Accrual Methods[1]

8/12/2019 Accrual Methods[1]

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ross income in the year the magazine, newspaper, or other periodical is to be delivered. f. PREPAID DUES INCOME. Section 456 provides that, at the election of certain membership organizations, prepaid dues income is includedin gross income in the year services or membership privileges are to be provided. C. TREATMENT OF COSTS AND EXPENSE ITEMS.1. Under an accrual method, a liability is incurred, and generally is taken into account for Federal income tax purposes, in the taxable year in which (1) all the events have occurred that establish the fact of the liability, (2) the amount of the liability can be determined with reasonable accuracy, and (3) economic performance has occurred with respect to the liability. Reg. 1.4461(c)(1)(ii). Each requirement is independent, and no deduction is allowed until eachhas been satisfied.2. FACT OF THE LIABILITY. A liability must exist on the basis offacts actually known or reasonably knowable as of the close of the year of deduction. a. An obligation may constitute a fixed liability even t

hough the ultimate payee is not yet determined. United States v. Hughes Properties, Inc., 476 U.S. 593 (1986); Washington Post Co. v. United States, 405 F2d 1279 (Ct. Cl. 1969). However, see discussion below with regard to economic performance for prizes, awards and jackpots.b. A liability is fixed if operative facts have occurredthat establish the liability, and taxpayer has a reasonable expectation that the expense will be incurred; the fact that conditions may later arise and eliminate the liability does not preclude accrual and deduction. United States v. Hughes Properties, Inc., 476 U.S. 593 (1986).c. If the existence of the liability is subject to a contingency or condition precedent, the obligation is not fixed until the conditionhas occurred or is satisfied. Brown v. Helvering, 291 US 193, 200 (1934); Dixie Pine Products Co. v. Commissioner, 320 US 516, 519 (1944); Simplified Tax Records, Inc., 41 TC 75 (1963).d. An asserted liability contested by the taxpayer is not fixed unless the taxpayer meets the requirements of 461(f).i. Section 461(f) requires a contested liability

to be paid, either to the claimant or to a trust beyond the control of the taxpayer, before the liability can be deducted (assuming the deduction is otherwiseallowable under 461(h) see 3. below).ii. See Reg. 1.4612 for definition of the terms"asserted liability" and "contest" as used in 461(f).A. ASSERTED LIABILITY: An item that would be deductible under an accrual method, except for the fact that it is contested.B. CONTEST: When there is a bona fide dispute as to the proper evaluation of the law or the facts necessary to determine the existence or correctness of the amount of an asserted liability.iii. PAYMENT UNDER 461(h). For purposes of economic performance under 461(h), Reg. 1.4614(g)(1)(ii)(A) says payment does not include an amount transferred as a loan, refundable deposit, or contingent payment with respect to which the taxpayer may be or may become entitled to receive a refu


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nd or credit. A contested liability is not deductible until it meets the economic performance test under 461(h).A. For certain types of liabilities, payment to the person to whom the liability is owed constitutes economic performance under 461(h). However, a payment to a trust, escrow account, fund, or any person other than the person to whom a liability is owed does not constitute economic performance. The Service believes that the tax treatment of contested liabilitiesshould be addressed in a separate regulations project, and the final regulationsreserve treatment of contested amounts paid to a trust or escrow. Therefore, for payment liabilities (discussed below) economic performance is currently not satisfied as long as the liability is contested.B. Economic performance can occur under therules of 461(f) for contested liabilities that are not payment liabilities; "payment" is not required for economic performance to occur.3. DETERMINATION OF AMOUNT WITH REASONABLE ACCURACY. The fact that the exact amount of a liability which has been incurred cannot be determinedwill not prevent the accrual and deduction of such part that can be computed with reasonable accuracy; any difference between such amount and the actual amountdetermined in a later year is taken into account in the later year. Reg. 1.4611(a)(2). 4. ECONOMIC PERFORMANCE SECTION 461(h) (FINAL REGULATIONS WEREISSUED UNDER 461(h) EFFECTIVE APRIL 10, 1992). For purposes of determining whether an accrual basis taxpayer can treat the amount of any liability as incurred,the all events test is not treated as met any earlier than the taxable year in which economic performance occurs with respect to the liability. The term "liability" includes any item allowable as a deduction, cost, or expense for Federal income tax purposes. Section 461(h) applies to exclusions as well as deductions,and any amount otherwise allowable as a capitalized cost, as a cost taken into

