Prepaid services must be fully completed to use 3 1/2-month rule.

• Author: Fiore, Nicholas J.

At the end of year 1, T enters into a 12-month service contract with X. Under the contract, X will provide services to T until the end of year 2. At the end of year 1, when the contract is executed, T makes a prepayment to X for a portion of the services to be provided in year 2. On its Federal income tax return for year 1, T deducted the prepayment as an expense, citing either the 3 1/2-month rule or the recurring-item exception as authority.

Analysis

Sec. 461 provides general rules that govern the year of deduction. Regs. Sec. 1.461-1 (a)(2) states that, under an accrual method, a liability is incurred, and generally is taken into account for Federal income tax purposes, 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 (the all-events test). Sec. 461(h)(1) provides that, in determining whether an amount has been incurred with respect to any item during any tax year, the all-events test shall not be treated as met any earlier than when economic performance with respect to such item occurs. (This request for advice relates to the economic performance requirement of the all-events test only. It does not address whether the liability for services would be fixed or determinable with reasonable accuracy.)

Sec. 461(h) (2) (A) provides that if a taxpayer's liability arises out of the provision of services to the taxpayer by another person, economic performance occurs as such person provides such services. Under this general rule, economic performance would occur for the prepaid services as the services are provided to T. Although payment was made in year 1, economic performance generally would not occur until year 2, when the services were provided. However, there are two exceptions to the general economic-performance rule applicable to service liabilities.

Exception

One exception is the so-called 3 1/2-month rule in Kegs. Sec. 1.461-4(d) (6)(ii), which allows a taxpayer to treat services or property as being provided (i.e., as economic performance) as the taxpayer makes payment to the person providing the services or property, if the taxpayer can reasonably expect the person to provide the services or property within 3 1/2 months after the date of payment.

Thus, T could treat the year 1 prepayment for services as economic performance as long as it can...