IRS Revenue Ruling 2012-1 clarifies the tax deduction of certain prepaid expenses
The IRS has issued Revenue Ruling 2012-1 to clarify the application of the “all-events test” recurring item exception under Sec. 461(h)(3).
Taxpayers must use an accounting method for tax purposes that clearly reflects income and deductions. Treasury Regulation 1.461-1(a)(2)(i) provides that an expense is deductible under the accrual method in the tax year when:
- All events establishing the liability occur.
- The amount of liability can be determined with reasonable accuracy.
- Economic performance occurs.
An exception to the economic performance rules allows certain recurring items to be treated as incurred during the tax year even though economic performance has not yet occurred. The exception applies when all of the following have been met:
- The all-events test is met (requirements 1 and 2 above) .
- Economic performance occurs by the earlier of the 15th day of the ninth month after the tax year end, or the date of the timely filed return (including extensions).
- The item is recurring in nature, and similar items are consistently treated as incurred in the tax year in which the all-events test is met.
- Either the item is not material or accruing the item in the year in which the all-events test is met results in a better matching of income than would result if the item were deducted in the year of economic performance.
Revenue Ruling 2012-1 addresses and clarifies the fourth item above: the issue of materiality and the matching of the income and expense for tax purposes.
The ruling limits the application of the “recurring item exception” for prepaids that are capitalized for book purposes. The ruling prevents the advance deduction of prepaid service contracts that represent routine service agreements as opposed to services to be provided under “unique and irregular circumstances” (i.e., disaster recovery, unexpected breakdowns, etc.).
To determine the tax treatment under these rules, the liability needs to be identified as either:
- A liability under a warranty or service contract in which the taxpayer enters into in connection with property purchased or leased, pursuant to which the other party to the contract promises to repair or replace the property under specified circumstances. Specified circumstances implies the occurrence of a unique or irregular circumstance necessitating the repair or replacement of the property. The regulations recognize this type of contract as being similar to an insurance contract. The deduction for these contracts is allowed when paid.
- A liability for general services, which are provided on an ongoing and recurring basis. For these types of contracts, economic performance occurs over the term of the agreement, as services are provided. Further analysis is then required to determine if the recurring item exception applies – looking at whether or not the liability is material or if deducting the liability in a year prior to performance of the service results in better matching of the expense to the related income.
In determining which prepaid expense items are deductible when paid, we need to take a closer look at the service contracts to determine which of these two categories they fall into. The ruling does not address the tax treatment for contracts that call for services to be performed on a recurring basis and for additional performance to be provided only in “specified circumstances” (a mixed contract).
It should be noted that prepaid insurance and regulatory assessments (other than the prepaid FDIC assessment) are still valid deductions under these rules. The ruling also reminds taxpayers that any change in a taxpayer’s accounting method to conform to the provisions of the Revenue Ruling 2012-1 would be a change in accounting method which would require application to the IRS. This is an automatic change which can be filed with the taxpayer’s Federal Income Tax return.