account in computing cost of goods sold, as a cost allocable to a longterm contract, or as any other cost or expense. 1.4461(C)(1)(ii)(B).a. EXCEPTIONS. If the liability of a taxpayer is subjectto 165 (losses), 170 (charitable contributions), 192 (black lung benefit trusts), 94A (employer liability trusts), 468 (mining and solid waste disposal reclamationand closing costs), or 468A(a) (certain nuclear decommissioning costs), the liability is taken into account as determined under that section and not under 461 orthe regulations thereunder. 1.4611(a)(2)(iii)(B).b. GENERAL RULES. Section 461(h) provides that, exceptas otherwise provided in regulations, the following general principles determinewhen economic performance occurs.i. If a liability of a taxpayer arises out of the providing of services or property to the taxpayer by another person, economicperformance generally occurs as such person provides the services or property.ii. If the liability of a taxpayer arises out ofthe use of property, economic performance occurs as the taxpayer uses the property. iii. If the liability of the taxpayer requires t

he taxpayer to provide property or services to another person, economic performance occurs as the taxpayer incurs costs to provide such property or services.iv. If the liability of a taxpayer requires payment to another person and arises under a workers compensation act or out of anytort, economic performance occurs as the payments to such person are made.v. For certain recurring items, 461(h)(3) provides an exception to the general rule requiring economic performance to occur before an item may be treated as incurred. Under the recurring item exception, an item may be treated as incurred in the taxable year before economic performance occurs. vi. In the case of any other liability of a taxpayer, economic performance occurs at the time determined under regulations.c. SERVICES OR PROPERTY PROVIDED TO THE TAXPAYER. Generally, if the 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. i. EXCEPTION 1. If an expense is attributable toa longterm contract with respect to which the taxpayer uses the percentage of co

mpletion method under 460, economic performance occurs (A) as the services or property is provided; or, if earlier, (B) as the taxpayer makes payment of the liability to the person providing the services or property. 1.4614(d)(2)(ii).A. This rule is generally effective for years beginning after 1991. 1.4614(k)(2).B. A taxpayer is granted automatic consentof the Commissioner to change its method of accounting for longterm contracts toconform with the final regulations for taxable years beginning in 1992; or if anamended return is filed by October 7, 1992, for taxable years beginning in 1990or 1991. See 1.4614(m)(2). ii. EXCEPTION 2. A taxpayer is permitted to treat services or property as provided to the taxpayer as the taxpayer makes paymentto the person providing the services or property, if the taxpayer can reasonabl


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y expect the person to provide the services or property within 31/2 months afterthe date of payment. 1.4614(d)(6)(ii).A. This exception does not require the services or property to actually be provided within 31/2 months; only reasonable expectation. B. This exception is not available for anyliability other than one arising out of the providing of services or property tothe taxpayer by another person.iii. EXCEPTION 3. If, in connection with the sale or exchange of a trade or business by a taxpayer, the purchaser expressly assumes a liability arising out of the trade or business that the taxpayer, but forthe economic performance requirement, would have been entitled to incur as of the date of the sale, economic performance with respect to that liability occurs as the liability is properly included in the amount realized on the transaction by the taxpayer. 1.4614(d)(5)(i).iv. A taxpayer can treat property as provided tothe taxpayer when the property is delivered or accepted, or when title to the property passes. The method used is a method of accounting. Therefore, the method of determining when property is provided must be used consistently from yearto year, and cannot be changed without the consent of the Commissioner. 1.4614(d)(6)(iii). v. DEFERRED COMPENSATION: Although economic performance may have occurred at year end, compensation expense accrued at year endand paid later than 21/2 months after year end to a cash method employee or independent contractor is presumed to be pursuant to a plan to defer compensation,and therefore is not deductible until the year paid. 404(b) and (d); Temp. Reg. 1.404(b)1T. d. USE OF PROPERTY BY THE TAXPAYER. Generally, if the liability of a taxpayer arises out of the use of property by the taxpayer, economic performance occurs ratably over the period of time the taxpayer is entitled t

o the use of the property. i. EXCEPTION 1. If all or a portion of the liability is determined by reference to the frequency or volume of use of the property or the income from the property, economic performance occurs as the taxpayer uses the property or includes income from the property, subject to review by theDistrict Director. 1.4614(d)(3)(ii).ii. EXCEPTION 2. The sale of a trade or businessexception under 1.4614(d)(5)(i), described above, also applies here.e. SERVICES OR PROPERTY PROVIDED BY THE TAXPAYER. Generally, if the liability of a taxpayer requires the taxpayer to provide services orproperty to another person, economic performance occurs as the taxpayer incurscosts in connection with the satisfaction of the liability. 1.4614(d)(4).i. If the taxpayer is provided services, property, or the use of property in connection with its liability to provide services or property to another person, costs are incurred under the rules above for services, property, or the use of property provided to the taxpayer, rather than whenpayment is made. ii. EXCEPTION. The sale of a trade or business e

