Economic performance.

• Author: Nellen, Annette
• Position: Part 1

It's Only Part of the Picture

In 1992, final regulations under Sec. 461(h), the economic performance rules, were issued. Because economic performance is part of the picture in determining when an accrual method taxpayer may treat an item as incurred, with this picture now complete, taxpayers can deal with the entire framework and how it may have changed in light of the economic performance regulations.

This article will explain the sequence of steps an accrual method taxpayer must take to determine whether an item has been "incurred." Although Sec. 461 is typically thought of as dealing with the timing of deductions, and in fact is entitled "General Rule For Taxable Year Of Deduction," its application is much broader. Sec. 461(h) serves to determine when a liability has been incurred so that a taxpayer will know whether to consider it as a deduction (if it is deductible) or to add it to basis (if it is a capitalizable item).(1) The flowchart on pages 196-197 shows how an accrual method taxpayer deals with the question, "When is a liability incurred?" The flowchart is a simplified version of the rules interspersed in the Sec. 461 regulations and the Code. It begins with the steps that are most likely to lead to the answer, "No, not incurred yet," as there is no point going through more complicated steps first, only to reach "no" at a later step. Steps 1 through 6 of the flowchart are covered in Part I, below; Steps 7 through 10 will be discussed in Part II to be published next month. Sec. 461(h) and the Sec. 461 regulations provide that under the accrual method of accounting, a liability is incurred in the tax 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.

   Items 1 and 2 are known as the "all events test" according to Sec. 4611(h)(4), or the "fixed and determinable" requirement. Although the above items are not specifically numbered, that sequence is suggested in Regs. Sec. 1.461-1(a)(2)(i). However, the Sec. 461 analysis is simpler if the three items are considered in reverse order. For example, item 1, the "fixed" part, can be a complex determination and has led to many disputes between the Service and taxpayers. However, with the addition of the economic performance requirement in 1984, many of these disputes are less significant. For example, in the 1977 case, World Airways,(2) the application of the fixed part of the all events test was in dispute. The Tax Court held that the liability was not fixed for the expected costs of overhauling airplane engines until a certain number of miles had been flown. Thus, the airline was not able to accrue the expected costs as each mile was flown. If the economic performance requirement had been in effect before 1984, World Airways and the Service would have had no dispute because that requirement would not have been met until the work was actually performed. This outcome is not unusual since the economic performance requirement often serves to delay the time when a liability is incurred. This is why taxpayers can simplify the application of the three items by considering the economic performance requirement first. In addition, the economic performance requirement is a simpler determination than the all events test.

   However, the economic performance test does not eliminate the need to consider the all events test. In addition, several other items must be considered, such as whether the timing of the deduction reflects consistent application of a method of accounting, whether the payment involves a related party and whether the expenditure must be capitalized because it creates an asset. All parts of the Sec. 461 analysis must be met before an item is considered "incurred."(3)

   Sec. 461 Analysis

   The 10 steps of the Sec. 461 analysis (see the flowchart) are explained below and in May, along with examples. According to Regs. Sec. 1.461-1(a)(2)(i), this analysis is also necessary in the determination of a corporation's earnings and profits (E&P).

   * Step 1: Is the liability of a type not subject to the Sec. 461 analysis?

   Under Regs. Sec. 1.461-1(a)(2)(iii), the following liabilities are not subject to the rules of Sec. 461 or its regulations; instead, the rules provided in the specified section determine when the amount is considered incurred.

   * Sec. 165: Losses. * Sec. 170: Charitable contributions. * Sec. 192: Black lung benefit trusts. * Sec. 194A: Employer liability trusts. * Sec. 468: Mining and solid waste disposal reclamation and closing costs. * Sec. 468A(a): Certain nuclear decommissioning

   costs. * Various: Amounts allowable under the Code as a deduction for a reserve for estimated expenses, such as Sec. 585. Example 1: W Corporation, an accrual method taxpayer, agreed to make a $12,000 donation to charity within the next three months. W would determine the proper time to deduct the $12,000 by following the rules of Sec. 170; Sec. 461 would not apply.

   Note that depreciation rules are not part of this list. However, Regs. Sec.1.461-1(a)(2)(ii) states that if an "incurred" item is capitalizable, depreciation rules would then be considered to compute taxable income. Thus, the Sec. 461 analysis is performed first to determine whether an item potentially affecting basis has been incurred; if it has, the Sec. 461 analysis is complete and other rules (such as Sec. 168) may be considered.

   An issue that could arise in Step 1 is distinguishing between Sec. 162 deductions and Sec. 165 losses, which is not always an easy task.(4) However, it is necessary because Sec. 165 losses are not subject to the Sec. 461 analysis, while Sec. 162 deductions are. Generally, Sec. 165(a1 permits a deduction for the cost of property acquired in carrying on a business that is not deductible under Sec. 162 and not recoverable under disposition or depreciation rules. However, this statement is limited in the case of illegal payments and penalties that would not be deductible or capitalizable.(5)

   Example 2: A professional law corporation reimburses a client for a loss it suffered due to an attorney's error. Is this expenditure a Sec. 162 item or a Sec. 165 loss, or neither?(6)

   * Step 2: Is the liability either deductible or capitalizable?

   This question is addressed early in the Sec. 461 analysis because if an expenditure is neither deductible nor capitalizable, it is not necessary to know when it is incurred, unless the taxpayer needs to calculate E&P. Sec. 161 permits deductions for items specified in part VI (Secs. 161 to 196) of Subchapter B of Chapter 1 of the Code, subject to the exceptions enumerated in part IX (Secs. 261 to 280H). For example, no further analysis is necessary if the expenditure is disallowed under Sec. 265(a)(2) as interest related to tax-exempt income. If an item is not deductible, the next determination is whether it is capitalizable. If it is capitalizable, the Sec. 461 analysis is continued in order to determine basis.

   Some expenditures are neither deductible nor capitalizable. For these expenditures, the Sec. 461 analysis ends at Step 2. For example, a fine paid to a government for the violation of any law is not deductible under Sec. 162(f), and thus it is not necessary to analyze when the liability was incurred (unless the taxpayer is measuring E&P). A nondeductible fine is also not capitalized because doing so would result in a tax benefit on disposition.(7) According to the Service, an ordinary and necessary trade or business expense may be capitalized only if it is otherwise deductible under Sec. 162.(8) The Sec. 461 analysis must be continued for expenditures that are partially disallowed, such as meal and entertainment expenses subject to the Sec. 274(n) 50% disallowance.

   Deposits: Arguably, if the payee (recipient) has a deposit, rather than income, the payor does not have a deduction. In Rev. Rul. 79-229,(9) the Service held that whether or not an expenditure was a payment or a deposit depended on the particular facts and circumstances. If the expenditure is not refundable and is made pursuant to an enforceable sales contract, it will be considered a payment and not a deposit. If the payment is refundable, it will likely be viewed as a...