Part I. Rulings — Internal Revenue Bulletin 2012-2

identification number, acceptance agent, and authorized e-file provider programs. These regulations only finalize the user fee to take the registered tax return preparer competency examination.

The notice of proposed rulemaking announced a public hearing on October 7, 2011. Four individuals testified at the public hearing. The testimony at the hearing focused on the proposed fingerprinting user fee. No individual at the hearing offered testimony on the competency examination user fee.

Treasury and the IRS received written comments responding to the notice of proposed rulemaking. These comments are available for public inspection at http://www.regulations.gov or upon request. After consideration of all the comments, the proposed regulations are adopted as modified by this Treasury decision.

Summary of Comments and Explanation of Revisions

Treasury and the IRS received more than twenty written comments in response to the notice of proposed rulemaking. Treasury and the IRS received four written comments relating to the user fee to take the registered tax return preparer competency examination. The majority of the written comments concerned the user fee to be fingerprinted in conjunction with the preparer tax identification number, acceptance agent, and authorized e-file provider programs. Treasury and the IRS also received a few comments regarding other aspects of the IRS’s efforts to regulate tax return preparers. To the extent that comments address other aspects of the IRS’s increased oversight of the tax return preparation industry, the comments will be addressed, as appropriate and practicable, in future guidance. Further, some of the comments received related to testing locations and whether an online examination would be offered. The IRS received similar comments in response to Notice 2011–48, 2011–26 I.R.B. 927 (June 27, 2011) available at www.irs.gov/pub/irs-irbs/irb11–26.pdf, which specifically requested comments regarding the registered tax return preparer

26 CFR 300.0: User fees; in general.

T.D. 9559

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 300

User Fee to Take the Registered Tax Return Preparer Competency Examination

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains amendments to the user fee regulations. The final regulations redesignate rules pertaining to fee for obtaining a preparer tax identification number. These final regulations also establish a user fee for individuals to take the registered tax return preparer competency examination. The final regulations affect individuals who take the registered tax return preparer competency examination. The charging of user fees is authorized by the Independent Offices Appropriations Act of 1952.

DATES: Effective Date: These regulations are effective beginning November 25, 2011. Applicability Date: For date of applicability, see §300.12(d).

FOR FURTHER INFORMATION CONTACT: Concerning the final regulations, Emily M. Lesniak at (202) 622–4570; concerning cost methodology Eva J. Williams at (202) 435–5514 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document contains final regulations establishing a user fee to take the registered tax return preparer competency examination. New §300.12 establishes a $27 IRS user fee to take the registered tax

return preparer competency examination; this IRS user fee is in addition to any reasonable, IRS-approved fee charged by the third-party vendor. These regulations also redesignate prior §300.12 as §300.13.

The Independent Offices Appropriations Act of 1952 (IOAA), which is codified at 31 U.S.C. 9701, authorizes agencies to prescribe regulations establishing user fees for services provided by the agency. Regulations prescribing user fees are subject to the policies of the President, which are currently set forth in the Office of Management and Budget Circular A–25 (the OMB Circular), 58 FR 38142 (July 15, 1993). The OMB Circular requires agencies seeking to impose user fees for providing special benefits to identifiable recipients to calculate the full cost of providing those benefits.

These regulations are part of a broader IRS effort to increase the oversight of the tax return preparer community. As part of this effort, Treasury and the IRS published final regulations in the Federal Register (T.D. 9527, 2011–27 I.R.B. 1

[76 FR 32286]) on June 3, 2011, amending the regulations governing practice before the IRS. These regulations are found in 31 CFR part 10 and have been reprinted as Treasury Department Circular No. 230 (Circular 230). The amendments to Circular 230, in part, include registered tax return preparers as practitioners under Circular 230. Registered tax return preparers must demonstrate the necessary qualifications and competency, which includes passing a minimum competency examination. Registered tax return preparers receive the special benefit of being able to prepare and sign tax returns, claims for refund, and other documents as provided in forms, instructions, or other appropriate guidance.

