The sec. 461 all-events test: timing for deducting accrued warranty claims.

• Author: Kinkaid, Amy I.

Many companies that offer warranties for their products or services are required to accrue a warranty liability at the end of the year when preparing the companies' financial statements. Practitioners must carefully consider several tests under Sec. 461 to determine the deductibility of accrued warranty expense for tax purposes, paying particular attention to whether a fixed liability actually exists at the end of the year. The practitioner must analyze and document whether the all-events test has been met and economic performance has occurred before considering whether the recurring item exception applies to the accrued warranty liability.

Sec. 461(h): The All-Events Test and Economic Performance

Taxpayers can deduct an accrued expense for tax purposes only after the all-events test has been met and economic performance has occurred.

Under Sec. 461(h), a three-prong all-events test is met when (1) all 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.

Sec. 461(h)(2)(A) and Regs. Sec. 1.461-4(d)(3) state that economic performance occurs when the taxpayer receives services or property or uses property another party provided. Sec. 461(h)(2)(B) states that economic performance also occurs when the taxpayer provides property or services to another party.

A company's liability for warranties provided to its customers is deductible for tax purposes when the all-events test has been met and economic performance has occurred. The expense must fulfill the first prong of the all-events test, and it is essential that all facts have occurred that establish the liability. It must be clear that the taxpayer has incurred an obligation to render the warranty service. The expense is not currently deductible if it is subject to contingencies. The obligation to provide warranty service must be fixed and determinable, but the service does not need to be performed by the end of the year to be deductible.

Sec. 461 (h)(3): Recurring Item Exception

Sec. 461(h)(3) provides for an exception as to when economic performance occurs. Sec. 461(h)(3) states that an expense is incurred and deductible in the tax year if the all-events test is met during the year, and economic performance occurs within the shorter of a reasonable period after the close of the tax year or 8% months after the close of the tax year. Additionally, the item must be recurring, and the taxpayer must consistently treat similar items as incurred in the tax year. The expense must also not be material, or the accrual of the expense in the tax year must result in a better match against income than accruing the item in the tax year when economic performance occurs.

Taxpayers may think that the recurring item exception alone will secure a current deduction for warranty work However, the courts make it clear that the recurring item exception in Sec. 461(h)(3) requires taxpayers to prove that they have satisfied the...