Under the accrual method of accounting, a liability is generally deductible for federal income tax purposes in the tax year in which all events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred for the liability. Under IRC Sec. 461(h)(1), the all-events test is not met any earlier than when economic performance occurs.
In certain instances, payment must be made before economic performance can occur. Reg. 1.461-4(g) lists the types of liabilities for which economic performance does not occur until payment is made (i.e., payment equals performance), which include rebates, refunds, awards, prizes, and jackpots, to name a few.
However, an accrual method business can adopt the recurring item exception to the economic performance rules [IRC Sec. 461(h)(3); Reg. 1.461-5]. This exception allows the business to elect to treat certain recurring liabilities as incurred during the current year if the all-events test is met even if economic performance has not occurred before the end of the year. Under the recurring item exception, an item can be taken into account in the year it becomes fixed and determinable if economic performance occurs by the earlier of:
- the 15th day of the ninth calendar month following the close of the tax year (i.e., within 8 1/2 months after the year-end), or
- the date the corporation files a timely tax return for the year.
Planning Tip: If economic performance occurs within 8 1/2 months after the year-end but after the return has been filed, an amended return can be filed to deduct the item [Reg. 1.461-5(b)(2)].
Eligibility for the Exception
A liability can qualify as a recurring item if it is reasonable to expect the same item will be incurred on a recurring basis in the future [Reg. 1.461-5(b)(3)]. To qualify for the recurring item exception, the recurring item must also meet one of the following tests [Reg. 1.461-5(b)(1)]:
- It is immaterial in amount. Generally, an item is immaterial if it is immaterial in absolute terms and in comparison with other items of income and expense, or it is immaterial for financial statement purposes under GAAP [Reg. 1.461-5(b)(4)].
- It is better matched to income in the earlier year. GAAP is an important factor in determining whether this requirement is met, but is not conclusive. The matching standard is automatically met for rebates, refunds, awards, prizes, jackpots, and certain other items [Reg. 1.461-5(b)(5)].
For example, assume that Handorf, Inc. is a calendar year, accrual method corporation that operates a chain of appliance stores. Handorf has a policy of refunding the full purchase price to any customer for any reason. As of December 31, the company owes 100 customers refunds totaling $30,000. The company will pay the $30,000 liability during the first 2 1/2 months of the following year (i.e., prior to March 15).
Since the "payment equals performance" rule applies to refunds, economic performance with respect to this $30,000 liability will not occur until next year, and under the general rules, Handorf will be unable to deduct any of the $30,000 customer refund liability on its current year return. But because the item involves the payment of a refund or rebate, it automatically meets the better matching standard. Since Handorf will pay the entire $30,000 liability prior to the time it files its current year return on March 15, it can deduct the full amount on its current year return.
Identifying Expenses Not Eligible for the Exception
Some expenses are not eligible for the recurring item exception, including: (1) interest expense; (2) expenses from workers compensation, torts, breach of contract, or violation of law claims; (3) liabilities incurred by a tax shelter; and (4) liabilities not addressed in the economic performance (or other) regulations [Reg. 1.461-5(c)].
Retailer Can't Accrue Rebate Liability
When the liability involves the payment of a rebate or refund to another person (e.g., a customer), economic performance occurs as payment is made to the customer (payment equals performance) [Reg. 1.460-4(g)(3)]. If payment is first made to someone other than the customer (such as a third party administrator of the rebate program), economic performance doesn't occur until payment is made by the program administrator to the customer, but only to the extent the taxpayer has transferred equal or greater amounts to the program administrator [Reg. 1.460-4(g)(1)].
Recently issued Chief Counsel Advice (CCA) 200834019 involves an accrual method retailer of consumer products that has a cash rebate program operated by a third-party administrator. Customers pay full price for the product but receive a rebate offer for a stated amount. To obtain the rebate, the customer has to fill out the rebate form, cut out and attach a copy of the UPC code from the merchandise, attach a copy of the sales receipt, and send those items to the administrator within 30 days of the purchase. The administrator waits at least 30 days after the purchase date before issuing a check to ensure that the customer hasn't returned the merchandise, but the check is often issued several months after a rebate request was submitted. Based on past experience, the retailer estimates that it paid or redeemed a certain percentage of the total rebate offers.
The IRS concludes that the retailer can't rely on the recurring item exception to treat the liability as incurred when the rebate offer is issued with the sale of the product. The rebate liability doesn't meet the requirements of the recurring item exception at that point because the liability isn't fixed. Rather, the filing of a claim is necessary to fix the retailer's liability. On the other hand, the IRS saw no reason to argue that the processing and issuing of a rebate "is anything other than a ministerial act." Therefore, the last event fixing the retailer's liability for the cash rebates occurs when the customer mails a properly completed rebate form with the required attachments.
Adopting the Recurring Item Exception
If the business has not incurred an item eligible for the recurring item exception before the current tax year, an election to adopt the exception can be made for the current year (i.e., the first year such a liability is incurred) by deducting the expense on the return. (Although not required, it is helpful to attach a statement to the return for the first year the item is incurred.) Businesses that incurred these liabilities in a prior tax year must request approval on Form 3115 (Application for Change in Accounting Method) for the change in the year they elect to use the recurring item exception method. The normal accounting change rules of IRC Sec. 446 and the related regulations apply.
The recurring item exception works well for repetitive annual expenses such as insurance, certain taxes, and, as illustrated in CCA 200834019, customer refunds and rebates. However, as already noted, the recurring item method is a method of accounting that must be properly elected the first year in which the expense item is incurred.