Deducting executory contract expenses.

• Author: Smith, Nathan K.

On Dec. 21, 2006, the IRS released Rev. Rul. 2007-3, which provides guidance on whether the execution of a contract for services or insurance (an executory contract liability) establishes the "fact of the liability" under Sec. 461. The determination of whether a contract for services or insurance establishes the fact of the liability is key in determining the timing for deducting such expenditures for an accrual-basis taxpayer under Regs. Sec. 1.461-1(a)(2)(i).

Background

In general, an accrual-basis taxpayer is allowed a deduction for an otherwise deductible expense in the period in which the following three-pronged test is met (the first two prongs are referred to collectively as the "all-events test"; see Sec. 461(h)(4)):

1. All events have occurred that determine the fact of the liability.

2. The amount of the liability can be determined with reasonable accuracy.

3. Economic performance has occurred with respect to the liability.

Because the all-events test is based on the facts and circumstances as to the nature and extent of the taxpayer's liability, the terms of a contract that may give rise to a liability generally will determine the events that establish the fact of the liability; see, e.g., Decision, Inc., 47TC 58 (1966), acq., 1967-2 CB 2.

The general rule under Regs. Sec. 1.461-4(d)(2) provides that economic performance occurs for a liability arising out of the provision of property or services to the taxpayer by another person as the property or services are provided. Regs. Sec. 1.461-4(g) generally provides that for certain types of liabilities, including those arising out of the provision of insurance to the taxpayer, economic performance occurs as payment is made to the person to whom the liability is owed.

The recurring-item exception of Sec. 461(h) and Regs. Sec. 1.461-5 provides an exception to the general rules of economic performance. If a taxpayer is eligible to use the recurring-item exception for a particular liability and meets all of the requirements, economic performance will be deemed to occur at year-end, to the extent that it actually occurs within 8 1/2 months of year-end.

Thus, if a liability for services or insurance is considered fixed and determinable at year-end, a taxpayer may be able to accelerate economic performance through use of the recurring-item exception, to the extent that economic performance (i.e., payment of the insurance premium or provision of the services) occurs within 8 1/2 months of...