Part I. Rulings — Internal Revenue Bulletin 2007-4

Section 446.—General Rule for Methods of Accounting

This revenue procedure provides procedures by which a taxpayer may obtain automatic consent to change its method of accounting for services or insurance under section 461 to comply with Rev. Rul. 2007–3, page 350, this Bulletin. See Rev. Proc. 2007-14, page 357.

26 CFR 1.446–1: General rule for methods of ac- counting.

May a taxpayer change its method of accounting under § 446(e) of the Internal Revenue Code for depreciable or amortizable property after its disposition? See Rev. Proc. 2007-16, page 358.

Section 461.—General Rule for Taxable Year of Deduction

26 CFR 1.461–1: General rule for taxable year of deduction. (Also §§ 1.461–4, 1.461–5.)

Executory contract liabilities. This ruling provides guidance on when a taxpayer using an accrual method of accounting incurs a liability for services or insurance under section 461 of the Code.

Rev. Rul. 2007–3

ISSUES

(1) Under § 461 of the Internal Revenue Code, when does a taxpayer using an accrual method of accounting incur a liability for services?

(2) Under § 461, when does a taxpayer using an accrual method of accounting incur a liability for insurance?

FACTS

X is a corporation that uses an accrual method of accounting and files its federal income tax returns on a calendar year basis.

Situation 1 . On December 15, 2006, X executes a contract with Y for the provision of services. The contract provides for services to begin on January 15, 2007, and end on January 31, 2007. Under the terms of the contract, payment for the services is due to Y on January 15, 2007, and X pays Y for the services on January 15, 2007. X uses the recurring item exception under § 1.461–5.

Situation 2 . On December 15, 2006, X executes a contract with W, an insurance company regulated under state law, for the provision of insurance. The insurance contract covers the period from January 15, 2007, through December 31, 2007. Under the terms of the contract, payment of the insurance premium is due to W on January 15, 2007, and X pays the premium to W on January 15, 2007. X uses the recurring item exception under § 1.461–5.

LAW

Section 461(a) provides that the amount of any deduction or credit must be taken for the taxable year that is the proper taxable year under the method of accounting used by the taxpayer in computing taxable income.

Section 1.461–1(a)(2)(i) of the Income Tax Regulations provides that, under an accrual method of accounting, a liability is incurred, and is generally taken into account for federal income tax purposes, in the taxable year in which (1) all the 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 with respect to the liability (the “all events test”). See also § 1.446–1(c)(1)(ii)(A).

The first prong of the all events test requires that all the events have occurred that establish the fact of the liability. Therefore, it is fundamental to the all events test that although expenses may be deductible before they become due and payable, liability first must be firmly established. United States v. General Dynamics Corp., 481 U.S. 239, 243–4 (1987). Generally, under § 1.461–1(a)(2), all the events have occurred that establish the

fact of the liability when (1) the event fixing the liability, whether that be the required performance or other event, occurs, or (2) payment therefore is due, whichever happens earliest. Rev. Rul. 80–230, 1980–2 C.B. 169; Rev. Rul. 79–410, 1979–2 C.B. 213, amplified by Rev Rul. 2003–90, 2003–2 C.B. 353. The terms of a contract are relevant in determining the events that establish the fact of a taxpayer’s liability. See, e.g., Decision, Inc. v. Commissioner, 47 T.C. 58 (1966), acq., 1967–2 C.B. 2. Section 461(h) and § 1.461–4 provide that, for purposes of determining whether an accrual basis taxpayer can treat the amount of any liability as incurred, the all events test is not treated as met any earlier than the taxable year in which economic performance occurs with respect to the liability.

Section 1.461–4(d)(2) provides that if a liability of a taxpayer arises out of the providing of services or property to the taxpayer by another person, economic performance occurs as the services or property is provided.

Section 1.461–4(g)(5) provides that if a liability of a taxpayer arises out of the provision to the taxpayer of insurance, economic performance occurs as payment is made to the person to which the liability is owed.

Section 1.461–5(b)(1) provides a recurring item exception to the general rule of economic performance. Under the recurring item exception, a liability is treated as incurred for a taxable year if: (i) at the end of the taxable year, all events have occurred that establish the fact of the liability and the amount can be determined with reasonable accuracy; (ii) economic performance occurs on or before the earlier of (a) the date that the taxpayer files a return (including extensions) for the taxable year, or (b) the 15th day of the ninth calendar month after the close of the taxable year; (iii) the liability is recurring in nature; and (iv) either the amount of the liability is not material or accrual of the liability in the taxable year results in better matching of the liability against the income to which it relates than would result from accrual of

2007–4 I.R.B. 350 January 22, 2007

DRAFTING INFORMATION

The principal author of this revenue ruling is Leta A. Ayres of the Office of Associate Chief Counsel (Income Tax & Accounting). For further information regarding this revenue ruling, contact Ms. Ayres at (202) 622–5020 (not a toll-free call).

Section 481.—Adjustments Required by Changes in Method of Accounting

Section 1016.—Adjust- ments to Basis

26 CFR 1.1016–3: Exhaustion, wear and tear, ob- solescence, amortization, and depletion for periods since February 28, 1913.

