December 31st? January 1st? What's the Difference?

Alonzo Bertron (May, 2017)

Most of the time it's "just a timing difference," but sometimes timing makes ALL the difference when you want to save on taxes.  When it comes to recognizing income and claiming deductions, the recipe is simple, -ish.  Most taxpayers want to defer income for as long as possible, and accelerate deductions as fast as possible.  Generally that mindset makes for good tax planning.  However, when planning you need to look at the big picture and the nuances involved, so if you are interested in some year-end, or even mid-year, planning please do not hesitate to contact a tax professional or your trusted advisor at Dermody, Burke & Brown, CPAs. 

Before you can do any planning though, you need to understand the rules that constrain the deductions you take, and when.  If you don't know the rules then you're either stuck with what you've got, or worse, you're stuck with an audit.  The first step to learning the rules is understanding your method of accounting.  For a cash basis taxpayer the rules are simpler; deduct it when you pay it, with some exceptions.  For an accrual basis taxpayer the rules are more complex and will be the subject of this article. 

For an accrual basis taxpayer the timing of your deductions is primarily dictated by the rules laid out in the Internal Revenue Code's Section 461(Sec. 461) and the Regulations surrounding it.  Sec. 461, like all tax legislation, is plagued with rules that only apply in specific cases and exceptions for every rule that are just as specific.  So for the purposes of this article, and the sake of sanity, we will focus on the two general guidelines provided in Sec. 461 (h):

  1. The all events test, and
  2. The requirements of economic performance

The All Events Test

The all events test dictates that all events must occur before an expense becomes deductible.  So what are "all" these events?  Per Sec. 461 they are all the events that establish two things with respect to a deduction; the fact of the liability and a reasonably accurate measurement of that liability.  If that seems incredibly unhelpful, that's because it is. 

To establish "the fact of a liability" an event must establish its existence and your obligation with regards to it.  Once the fact is established, measurement is just the dollar value you can expect to be required to pay and it can be as simple or as complex as the situation of the transaction allows.  The key is that when the payment amount is uncertain it precludes you from passing the all events test.

To illustrate, let's consider two scenarios:

Scenario 1:  You sign a binding contract which states that you will purchase 10 or 15 items from a vendor for $100 or $150 depending on an independent event to occur later.  In this situation the all events test is not passed upon signing the contract.  A liability has been established, however the measurement is uncertain.  The test will not be passed until this secondary event comes to pass and the quantity and price are established.  The fact of a liability exists at signing, but its measurement is uncertain.

Scenario 2:  You sign a binding contract which states that you will purchase 10 items from a vendor for $100.  In this situation you would think that the all events test is passed upon signing the contract.  You have established the fact of the liability, you will purchase 10 items, and in the contract the measurement of that liability is clearly stated at $100.  Both parts of the test are established upon signing.  So you can claim your deduction now…right?  Not quite. 

Unfortunately Sec. 461(h) adds an additional requirement for the occurrence of economic performance prior to actually passing the all events test and claiming your deduction.  So what is economic performance?

Economic Performance

Economic performance is usually a simple concept.  It is the delivery or accomplishment of the goods or services that the liability applies to.  In our two scenarios above economic performance would occur upon delivery of the items of the contract, once ownership passes from the vendor to you.  It is upon this delivery that your deduction is realizable. 

What About Planning?

For most transactions the time from inception of a deal to the achievement of economic performance is never going to pass through our minds.  The only time we really care is at the end of the year.  When you have a good year there is always a scramble to purchase that piece of equipment you need so you can spend your money on something productive while lowering your tax burden.  In those final months it is imperative that you meet the tests and requirements of Sec. 461 or you could see your deduction deferred until next year.  We all know that not every year is a "good" year so it is important that those big planning deductions are deductible in the correct year, otherwise they might not do nearly as much work for you.

Exceptions and Special Rules

I promised I wouldn't discuss them, and I won't, but just to prove I'm not lying and to show that the rules in tax are never clear cut, here are a few of the gems Sec. 461 sprinkles in:

  1. Special rule in case of death, Sec 461(b)
  2. Special rule for accrued real property taxes, Sec 461(c)
  3. The recurring item exception, Sec. 461(h)
  4. Limit on excess farm losses for certain taxpayers, Sec. 461(j)

And the list goes on. 

Clearly every situation is different and the determination of deductibility relies on a certain level of judgement the more complex a transaction becomes.  Not only that, but the Code includes other Sections with numerous rules which build upon the guidance of Sec. 461, establishing further exceptions.  Due to this evolving complexity it becomes critical to analyze your situation from all directions and make fully informed determinations come planning time.  So please contact Dermody, Burke and Brown, CPAs to help you navigate your year.

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