Sec. 263(a) 12-month rule and economic performance accounting method changes.

• Author: Luchs, Lorin

As has previously been discussed (see Tax Clinic, Fitzpatrick, "Rev. Proc. 2005-9 Extends Automatic Accounting-Method Changes Relating to Intangibles Capitalization," TTA, p. 318, June 2005; Tax Clinic, Borrack and Fitzpatrick, "Guidance on Accounting Method Changes for Intangibles" TTA, p. 330, June 2004; and Tax Clinic, Jagdman, "Final Regs. on Capitalization of Intangibles, TTA, p. 203, April 2004), the final regulations under Sec. 263(a) issued in January 2004 included a 12-month rule (Kegs. Sec. 1.263(a)4(f)), whereby taxpayers are not required to capitalize an expense if it is paid or incurred (see Regs. Sec. 1.263(a)-4(j)) to create a right or benefit that does not extend beyond the earlier of (1) 12 months after the first date of the right or benefit or (2) the end of the tax year following the tax year in which the expense was paid or incurred.

Regs. Sec. 1.263(a)-4(f)(6) makes it clear that, for an accrual-method taxpayer, the 12-month rule does not eliminate the other requirements for deduction--all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.

Example: Corporation X, an accrual-method taxpayer with a calendar tax year, made two prepayments in June 2005. One payment was for a fire and casualty insurance policy; the other was for equipment rental. Both payments covered the period July 1, 2005-June 30, 2006. X is not required to capitalize the portion of the insurance payment attributable to 2006 because of the 12-month rule, and the portion can be deducted in 2005 because the all-events test is met, the amount is determinable with reasonable accuracy, and economic performance was satisfied on payment. The portion of the rental payment attributable to 2006 does not have to be capitalized because of the 12-month rule and, with the all-events and determinable-with-reasonable-accuracy requirements met, it can be deducted in 2005 if the payment satisfies the requirements for the economic performance recurring-item exception under Regs. Sec. 1.461-5.

The Sec. 263(a) regulations provided that for the first tax year ending on or after Dec. 31,2003, taxpayers wishing to change their accounting method to a method consistent with the regulations can make the change using the automatic consent procedure described in Rev. Proc. 2002-9. Accordingly, for example, a calendar-year...