Does the allowed or allowable rule under § 1016(a)(2) of the Internal Revenue Code permanently affect a taxpayer’s lifetime income for purposes of determining whether a change in depreciation or amortization is a change in method of accounting? See Rev. Proc. 2007-16, page 358.

Section 1274A.—Special Rules for Certain Transactions Where Stated Principal Amount Does Not Exceed $2,800,000

26 CFR 1.1274A–1: Special rules for certain trans- actions where stated principal amount does not ex- ceed $2,800,000. (Also §§ 483, 1274, 7872.)

Section 1274A – Inflation adjusted numbers for 2007. This ruling provides the dollar amounts, increased by the 2007 inflation adjustment, for section 1274A of the Code. Rev. Rul. 2005–76 supplemented and superseded.

Rev. Rul. 2007–4

This revenue ruling provides the dollar amounts, increased by the 2007 inflation adjustment, for § 1274A of the Internal Revenue Code. This ruling also provides that the Internal Revenue Service will no

the liability in the taxable year in which economic performance occurs.

ANALYSIS

Situation 1 . In Situation 1, the first event that occurs to establish the fact of X ’s liability for services is that payment is due under the contract on January 15, 2007. See Rev. Rul. 80–230; Rev. Rul. 79–410. Thus, for purposes of § 461, the fact of the liability is established on January 15, 2007. At that time, the amount can be determined with reasonable accuracy. Economic performance with respect to the liability occurs as the services are provided, from January 15, 2007, through January 31, 2007. See § 1.461–4(d)(2). Therefore, X incurs a liability for services in 2007.

The fact of the liability is not established in 2006, even though X executed the service contract on December 15, 2006. It is well established that an accrual basis obligor is not permitted to deduct an expense stemming from a bilateral contractual arrangement, that is, mutual promises, prior to the performance of the contracted for services by the obligee. Rev. Rul. 80–182, 1980–2 C.B. 167, citing Levin v. Commissioner, 21 T.C. 996 (1954), aff’d, 219 F.2d 588 (3d Cir. 1955) (an agreement for services to be performed in the next year did not establish the fact of the taxpayer’s liability but was simply an agreement under which a liability would be incurred in the future) and Amalga- mated Housing Corp. v. Commissioner, 37 B.T.A. 817 (1938), aff’d per curium, 108 F.2d 1010 (2d Cir. 1940) (an agreement to renovate property in the future did not establish the fact of the taxpayer’s liability; the accrual was for services in renovating, not the duty to renovate). Thus, the mere execution of the contract by X in 2006 is not sufficient, by itself, to establish the fact of the liability. Further, the recurring item exception does not apply because the fact of the liability is not established in 2006. Situation 2 . In Situation 2, the first event that occurs to establish the fact of X ’s liability for insurance is that the premium is due under the contract. See Rev. Rul. 80–230; Rev. Rul. 79–410. Thus, for purposes of § 461, the fact of the liability is established on January 15, 2007. At that time, the amount can be determined with reasonable accuracy. Economic per

formance with respect to the liability occurs as payment is made, on January 15, 2007. See § 1.461–4(g)(5). Therefore, X incurs a liability for insurance in 2007.

The fact of the liability is not established in 2006, even though X executed the insurance contract on December 15, 2006. See Rev. Rul. 80–182. Although federal or state regulations may impose certain legal obligations on taxpayers, those obligations, without more, do not necessarily establish the fact of a taxpayer’s liability under § 461. See Chrysler Corp. v. Commis- sioner, 436 F.3d 644 (6th Cir. 2006) (statutory obligation related to warranty obligation was not sufficient to establish the fact of the taxpayer’s liability to provide warranty services). Further, the recurring item exception does not apply because the fact of the liability is not established in 2006.

HOLDINGS

(1) Under § 461, all the events have occurred that establish the fact of the liability for services provided to the taxpayer when (1) the event fixing the liability, whether that be the required performance or other event, occurs, or (2) payment is due, whichever happens earliest. The mere execution of a contract, without more, does not establish the fact of a taxpayer’s liability for services.

(2) Under § 461, all the events have occurred that establish the fact of the liability for insurance when (1) the event fixing the liability, whether that be the required performance or other event, occurs, or (2) payment is due, whichever happens earliest. The mere execution of a contract, without more, does not establish the fact of a taxpayer’s liability for insurance.

APPLICATION

A change in the treatment of liabilities for services or insurance to comply with this revenue ruling is a change in method of accounting within the meaning of §§ 446 and 481 and the regulations issued thereunder. Accordingly, a taxpayer that wants to change its treatment of liabilities for services or insurance to comply with this revenue ruling must obtain the consent of the Commissioner under § 446(e) and § 1.446–1(e)(2)(i) by following the procedures in Rev. Proc. 2007–14, page 357, this Bulletin.

January 22, 2007 351 2007–4 I.R.B.