xception under 1.4614(d)(5)(i), described above, also applies here.f. BARTER TRANSACTIONS. If a liability requires the taxpayer to provide services, property, or the use of property, and arises out of the use of property by the taxpayer, or out of the provision of services or property to the taxpayer by another person, economic performance occurs to the extentof the lesser of (A) costs incurred by the taxpayer in connection with the liability, or (B) the extent to which the services or property is provided to the taxpayer. 1.4614(d)(4)(ii). i. This rule could cause unexpected results. See Tax Accounting Policy Subcommittee of the ATA, "Improved Treatment of Barter Transactions for AccrualMethod Taxpayers," Tax Notes, March 20, 1995.g. LIABILITIES FOR WHICH PAYMENT IS ECONOMIC PERFORMANCE REG. 1.4614(g). i. DEFINITION OF PAYMENT.A. For all purposes of 461(h), a "payment" occurs only if both a cash method payee would be considered to have received income and a cash method payor would be considered to have made a payment. Paymentdoes not include the furnishing of a note or other evidence of indebtedness of t

he taxpayer, whether or not the evidence is guaranteed by a letter of credit orby any third party. In addition, payment does not include an amount transferredas a loan, refundable deposit, or contingent payment.I. See below for special rule for payment of taxes that are refundable. II. The final regs. are silent regardingwhether the issuance of the taxpayer's own stock constitutes payment. Presumably the rule with respect to notes will not be applied to stock.B. Economic performance occurs only when, and to the extent that, payment is made to the person to which the liability is owed. Therefore, economic performance does not occur as a taxpayer makes payments in connection with such a liability to any other person, including a trust, escrow account, courtadministered fund, or any similar arrangement, unless the pers


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on to which the liability is owed would be treated as having actually or constructively received the amount of the payment as gross income under the principlesof 451 (without regard to exclusions). I. The amount of economic performance that occurs as payment is made from the other person or fund to the person to which the liability is owed may not exceed the amount the taxpayer transferred to the other person or fund. Reg. 1.4614(g)(1)(i).II. Special rules relating to the taxation of amounts transferred to "qualified settlement funds" are in 468B and regulations thereunder. C. Payment is deemed to occur when the purchaser of a trade or business expressly assumes a liability of the taxpayer underthe provisions of 1.4614(d)(5)(i), described above.ii. LIABILITIES ARISING UNDER A WORKERS COMPENSATION ACT OR OUT OF ANY TORT, BREACH OF CONTRACT, OR VIOLATION OF LAW. Reg. 1.4614(g) expands the statutory category of liabilities under a worker's compensationact or out of any tort, to include breach of contract or violation of law.A. This payment rule was expanded because of the nature of the liabilities and the difficulty in applying the statutory rules to these liabilities. For example, in the case of liabilities arising out ofa breach of contract or violation of law, it is often difficult to distinguishamong actions based on breach of contract, violation of law, and tort because many such actions are brought on alternative grounds and settled without any objective determination of the prevailing theory.B. A liability arising out of a tort, breach of contract, or violation of law includes a liability arising out of the settlement of a dispute in which a tort, breach of contract, or violation of law, respectively, is alleged. iii. REBATES AND REFUNDS. Economic performanceoccurs as payment is made to the person to which a rebate or refund is owed. This rule applies to all rebates, refunds, and payments or transfers in the nature

of a rebate or refund, regardless of whether they are characterized as a deduction from gross income, an adjustment to gross receipts or total sales, or an adjustment or addition to cost of goods sold.A. Liabilities for rebates or refunds are deemed to satisfy the matching requirement under the recurring item exception, discussed below, which permits them to be taken into account in the taxable yearprior to the year in which they are paid. Reg. 1.4615(b)(5).B. See Reg. 1.4614(g)(8), Example 2.iv. AWARDS, PRIZES, AND JACKPOTS. If the liability of a taxpayer is to provide an award, prize, jackpot, or other similar payment to another person, economic performance occurs as payment is made to the person to which the liability is owed.A. Note that this rule negates the SupremeCourt decision in United States v. Hughes Properties, Inc., 476 U.S. 593 (1986),with respect to deductibility of a jackpot. However, the Hughes case is stillprecedent in determining when a liability is fixed.B. Liabilities for awards, prizes and jackpots are deemed to satisfy the matching requirement under the recurring item exce

ption, discussed below, which permits them to be taken into account in the taxable year prior to the year in which they are paid. Reg. 1.4615(b)(5).C. See Reg. 1.4614(g)(8), Example 4.v. INSURANCE, WARRANTY, AND SERVICE CONTRACTS. If the liability of a taxpayer arises out of the provision to the taxpayer of insurance, or a warranty or service contract, economic performance occurs as payment is made to the person to which the liability is owed.A. Defined in Reg. 1.4614(g)(5).B. Liabilities for insurance, warranty, andservice contracts are deemed to satisfy the matching requirement under the recurring item exception, discussed below, which permits them to be taken into account in the taxable year prior to the year in which they are paid. Reg. 1.4615(b)(5). vi. TAXES. Generally, if the liability of a taxpayer is to pay a tax, economic performance occurs as the tax is paid to the governmental authority that imposed the tax.A. For this purpose, payment includes payments of estimated income tax and payments of tax where the taxpayer subsequentlyfiles a claim for credit or refund.B. Liabilities for taxes are deemed to sati

sfy the matching requirement under the recurring item exception, discussed below, which permits them to be taken into account in the taxable year prior to the year in which they are paid. Reg. 1.4615(b)(5).C. REAL PROPERTY TAXES. If a valid electionhas been made under 461(c) to accrue real property taxes ratably over the periodof time to which they relate ("ratable accrual method"), the taxpayer's accrualfor real property taxes is determined under 461(c).I. Under the ratable accrual method, real property taxes accrue ratably over the property tax year without regard to thelien date or the payment dates. Reg. 1.4611(c)(1).a. Section 461(c) says "any real property tax which is related to a definite period of time shall be accrued ratably over that period." b. So the period to which the taxes


