Vincent van Gogh is quoted as saying that, “great things are done by a series of small things brought together.” Apparently the IRS thinks so too. A recent revenue procedure offers a safe harbor to accrual basis taxpayers – allowing them to ratably deduct the cost of regular and routine services rather than waiting until the end of the contract. While this change may appear subtle, it is actually quite significant although some background is required to understand why.
Deductibility of expenses (as well as, in some cases, recognition of income) for accrual basis taxpayers depends on satisfying two tests – the so-called “all events test” (which, in itself, has two parts) and establishing that there has been economic performance. The two parts of the all events test are:
1. All the events have occurred that establish the fact of the liability; and
2. The amount of the liability can be determined with reasonable accuracy.
The fact of the liability is established upon the earlier of the payment due date or the occurrence of an event fixing the liability, generally the performance of services or the provision of goods.
For services, economic performance occurs as the services are provided. but it has always been confusing how to interpret full satisfaction of this test in the context of a service contract which may span two tax years. There are also two exceptions that allow taxpayers in certain circumstances to accelerate deductions into a year prior to the year in which economic performance occurs:
1. Under the 3 ½ month rule, a taxpayer may treat economic performance as occurring as the taxpayer makes payment to the person providing the services if the taxpayer can reasonably expect the person to provide the services within 3 ½ months after the taxpayer makes the payment.
2. Under the recurring item exception in §461(h)(3)(A) and §1.461-5(b), a liability is treated as incurred for a taxable year if: (i) at the end of the taxable year, all the events have occurred that establish the fact of the liability and the amount can be determined with reasonable accuracy; (ii) economic performance occurs on or before the earlier of (A) the date that the taxpayer files a timely return (including extensions) for the taxable year, or (B) the 15th day of the ninth calendar month after the close of the taxable year; (iii) the liability is recurring in nature; and (iv) either (A) the amount of the liability is not material or (B) the accrual of 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.
These rules, however, don’t apply neatly in the context of a contract where services are to be rendered over a period of time, may be paid for in increments and span more than two tax years. Now, to make life simpler for taxpayers (and this is truly a taxpayer friendly provision), the IRS is offering a safe harbor for accrual method taxpayers to ratably expense the cost of regular and routine services, such as janitorial or landscape maintenance. The safe harbor treats economic performance as occurring ratably on contracts for services performed on a regular basis. Contracts for one-time services, such as an environmental study, aren’t considered ratable service contracts.
In order to qualify as a ratable service contract:
1. The contract must provide 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 are 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 (not including renewals).
Adopting this method is considered a change in accounting. Approval is automatic, but certain forms must be filed with your tax return to make the change. The amount of the deduction is computed by dividing the contract price for the services by the number of daily, weekly or monthly provisions of service under the terms of the contract and using that proration to compute the deduction for the year.
Your Friedman LLP tax advisor can help you decide if this subtle but important provision makes sense for your business. •