Section 1274A(d)(2) provides that, for any debt instrument arising out of a sale or exchange during any calendar year after 1989, the dollar amounts stated in § 1274A(b) and § 1274A(c)(2)(A) are increased by the inflation adjustment for the calendar year. Any increase due to the inflation adjustment is rounded to the nearest multiple of $100 (or, if the increase is a multiple of $50 and not of $100, the increase is increased to the nearest multiple of $100). The inflation adjustment for any calendar year is the percentage (if any) by which the CPI for the preceding calendar year exceeds the CPI for calendar year 1988. Section 1274A(d)(2)(B) defines the CPI for any calendar year as the average of the Consumer Price Index as of the close of the 12-month period ending on September 30 of that calendar year.

INFLATION-ADJUSTED AMOUNTS UNDER § 1274A

For debt instruments arising out of sales or exchanges after December 31, 1989, the inflation-adjusted amounts under § 1274A are shown in Table 1.

longer publish the inflation adjustment under § 7872(g)(2) because of amendments made to § 7872 by the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), Pub. L. No. 109–222, 120 Stat. 345, and the Tax Relief and Health Care Act of 2006, Pub. L. No. 109–432, 120 Stat. 2922.

BACKGROUND

In general, §§ 483 and 1274 determine the principal amount of a debt instrument given in consideration for the sale or exchange of nonpublicly traded property. In addition, any interest on a debt instrument subject to § 1274 is taken into account under the original issue discount provisions of the Code. Section 1274A, however, modifies the rules under §§ 483 and 1274 for certain types of debt instruments.

In the case of a “qualified debt instrument,” the discount rate used for purposes of §§ 483 and 1274 may not exceed 9 percent, compounded semiannually. Section 1274A(b) defines a qualified debt instrument as any debt instrument given in consideration for the sale or exchange of property (other than new § 38 property within the meaning of § 48(b), as in effect on the day before the date of enactment of the Revenue Reconciliation Act of 1990) if the

stated principal amount of the instrument does not exceed the amount specified in § 1274A(b). For debt instruments arising out of sales or exchanges before January 1, 1990, this amount is $2,800,000. In the case of a “cash method debt instrument,” as defined in § 1274A(c), the borrower and lender may elect to use the cash receipts and disbursements method of accounting. In particular, for any cash method debt instrument, § 1274 does not apply, and interest on the instrument is accounted for by both the borrower and the lender under the cash method of accounting. A cash method debt instrument is a qualified debt instrument that meets the following additional requirements: (A) In the case of instruments arising out of sales or exchanges before January 1, 1990, the stated principal amount does not exceed $2,000,000; (B) the lender does not use an accrual method of accounting and is not a dealer with respect to the property sold or exchanged; (C) § 1274 would have applied to the debt instrument but for an election under § 1274A(c); and (D) an election under § 1274A(c) is jointly made with respect to the debt instrument by the borrower and lender. Section 1.1274A–1(c)(1) of the Income Tax Regulations provides rules concerning the time for, and manner of, making this election.

2007–4 I.R.B. 352 January 22, 2007

after 2010. Section 425 of the Tax Relief and Health Care Act of 2006 amended § 7872(h) by striking subsection (4), making the § 7872(h) exception for loans to qualified continuing care facilities permanent.

EFFECT ON OTHER DOCUMENTS

Rev. Rul. 2005–76, 2005–2 C.B. 1072, is supplemented and superseded.

DRAFTING INFORMATION

The author of this revenue ruling is Richard C. LaFalce of the Office of the Associate Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling, please contact Mr. LaFalce at (202) 622–3930 (not a toll-free call).

INFLATION-ADJUSTED AMOUNTS UNDER § 7872(g)(2)

The Service will no longer publish the inflation adjustment under § 7872(g)(2), regarding the amount that a taxpayer may lend to a qualifying continuing care facility without incurring imputed interest, because of amendments made to § 7872 by TIPRA and the Tax Relief and Health Care Act of 2006.

Section 7872(g)(2) provides an exception for certain below-market loans to qualified continuing care facilities only to the extent that the aggregate outstanding amount of any loan to which § 7872(g)(1) applies (determined without regard to § 7872(g)(2)), when added to the aggregate outstanding amount of all other previous loans between the lender (or the lender’s spouse) and any qualified contin

uing care facility to which § 7872(g)(1) applies, does not exceed $90,000. Section 7872(g)(5) generally provides that, for loans made during any calendar year after 1986 to which § 7872(g)(1) applies, the $90,000 limit specified in § 7872(g)(2) is increased by an inflation adjustment.

Section 7872(g)(6) generally suspends the application of § 7872(g) for any calendar year to which § 7872(h), as amended by TIPRA, applies. Section 7872(h) generally provides that § 7872 shall not apply for any calendar year to any below-market loan owed by a facility which on the last day of such year is a qualified continuing care facility, if such loan was made pursuant to a continuing care contract and if the lender (or the lender’s spouse) attains age 62 before the close of such year. Section 7872(h)(4) provided that paragraph (h) shall not apply for any calendar year

January 22, 2007 353 2007–4 I.R.B.