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relate can be designated by the taxing jurisdiction regardless of the assessment or lien date. II. Generally, advance consent of the Commissioner is required to change to or from the ratable accrual method. 1.4611(c)(3)(ii) and 1(c)(4). Election can be made without consent for 1st year property taxes are incurred. III. Rev. Proc. 9228 provides automaticprocedures to make or revoke an election under 461(c) for tax years beginning in1990, 1991, or 1992. Rev. Proc. 9432 extends these procedures for the first taxable year beginning after 1992, if the taxpayer files a timely return, or amends its return for that year by September 15, 1994. For years after 1993, Form 3115 must be filed to request a change in accounting method.IV. Under Rev. Proc. 9228, a taxpayer may elect the ratable accrual method under 461(c) by attaching a statement to itstimely filed original return for the year of change (including extensions) or anamended return for 1990 or 1991, if the amended return is filed on or before October 6, 1992. V. Under Rev. Proc. 9228, either a cutoff transition method or a 481(a) adjustment transition is permitted. For yearsprior to the application of Rev. Proc. 9228, changes to or from the ratable accrual method were granted only with a cutoff transition method. The 481 method is usually better because you get a double deduction, then take the excess into income over a spread period. Rev. Proc. 9432 extends the procedures under Rev.Proc. 9228 for 1993, but for years after 1993 the 481 adjustment method might not be an option. VI. The ratable accrual election apparently must apply to all of a taxpayer's real property taxes. Therefore, taxpayerswho are subject to multiple taxing jurisdictions must analyze the overall benefit of the election. VII. If a 461(c) election is not in effec

t, economic performance occurs as real property taxes are paid, unless the recurring item exception applies (discussed below).VIII. In Minnesota, taxes assessed on real property are a perpetual lien on the property for the year in which the property is assessed. Minnesota Statute 272.31 as amended by Minnesota laws 1991, Chapter 291, Art. 12, 6. Assessments occur on real property on January 2 of the yearpreceding the year the taxes are due and payable. Thus, for real estate taxes payable in 1993, the assessment date is Jan 2, 1992 and the lien runs from Jan 2,1992. The payment dates are in two equal installments due on May 15 and October15. Prior to 1993, Minnesota Statute 275.28 Subdiv. 3 provided that property taxes for both cash and accrual basis taxpayers shall be related to and designatedby the year in which they become payable. In 1993, the law was changed for taxes payable in 1993 and later years. The new provision states: "For accrual basis taxpayers, taxes on real and personal property shall relate to the year in whi

ch the lien arose." This change in the Minnesota statutes was made in order that the ratable accrual method under 461(c) would benefit Minnesota taxpayers. TheIRS has not formally indicated that the change in the Minnesota law would not be affected by 461(d) (Limitation on Acceleration of Accrual of Taxes).vii. LIABILITIES NOT MENTIONED. If a liability cannot properly be characterized under rules provided in 461 or the regulations orrulings, economic performance occurs as the taxpayer makes payments in satisfaction of the liability to the person to which the liability is owed. 1.4611(g)(7). viii. EFFECTIVE DATES. The above rules under thefinal regulations for payment liabilities (other than workers compensation andtort liabilities) generally apply for taxable years beginning after 1991. 1.4614(k)(3). A. The payment requirement applies to all workers compensation and tort liabilities that would, under the law in effect before the enactment of section 461(h), be incurred after July 18, 1984. See 461(h)

(2)(C) and 1.4614(k)(1). B. A taxpayer is granted automatic consentof the Commissioner to change its method of accounting for payment liabilities to conform with the final regulations for taxable years beginning in 1992; or ifan amended return is filed by October 7, 1992, for taxable years beginning in 1990 or 1991. See 1.4614(m)(2). I. Change is implemented using the "cutoff" method (see below) on the original return (or amended return for 1990 or 1991) for the year of change and subsequent years using the payment rule for payment liabilities that were not accrued in prior years under the taxpayer's prior method. 1.4614(m)(2). II. Change is implemented using the 481(a) method (see below) by attaching an election statement to the return. See 1.461


