Stephen J. Ehrenberg Stephen J. Ehrenberg

The all-events test and temporary deductions: Figuring out when (and if) a deduction is allowed

A recent Tax Court decision highlights difficulties with the recurring-item exception.

December 12, 2013
by Stephen J. Ehrenberg, CPA

Taxpayers and tax practitioners alike have long battled with tax authorities over temporary deductions, which are deductions that are permitted under the Code, but the timing of which may be different for book and tax purposes. Whereas treatment of a permanent item determines if a given item is subject to tax, determining temporary treatment affects the timing of when tax is paid. While the overall concept may seem straightforward, the analysis that taxpayers must undertake to determine not only if an item is taxable, but also when the tax on that item is due, can be quite difficult. Last month’s decision by the Tax Court in Veco Corp., 141 T.C. No. 14, highlighted the difficulties of this analysis in applying the recurring-item exception.

Accounting methods

Sec. 461 (the general rule for tax year of deduction) and the corresponding regulations provide the general rule for the period in which accrual-basis taxpayers may deduct a particular item. Taxpayers must analyze these rules in conjunction with a multitude of other Code sections, including (1) Sec. 448, Accrual vs. Cash Method, and (2) Sec. 451, General Rule for Year of Inclusion of Income Items, to comply with tax law when filing their tax returns.

In particular, the Sec. 461(h) all-events tests must be satisfied for accrual-basis taxpayers to deduct a given tax liability. The all-events test is a three-pronged test—each of the three tests below must be met for a taxpayer to properly deduct an accrued liability:

  • Liability must be fixed as of year end;
  • Liability must be determined with reasonable accuracy; and
  • Economic performance must occur.

While the first two prongs of the test apply regardless of the liability, the economic performance standard varies depending upon the type of liability.

For financial reporting purposes, liabilities are accrued in the period incurred. However, for tax purposes for accrual-basis taxpayers, the Sec. 461(h) all-events test must be met to allow a deduction in the tax period in which the liability is incurred. 

As many taxpayers can attest, situations frequently occur in which an item is deducted in a different period for financial reporting purposes than for tax purposes. Some examples are payroll-based liabilities, such as accrued vacation and accrued bonus, as well as other general accruals, such as accounts payable, accrued warranties, and accrued property taxes—these items frequently create temporary differences between tax returns and financial statements.

Economic performance

For tax purposes, satisfying the economic performance standard depends on the type of liability involved. For instance, economic performance occurs for liabilities for goods and services provided to the taxpayer as these goods and services are delivered (Regs. Sec. 1.461-4(d)(2)), whereas economic performance for liabilities for goods and services the taxpayer provides occurs as the taxpayer incurs costs in satisfying the liability (Regs. Sec. 1.461-4(d)(4)). Economic performance for real property liabilities, on the other hand, generally occurs ratably over the period of time the taxpayer is entitled to the use of the property (Regs. Sec. 1.461-4(d)(3)(i)). Finally, liabilities for certain types of payments, which typically include rebates, workers’ compensation claims, and certain other liabilities that are not specifically provided for elsewhere, are deducted when the taxpayer pays the creditor (Regs. Sec. 1.461-4(g)).

If economic performance occurs during the tax year, the liability is generally deducted during that particular year. However, the following exceptions are provided in the regulations, thus allowing accrual-basis taxpayers to deduct a given item in the period of accrual, even though actual payment does not occur until the following year:

  • 3½-month rule. A prepayment of a liability may be deductible if the taxpayer reasonably expects that the services will be performed or the property will be received within 3½ months of the date of payment.
  • Recurring-item exception. Provided a liability that satisfies the first two prongs of the all-events test recurs and is either immaterial or results in better matching with income, economic performance is deemed to occur on or before the earlier of:
    • The date the taxpayer timely files its tax return; or
    • 8½ months after year end.

While a number of other exceptions apply depending upon the type of liability incurred (i.e., interest expense, payroll-based liabilities, real property taxes, etc.), the recurring-item exception, otherwise known as the 8½-month rule, has given rise to a number of appeals and court cases as a result of taxpayers’ and the tax authorities’ disagreements over its application. One recent case, involving Veco Corp., has once again brought this issue to the forefront.

Veco Corp. and the recurring-item exception

Veco Corp., an Alaskan oil company, filed Form 3115, Application for Change in Accounting Method, claiming that liabilities associated with its contracts became fixed upon execution of the contracts and thus deductible in the year of accrual. Veco argued that the recurring-item exception should apply to insurance and maintenance components of these contracts, thus requesting a deduction for the year the liability is incurred, assuming payment of these liabilities is made no later than the earlier of (1) 8½ months after year end or (2) the filing of the tax return. Before filing Form 3115 in 2005, Veco had capitalized and amortized these liabilities over the life of the underlying contracts.

The Tax Court denied the deductions, stating that the first prong of the all-events test, which requires a liability to be fixed at year end, had not been satisfied because neither the required performance nor the payment due dates with respect to the majority of the accelerated deductions occurred before the close of Veco’s 2005 tax year. Citing a raft of cases, the court found that mere execution of a contract is not enough to fix a liability. The Tax Court found that the recurring-item exception did not apply because Veco had failed to prove that the liabilities in question were not material.

Taxpayer considerations

Veco eventually will be allowed a deduction. However, considering the time value of money, as well as that funds that would otherwise be currently available for other projects must be paid in taxes, the implications of the case are significant.

Applying Sec. 461 and the corresponding regulations can be challenging. Taxpayers should take time to review material accruals before year end and consider filing for method changes if necessary so they may feel some security when considering when deductions can be taken.

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Stephen J. Ehrenberg, CPA, is a tax principal in the Los Angeles office of Holthouse Carlin & Van Trigt LLP.