayer may treat economic performance for certain liabilities arising out of the provision of services to the taxpayer as occurring ratably over the term the services are provided. This new safe harbor may allow for the acceleration of certain ratable service liabilities into the year of payment and should reduce controversy between the IRS and taxpayers regarding when economic performance occurs for such services. Rev. Proc. 2015-39 is effective for taxable years ending on or after July 30, 2015.
Pursuant to section 461 and the regulations thereunder, an accrual method taxpayer may take a liability into account for federal income tax purposes only when such liability becomes fixed and determinable (collectively referred to as the "all events test") and economic performance occurs. A liability is treated as meeting the all events test when the event fixing the liability occurs (i.e., performance or some other event occurs) or payment is due, whichever occurs first. Where a liability arises out of services provided to the taxpayer, economic performance generally occurs as the services are provided. However, two exceptions to this general rule for economic performance exist:
- The 3.5 month rule under Reg. section 1.461-4(d)(6)(ii)
- The recurring item exception under Reg. section 1.461-5
Under the 3.5 month rule, a taxpayer may treat economic performance for a service liability as occurring upon payment if the taxpayer reasonably expects the services to be provided within 3.5 months of the date of payment. Under the recurring item exception, a taxpayer may treat a liability as being incurred during a taxable year if the following conditions are met: (1) the liability is fixed and determinable as of the end of the year; (2) economic performance occurs on or before the earlier of the date the taxpayer timely files its tax return for the taxable year or 8.5 months after the end of the taxable year; (3) the liability is recurring in nature; and (4) either the liability is immaterial or accruing the liability in the taxable year results in a better matching of the liability with the income to which it relates than would result from accruing the liability for the taxable year in which economic performance occurs.
Because neither the Code nor the underlying regulations provide clarity on when services are considered to be provided for purposes of the economic performance rule (i.e., whether economic performance occurs ratably over the term of the agreement or whether all of the services must be performed before economic performance is treated as occurring), controversy has arisen between taxpayers and the IRS as to the appropriate timing of incurring service-related liabilities.
In an effort to reduce controversy, Rev. Proc. 2015-39 provides a safe harbor method of accounting that allows taxpayers to treat economic performance for certain services as occurring ratably over the term of the related agreement. This safe harbor method applies to liabilities arising out of services provided to the taxpayer under Ratable Service Contracts. The revenue procedure defines a ratable service contract as a contract that: (1) provides for similar services to be provided on a regular basis, such as daily, weekly or monthly; (2) each occurrence of the service provides independent value, such that the benefits of receiving each occurrence of the service is not dependent on the receipt of any previous or subsequent occurrence of the service; and (3) the term of the contract does not exceed 12 months.
Rev. Proc. 2015-39 provides the following examples of 12-month service contracts that will meet the definition of a ratable service contract:
- A contract for the provision of monthly landscaping maintenance services
- A contract for the provision of daily janitorial services
- A contract for ongoing IT support and maintenance services
Conversely, the revenue procedure includes the following as examples of services that do not meet the ratable service contract definition:
- A contract for an environmental impact study for the taxpayer
- A contract to create an updated human resources software application for the taxpayer
The safe harbor does not apply to contracts that include both services that meet the definition of a ratable service contract and services that do not meet such definition unless the contract includes separate pricing for the qualifying and non-qualifying services.
The revenue procedure also provides examples of how a taxpayer with an established method of accounting that utilizes the 3.5 month rule and/or the recurring item exception may use the safe harbor method of accounting provided in Rev. Proc. 2015-39 to take into account liabilities that otherwise qualify for the 3.5 month rule or the recurring item exception.
Finally, Rev. Proc. 2015-39 adds an automatic accounting method change to Rev. Proc. 2015-14 to adopt the new safe harbor method of accounting. The revenue procedure waives the eligibility rule of section 5.01(f) of Rev. Proc. 2015-13 (limiting the ability to file automatic method changes for items that have been subject to an accounting method change within the past five years) for a taxpayer's first, second or third taxable year ending on or after July 30, 2015.
The safe harbor method of accounting is welcome news for taxpayers that incur qualifying service liabilities and wish to accelerate the recognition of such liabilities into the year of payment and for taxpayers with a ratable service contract that spans more than one tax year and wish to take into account the portion of the liability relating to the current year's services under the contract. Additionally, with the upcoming changes in the standards for revenue recognition for GAAP purposes, the safe harbor method of accounting may provide for the ability to minimize book/tax differences.
Taxpayers should note, however, that the method provided by Rev. Proc. 2015-39 is applicable only to certain services that occur ratably over the term of the agreement where each occurrence of the service provides independent value. Thus, contracts for services such as tax preparation or audit services are not likely to qualify as ratable service contracts. Additionally, taxpayers that have not already adopted the 3.5 month rule or the recurring item exception must request separate accounting method changes to adopt these methods. To adopt either the 3.5 month rule or the recurring item exception, a taxpayer will likely have to request a method change under the non-automatic procedures, meaning that the Form 3115 must be filed by the taxpayer's year-end with the applicable user fee.
Taxpayers should work with their tax advisors to determine whether any service liabilities will qualify for the safe harbor method of accounting provided by Rev. Proc. 2015-39 and whether requesting a change in method of accounting to adopt such safe harbor method is advantageous.