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4(m)(2) and 1.4617T, Q&A5. C. No specific guidance is provided for thetreatment of most payment liabilities prior to 1992.I. An amended return can be filed for 1990 and 1991, but treatment under the final regulations is not mandated for thoseyears. II. The Preamble to the final regulations simply states that "general principles of economic performance" must be followed. III. The IRS indicated in Notice 9064 that it would not apply the payment requirement during the gap period to propertytax liabilities. D. Automatic consent for changing accounting methods to comply with the final regulations has expired for 1992, as of 9/15/93. There are no automatic consent procedures in effect for years subsequent to1992. Therefore, for taxpayers who have not adopted the rules for payment liabilities, a change must be requested under Rev. Proc. 9727 (discussed in SectionV of this outline). It is not certain that the IRS will grant an option betweenthe cutoff method and the 481 method.ix. TRANSITION METHOD OPTIONS. Either a "cutoff" or 481(a) adjustment method is available for the transition procedure. 1.4611(m)(1) and (2). A. CUTOFF METHOD. The payment rule does not apply to a payment liability that is incurred in the year of change or in a later year under the new method, to the extent that the liability had previously been incurred under the taxpayer's prior accounting method.B. SECTION 481(a) METHOD. The final regulations apply to all payment liabilities incurred in the year of change or later years under the payment rule, even though a liability may have previously been incurred under the taxpayer's prior method of accounting.I. A 481 adjustment is required in orderto prevent duplicate deductions. II. The 481 adjustment is generally spread ratably over three taxable years beginning with the year of change. 1.4617T,

Q&A9(a). C. The method chosen must apply to an entire trade or business of a taxpayer. 1.4617T, Q&A3(b). The preferable choice involves comparing the present value cost or benefit under both methods.g. RECURRING ITEM EXCEPTION 461(h)(3) AND REG. 1.4615.i. GENERAL REQUIREMENTS FOR USE OF THE EXCEPTION. A liability is treated as incurred for a taxable year if:A. The all events test, other than economicperformance, has been met by the end of the taxable year (not necessarily during the year); B. Economic performance with respect to theliability occurs on or before the earlier of:I. The date the taxpayer files a timelyreturn (including extensions) for that taxable year; orII. The 15th day of the 9th calendar month after the close of that taxable year;C. The liability is recurring in nature; and D. Either:I. The amount of the liability is not MATERIAL; or II. The accrual of the liability for that taxable year results in a better MATCHING of the liability with the income towhich it relates than would result from accruing the liability for the taxable y

ear in which economic performance occurs.ii. AMENDED RETURNS. A taxpayer may file an amended return treating a liability as incurred under the recurring item exception for a taxable year if economic performance occurs after the original return is filed, but within 8 1/2 months after the close of that year. Reg. 1.4615(b)(2).A. Note tax planning opportunities. Once the recurring item method is established for a particular item, taxpayer has complete discretion over what year the item is deductible by when the income tax return is filed. Maximum flexibility is achieved by filing the return prior to when major recurring items are economically performed, but having economic performance occur within 81/2 months after year end.B. Timing of tax return filing is not a change of accounting method, but a fact within the method. Query: Would it be a change in method if in some years an amended return is filed for an item, but in other years it could be but is not?iii. LIABILITIES THAT ARE RECURRING IN NATURE. Aliability expected to be incurred from one taxable year to the next is recurrin

g in nature, even though it is not actually incurred each year. Reg. 1.4615(b)(3). iv. MATERIALITY REQUIREMENT. A liability is material if it is material under GAAP, but a liability that is immaterial under GAAPmay still be material for purposes of the recurring item exception. Reg. 1.4615(b)(4). v. MATCHING REQUIREMENT.A. Proper matching under GAAP is an important factor, but is not dispositive.B. The matching requirement is deemed to besatisfied for the following types of payment liabilities: (1) rebates and refunds; (2) awards, prizes, and jackpots; (3) insurance, warranty, and service contracts; and (4) taxes. Reg. 1.4615(b)(5). This means that treatment of these liabilities under GAAP is irrelevant; and it doesn't matter that they are material.vi. LIABILITIES NOT ELIGIBLE. Under 1.4615(c), th


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e recurring item exception does not apply to:A. Interest; workers compensation or tort liabilities; liabilities for violation of law or breach of contract liabilities;the "other payment liabilities" of 1.4614(g)(7); orB. Any liability incurred by a tax shelter,as defined in 461(i) and 1.4481T(b). A "tax shelter" for this purpose is definedthe same as for limitation on use of the cash method of accounting under 448 see section II.C.2. C. In the case of the "other payment liabilities" described in section 1.4614(g)(7) (other liabilities not characterized under 461 or the regulations or rulings for which payment is economic performance) the Commissioner may provide for the application of the recurring item exceptionby regulation, revenue procedure or revenue ruling.vii. TIME AND MANNER OF ADOPTING.A. The recurring item exception is a methodof accounting that must be consistently applied with respect to a type of item,or for all items, from one taxable year to the next in order to clearly reflectincome. B. A taxpayer is permitted to adopt the recurring item exception as part of its method of accounting for any type of item for the first taxable year in which that type of item is incurred.C. FOR TAXABLE YEARS BEGINNING IN 1992, a taxpayer using an accrual method is granted the consent of the Commissioner to change to the recurring item exception method of accounting, or to expand or modify its use of the recurring item exception method.I. Either the 481(a) adjustment method orthe cutoff method, described in Reg. 1.4617T, may be used. See Reg. 1.4615(d)(2). However, the method used must be consistent with the transition method used to implement the payment rule for payment liabilities. 1.4615(d)(2)(i).II. A change to the recurring item exception is indicated by accounting for the item on a timely filed return (includingextensions). III. Automatic consent of the Commissioner is limited to those items accounted for under the recurring item exception me

