Don’t take the deductibility of accrued liabilities lightly. It’s not always as easy as it sounds.
Many accountants struggle with tax deductions related to accrued liabilities. At first glance, they seem simple, but when you look at the details, there are several considerations that require special attention. This is generally a concern for accrual-based taxpayers, as cash-based taxpayers are, for the most part, only allowed to deduct an expense when it is paid.
Three conditions must be met before deductibility can be obtained:
- All the events happened which established the fact of the responsibility.
- The amount of the liability calculation is reasonably accurate.
- Economic performance has taken place.
All events have occurred which established the fact of responsibility
An accrued liability is deductible when it is fixed in place. This means that there is no condition or contingency that calls into question the existence of true liability. The IRS is providing some guidance on this issue through Decision 2007-3. The decision states that the mere execution of a service provision agreement for a given year is not sufficient to satisfy the first point. The execution required by the agreement must be carried out before any regularization.
The amount of the liability calculation is reasonably accurate
An exact measure of the liability is not necessary if a reasonably precise amount can be determined. If it is determined that the exact amount is different, the difference should be taken into account and recognized in a subsequent year in which the exact determination is made.
Economic performance has occurred
While items one and two are simpler, item three can be more complicated. We will examine the nuances of several cases of regularization.
In most cases, economic performance occurs when the party to be compensated has done what it takes to earn that compensation. Economic performance may vary for different types of liabilities and taxpayers may choose to address some, but not all, liabilities except for recurring items. Under this provision, taxpayers can deduct an accumulated charge if the first two elements above have been met and the economic performance (depending on the category of expenditure, it is not necessarily the payment) occurs before the first. of the 8.5 months, or the deposit of the return. The expense should be what can generally be expected to be incurred year after year. Applying this exception requires a choice to be made, and once the choice is made, treatment should be followed consistently in the future.
Accrued rents / accrued interest
For accrual accounting purposes, these two expenses are generally treated the same. The economic performance is achieved in proportion to the duration for the use of the good (for the rental) and for the sums paid on the sums borrowed (for the interest). The concept of a recurring item exception does not apply to rental charges because this economic performance has not occurred since the property has not yet been used for this future period. Treasury regulations prohibit the use of the recurring item exception with respect to accrued interest.
The economic performance of services occurs as these services are provided. The recurring item exception can be applied to these accruals with a caveat; taxpayers should keep in mind the requirement to provide the service (not payment for those services) within the first of 8.5 months or filing the return.
Accumulated compensation (salaries, bonuses, vacation and severance pay)
With regard to accumulated remuneration, that is to say remuneration paid after the end of the financial year, the deduction of these expenses is included in the deferred remuneration rules. The general rule is that the deduction is not allowed until the individual has been paid. However, an exception to the rule allows the deduction of deferred compensation paid within 2.5 months of the end of the year. Keep in mind that economic performance is always at stake, which means any compensation accrued should be for services rendered before the end of the year. The recurring item exception does not apply to deferred compensation.
Accumulated workers’ compensation, tort payments, violation of law, breach of contract, discounts, insurance, prizes / rewards and guarantees
The first four of these regularizations are simple. Economic performance can only occur when these expenses are paid. The recurring item exception does not apply.
Likewise, the economic performance criteria for discounts, insurance, prices / premiums and guarantees are not met until payment is made. However, the recurring element exception can be applied if the choice has been made and the payment of one of these four expenses has been made no earlier than the 8.5 months or the filing of the return, the deduction is eligible.