Revenue Procedure 2015-39 provides accrual-method taxpayers a limited opportunity to accelerate the deduction for prepayments for certain ratable service contracts.
Taxpayers using the accrual method of accounting may not deduct an accrued expense any earlier than when all events have established the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance occurs. When the accrued expense relates to services being provided to a taxpayer, this generally is not deemed to happen any earlier than when the services are provided.
Under the new safe harbor, taxpayers may accelerate the deduction for prepaid services when the payment relates to a ratable service contract. A contract is a ratable service contract if all of the following are true:
- The contract provides for similar services to be provided on a regular basis, such as daily, weekly, or monthly.
- Each occurrence of the service provides independent value, such that the benefits of receiving each occurrence of the service are not dependent on the receipt of any previous or subsequent occurrence of the service.
- The term of the contract does not exceed 12 months, excluding options to extend the contract.
If a single contract includes services that meet the requirements of a ratable service contract and services or other items that do not meet the requirements, the services or other items that do not satisfy the ratable service contract requirements must be priced separately in the contract for the contract to qualify as a ratable service contract.
The safe harbor works in conjunction with two rules: the 3.5-month rule and the recurring item exception, which permits a taxpayer to take a liability into account in an earlier year. Under the 3.5-month rule, services can be deemed to be provided in an earlier year so long as it is reasonably expected that the services will be provided within 3.5 months from the date payment is made.
For example, assume a taxpayer enters into a weekly contract with a janitorial service company and makes a payment of $100,000 on Dec. 31, 2015, for services to be provided during 2016. Without the safe harbor, the taxpayer would not be able to claim any deduction for these services in 2015 because none of the services are provided in 2015, and the IRS generally requires all of the services called for under an undifferentiated, nonseverable contract to be provided within 3.5 months of payment. Under the safe harbor, because the taxpayer is paying for regularly provided janitorial services of independent value in a contract not longer than 12 months, the taxpayer can deduct 3.5 months, or $29,167, of the payment in 2015.
Under the recurring item exception, amounts prepaid for services to be provided in the next year are deductible in the current year as long as the services are recurring in nature and provided on or before the earlier of the date the taxpayer files its tax return or 8.5 months after the end of the taxable year. The amount of the deduction also must be immaterial or a current-year deduction that results in a better matching of the expense with the income to which it relates.
Continuing the previous example, the taxpayer can deduct up to 8.5 months of the janitorial contract, or $70,833, in 2015, assuming the taxpayer otherwise meets the recurring item exception. Unfortunately, it is unlikely that many taxpayers will be able to meet the recurring item exception. In Revenue Ruling 2012-1, the IRS stated that if a prepaid service contract is required to be capitalized and deducted over more than one taxable year for financial statement purposes under generally accepted accounting principles, the liability is material for purposes of applying the recurring item exception. The IRS also stated that deducting a prepaid service contract in the year before the services are provided does not result in better matching. Therefore, taxpayers generally will not be able to use the safe harbor in combination with the recurring item exception for prepaid service contracts included on their balance sheet.
Taxpayers wishing to take advantage of this limited opportunity will need to file an automatic consent Form 3115, “Application for Change in Accounting Method,” with their first tax return filed for a tax year ending after July 30, 2015.