thod on the timely filed return, unless the taxpayer indicates a wider scope ofchange by filing the statement provided in Q&A7(b)(2) of Reg. 1.4617T.D. FOR TAXABLE YEARS BEGINNING IN 1990 OR 1991, a taxpayer is granted consent of the Commissioner to change to the recurring item exception method, or to expand or modify its use of the method, on eithera timely filed original return for such year or on an amended return for such year filed on or before October 7, 1992.E. FOR TAXABLE YEARS BEGINNING AFTER 1992.Changing to or from the recurring item exception method for accrual method taxpayers requires the consent of the Commissioner, obtained by filing Form 3115 withthe IRS National Office. F. CHANGING FROM THE CASH TO AN ACCRUAL METHOD. Section 5.01 of Rev. Proc. 9860 provides that taxpayers changing from thecash to an accrual method under Rev. Proc. 9860 and desiring to adopt the recurring item exception as part of the change may do so, but only under the provisions of Rev. Proc. 9860. See section VI: Requirements for Changing Accounting Met

hods. h. SPECIAL RULES FOR REAL ESTATE DEVELOPERS. See Notice914 (19911 CB 315), Rev. Proc. 7525 (19751 CB 720), and Rev. Proc. 9229 (119217 IRB 12).


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QUESTIONS FOR CLASS DISCUSSIONA. Treatment Of Income Items Under An Accrual Method.Olga's husband, Ed, is a custom furniture maker, and the owner of Furniture by Ed, Inc. (FBE). FBE is a calendar year, accrual method taxpayer.1. FBE sold a couch in 1998, and accrued the income for book and tax purposes in 1998. In 1999, before the corporate tax return for 1998 was filed, the customer returned the couch because it was not satisfactory, and was given a fullrefund. Can FBE exclude the income from the couch on its tax return for 1998?2. FBE also runs an interior decorating service. Zelda is the company's interior decorator. Zelda's standard billing rate is $50 per hour. Zelda provided10 hours of service to a client in December of 1998 and 30 hours in January of 1999, and did not bill the client until 1999 when all services were performed. How much income must the company accrue in 1998 for the services performed by Zelda?3. FBE sold a building used in its business. The sales price was $150,000.The purchaser obtained third party financing for $140,000 of the purchase price,and FBE agreed to carry a contract on the $10,000 balance. Payments on the $10,000 contract to FBE will not begin until the $140,000 mortgage is paid in full in 15 years. What is FBE's amount realized in the year of the sale?4. With respect to the interior decorating service performed by Zelda, FBEdoes not require the payment of interest or penalties on past due accounts. Assume that FBE has previously adopted the nonaccrualexperience method with respectto its accounts receivable. Further, assume that FBE's total accounts receivable for 1998 and the five preceding taxable years is $330,000, and total bad debtexperience for 1998 and the five preceding taxable years is $66,000. Accounts receivable of $80,000 were earned in 1998, $50,000 of which are still outstandingat the end of 1998. The $50,000 outstanding accounts are as follows:AccountsReceivable1. $12,0002. $10,0003. $15,0004. $ 5,0005. $ 8,000$50,000a. Of the total $50,000 accounts receivable outstanding at the end of 1998, how much must FBE accrue as income?b. If, in 1999, the entire amount of account receivable number 3 becomesworthless, how much can FBE deduct as a bad debt?c. If, in 1999, FBE collects the entire amount of account receivable number 1, how much must be included in income for 1999?5. Zelda, FBE's interior decorator, has contracted with a client to perform

decorating services in a new building being built by the client. FBE was paid in advance for Zelda's services, which began in November of 1998 and will end, according to the contract, no later than one month after the completion of the newbuilding, which is scheduled for completion in October of 1999. Zelda estimatesthat she performed 1/12 of her total services in 1998.a. How much of the prepayment must FBE included in income in 1998?b. Assume the contract specifies that Zelda's services will end no laterthan December 31, 1999. FBE includes the entire prepayment in income for financial statement purposes in 1998. How much of the prepayment must FBE includedin income in 1998?6. FBE accrues income when furniture is shipped for purposes of its financial reports, and accrues income when furniture is delivered and accepted for taxpurposes. In 1998, the company received an advance payment of $5,000 for an order of custom furniture to be manufactured for a total price of $15,000. The furniture was shipped in December of 1998, but is was not delivered to and accepted by the customer until January of 1999.a. How much of the $15,000 contract price must be included by FBE in 199

