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IRS: SIGNING THE DEAL ISN'T ENOUGH TO EARN A DEDUCTION

December 22, 2006

The IRS yesterday spelled out (Rev. Rul. 2007-03) the rules for when deductions are available to accrual method taxpayers for insurance and service contracts. It also issued a procedure (Rev. Proc. 2007-14) for taxpayers to change their accounting methods to conform with the new revenue ruling.

CONTRACTS FOR SERVICES

The ruling said that an accrual-method taxpayer who signs a contract for services to be performed in a subsequent year cannot deduct the costs under the contract until the earlier of the performance of the services or the due date for payment under the contract. If the performance of services occurs after payment, it has to meet the tax law's "economic performance" requirements to be deductible.

CONTRACTS FOR INSURANCE

The ruling applies the same basic pattern to insurance contracts. Signing the contract doesn't accrue the liability for tax purposes; the liability doesn't create a deduction until payment is due.

ECONOMIC PERFORMANCE

The tax law applies two tests to determine when an expense may be accrued. The first test, the "all events" test, occurs when "all events" have taken place to determine the existence of the liability; the amount of the liability must also be determinable with "reasonable" accuracy.

The second test requires "economic performance" to occur. The ruling recaps how these rules apply to services and insurance (emphasis mine):

Section 1.461-4(d)(2) provides that if a liability of a taxpayer arises out of the providing of services or property to the taxpayer by another person, economic performance occurs as the services or property is provided.

Section 1.461-4(g)(5) provides that if a liability of a taxpayer arises out of the provision to the taxpayer of insurance, economic performance occurs as payment is made to the person to which the liability is owed.

The tax law does provide some leeway:

Section 1.461-5(b)(1) provides a recurring item exception to the general rule of economic performance. Under the recurring item exception, a liability is treated as incurred for a taxable year if: (i) at the end of the taxable year, all 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 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 the amount of the liability is not material or accrual of the liability in the taxable year results in better matching of the liability against the income to which it relates than would result from accrual of the liability in the taxable year in which economic performance occurs.

In other words, if the all-events test is met, you normally get the deduction if economic performance occurs within 8 1/2 months of year-end. This provision accounts for the "recurring item elections" routinely seen in tax returns for new businesses.

THE MORAL: If you want the deduction under an insurance or service contract this year, you'll need to pay this year.

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