8, and how much is included in 1999?b. How much of the $15,000 must be included in 1998 if income is accruedfor both book and tax purposes when furniture is accepted?c. How much of the $15,000 must be included in 1998 if the goods were not shipped until January of 1999?7. FBE accrues income when furniture is shipped for purposes of its financial reports and for tax purposes. FBE accounts for advance payments under 1.4515(b)(1)(ii). In 1992, FBE enters into a contract for the sale of custom furniturewith a total contract price of $10,000. Ed estimates that his total inventoriable costs and expenditures under the contract will be $5,000. FBE receives the following advance payments with respect to the contract:1992 $6,0001993 1,0001994 01995 1,0001996 1,0001997 1,000The furniture is shipped in 1998. FBE does not have furniture in closinginventory that will satisfy the order until 1994. What is the first year FBE must include in gross income payments on the contract? (Read Reg. 1.4515(c) verycarefully.)B. Treatment Of Costs And Expense Items.FBE (a calendar year accrual method taxpayer) has not elected to use the recurring item exception under the economic performance rules.1. FBE sells hideabeds under a threeyear warranty that obligates the company to make any reasonable repairs to each hideabed it sells. During 1998, Ed

sold ten hideabeds. Ed estimates that the average cost for repairing each hideabed during the warranty period will be $200. Ed would like to deduct in 1998the estimated repair costs of $2,000 for its 1998 sales.a. Do you see a problem with this?b. What if FBE contracted with Bob's Bed Repair, a cash basis taxpayer,to service the beds. Bob serviced one bed in 1998, and FBE paid Bob $200 for thework in June of 1999. When is the $200 liability deductible by FBE?c. Assume that FBE contracted with Bob's Bed Repair to service the beds,and paid Bob $200 in December of 1998 for servicing one bed, with the understanding the bed would be repaired by the end of February of 1999. When is the liability deductible by Ed?d. Assume that FBE contracted with Bob's Bed Repair to service the beds,and paid Bob $200 in December of 1998 for servicing one bed, with the understanding the bed would be repaired by the end of February of 1999. Bob got the repai


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rs done in June of 1999. When is the liability deductible by Ed?e. What if Bob's Bed repair serviced one bed in 1998 and billed FBE for$200, but FBE considers the repair work defective. FBE contests the liability. To provide for the contingency, FBE establishes a separate bank account in 1998 in its own name and transfers the $200 contested liability to the bank account until the contest is settled. Can FBE deduct the expense in 1998?f. Assume the same facts as in e. above, except that the $200 is transferred to an irrevocable trust in 1998 pursuant to a written agreement among the trustee, FBE and Bob's Bed Repair that the money shall be held until the contestis settled and then disbursed in accordance with the settlement. Can FBE deductthe expense in 1998?2. In November of 1998 FBE contracted with a Minneapolis accounting firm tofurnish its entire office by the end of 1999. This is not a longterm contractunder 460. In 1998 Ed paid a machinery company $20,000 to lease, for one year beginning on January 1, 1999, extra machinery for the contract. Also in 1998, Ed bought materials for the contract at a cost of $30,000. The materials were provided to Ed in 1999. In what year are these costs incurred by FBE?3. FBE purchased some wood at a discount by paying $10,000 for it in advance. Payment was made in October 1998, and the wood is to be delivered in June of1999. a. When does economic performance occur with respect to the wood?b. If FBE sold its furniture making business in November of 1998, including the right to the wood, when does economic performance occur with respect tothe wood?4. FBE entered into a fiveyear lease with Copiers From Heaven, Inc. for the use of a copy machine on July 1, 1998. The lease obligates FBE to pay Copiersa base rental payment of $6,000 per year at the beginning of each lease year andan additional charge of 5 cents per copy 30 days after the end of each lease year. The machine is used to make 50,000 copies during the first lease year: 20,000 copies in 1998 and 30,000 copies from January 1, 1999, to July 1, 1999. FBE paid the $6,000 base rental payment to Copiers on July 1, 1998, and the $2,500 var

iable use payment on July 30, 1999.a. How much can FBE deduct for lease payments for the taxable year 1998?b. What if FBE paid the base rental fee in 1999?5. FBE entered into a barter transaction in 1998 with its attorney, who isa calendar year accrual basis taxpayer. FBE provided the attorney with office furniture valued at $5,000, in exchange for $5,000 of legal services from the attorney. FBE incurred $7,000 in costs with respect to the office furniture providedto the attorney.a. To what extent has economic performance occurred with respect to theproperty provided by FBE?b. Assume that FBE transferred the furniture in 1998. The attorney agreed to provide $5,000 of services to FBE in exchange for the furniture, but had not yet done so at the close of 1998.1) When must FBE report the amount realized with respect to the transfer of furniture?2) When does economic performance occur with respect to the property transferred by FBE?3) Assuming the attorney received the furniture in 1998 without restriction or substantial risk of forfeiture, how much income must the attorney report in 1998?4) What is the attorney's basis in the furniture received in 1998,assuming no costs are incurred by the attorney to provide services in 1998?6. In addition to its own products, FBE sells furniture manufactured by GYP

CO. GYPCO does not guarantee its products. FBE purchases a threeyear insurancepolicy which insures FBE against any claims due to defects in the GYPCO furniture. FBE pays the insurance company the entire premium of $15,000 in January, 1998. a. When does economic performance occur with respect to the insurance policy? b. When is the insurance payment deductible?7. FBE is sued by a customer who is injured when one of FBE's chairs breakswhen the customer tries to sit in it. FBE settles the lawsuit by agreeing to purchase an annuity contract that will pay the injured party $5,000 per year for 25 years. In December of 1998, FBE purchases the annuity for $49,000 and retainsownership of the annuity (it is not constructively received by the customer whenpurchased).a. When does economic performance occur with respect to FBE's liabilityto the customer?b. What would be the tax effects to FBE if it later transferred ownership of the annuity contract to the injured customer?c. Assume Ed sells his furniture business when the FMV of the annuity is$45,000. When does economic performance occur with respect to the annuity payme

nts?8. FBE owns an apartment building as an investment, but Ed has not managedthe building well, and costs have exceeded its cash flow. In 1998, the buildingwas subject to a nonrecourse mortgage in the amount of $500,000. FBE accrued $20,000 of interest and $30,000 of real estate taxes on the property for book purposes in 1998, but was in default on the mortgage and payment of the interest andtaxes. FBE refinanced the loan with the same lender on more favorable terms for$550,000 in 1999, and the lender credited FBE for the accrued interest, and paid the property taxes of $30,000. (One issue here is found in Reg. 1.4614(g)(1)(i).) a. When is the $20,000 of accrued interest deductible by FBE?b. When is the $30,000 of accrued property taxes deductible by FBE?Assume for questions 9 and 10 that FBE has elected to use the recurring item exception rule (under the economic performance rules) with respect to rebates and r


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efunds and real property taxes.9. FBE offers a full refund to any purchaser not satisfied with an item ofFBE's furniture. In 1996, FBE purchased a case of faulty glue, and constructedand sold twenty chairs manufactured with the glue before FBE discovered that itwould not hold a joint. In 1997, each of the twenty chairs fell apart, and eachof the purchasers of the chairs demanded a refund of their $100 purchase price.FBE mailed refund checks totaling $1,000 on September 13, 1998, and the remaining $1,000 is refunded on October 15, 1998.a. How are the refund payments treated if FBE timely files its 1997 taxreturn by the extended due date of September 15, 1998?b. How are the refund payments treated if FBE timely files its 1997 return by March 15, 1998?10. Real property taxes for FBE's factory are assessed and become a lien onDecember 1, but are not payable until March 1 of the following year. On December10, 1996, FBE contested $500 of the $2,000 asserted real property tax that wasassessed and became a lien on December 1, 1996. On March 1, 1997, FBE paid the entire $2,000 to the county. FBE has adopted the recurring item exception described in Reg. 1.4615 as a method of accounting for taxes. In 1998, the contest was settled and FBE received a refund of $100. In what amounts and in what years is the property tax liability deductible?C. The Recurring Item Exception And The Ratable Accrual Method For Real PropertyTaxes.1. Olga's Beauty Salon, Inc. is a calendar year accrual method S corporation. For real property taxes, the lien date on Olga's shop is January 1, 1998. The property tax year is calendar 1998, and tax payment due dates are June 1999 and October 1999. Olga has the following options with respect to her real propertytax deduction: (1) request permission to change to the ratable accrual method for real property taxes under 461(c); (2) request permission to change to the recurring item exception to the economic performance rules under 461(h); or (3) do neither. Under the above facts, which method would provide for the earliest deduct

ion of the real property taxes?2. Assume instead that the lien date is December 31, 1998, the property taxyear is calendar 1999, and the tax payments are due in June 1999 and October 1999. Which method would provide for the earliest deduction of the real property taxes?3. Assume the same facts as in 2 above, but the lien date is January 1, 1999 rather than December 31, 1998. Which method would provide for the earliest deduction of the real property taxes?4. Assume the same facts as in 2 above, but Olga's Beauty Salon is classified as a tax shelter under 461(i)(3). Which method would provide for the earliestdeduction of the real property taxes?Section III ACCRUAL METHODSPAGE PAGE 1Copyright 2007, Gary W. Carter&LS./jk!!h#i#')**-7 7889P:Q:R:g::::HCLCMCOCPCfCGGHIJJ J


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