On September 26, 2011, Treasury and the IRS published a notice of proposed rulemaking (REG–116284–11, 2011–43 I.R.B. 598) in the Federal Register (76 FR 59239) proposing a user fee to take the registered tax return preparer competency examination. The notice of proposed rulemaking also proposed to establish a user fee to be fingerprinted in conjunction with the preparer tax

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agent, and authorized e-file provider programs by and large expressed concern with the IRS’s plan to fingerprint participants in these programs generally, as well as the imposition and amount of the proposed user fee. In light of the significant issues raised at the hearing and in the written comments received on the fingerprinting user fee, Treasury and the IRS have decided not to finalize the proposed user fee to be fingerprinted in conjunction with the preparer tax identification number, acceptance agent, and authorized e-file provider programs at this time. Rather, Treasury and the IRS will consider alternatives as to how the IRS can best implement the Circular 230 provision authorizing the IRS to conduct a suitability check to become a registered tax return preparer. In evaluating these alternatives, consideration will be given to how the suitability check achieves the goals of increasing oversight of the tax return preparer community and how the suitability check can be conducted most efficiently while not creating undue burden on the individual applicants and the firms or other entities that employ them. Thus, Treasury and the IRS are still interested in receiving further comments regarding the use of fingerprinting as part of the suitability check to become a registered tax return preparer. If the result of this reconsideration will require any individual to pay a user fee in conjunction with the implementation of the suitability check, including a possible fingerprinting requirement, Treasury and the IRS will publish a new notice of proposed rulemaking with respect to this user fee.

Treasury and the IRS adopt the proposed regulations after eliminating the proposed user fee to be fingerprinted in conjunction with the preparer tax identification number, acceptance agent, and authorized e-file provider programs. The portion of the proposed regulations pertaining to the user fee to take the registered tax return preparer competency examination is adopted without substantive modification.

Effective/Applicability Date

The Administrative Procedure Act provides that substantive rules will not be effective until thirty days after the final regulations are published in the Federal Reg- ister (5 U.S.C. 553(d)). Final regulations

competency examination. The IRS and the competency examination vendor continue to consider these comments, along with other comments received in response to Notice 2011–48, as they implement the competency testing program. The IRS is committed to addressing the concerns expressed in these comments to the extent practical and appropriate.

One comment regarding the proposed user fee to take the registered tax return preparer competency examination encouraged Treasury and the IRS to monitor the fee charged by the third-party vendor. The third-party vendor’s fee is approved by the IRS, including any changes to the vendor’s fee. Thus, the IRS will be aware of any possible fee changes and will approve the final vendor fee.

Three comments related to the total cost and the components of the user fee to take the registered tax return preparer competency examination. These comments expressed a general concern that the fee may be a financial burden on tax return preparation businesses. One commentator requested that a definitive, specific fee amount be provided and expressed confusion over whether a single user fee covers multiple attempts to take the examination. Another commentator stated that the fee was duplicative for preparers who are independently tested under an employer’s program, and requested that the IRS develop a process to review and certify employer testing programs.

Treasury and the IRS have considered these comments, and for the reasons described in this preamble, the portion of the proposed regulations relating to the user fee for the competency examination is finalized without substantive change.

As stated earlier in this preamble, the OMB Circular generally requires agencies to recover the full cost of providing a special benefit to an identifiable recipient. The full cost to the IRS to administer the registered tax return preparer competency examination is $27 per applicant each time the applicant takes the examination. The costs to the IRS to administer the competency examination include conducting background checks on employees of the third-party vendor who are involved in the administration of the examination and the personnel, administrative, management, and information technology costs to the IRS for developing and reviewing

the competency examination, overseeing the competency examination, validating the competency examination results, and establishing a review procedure for applicants who contest any portion of the competency examination. The IRS will make expenditures for all of these costs associated with the competency examination and, thus, is generally required to recover these costs through a user fee as provided by the OMB Circular. The IRS will inform the public of the total finalized testing fee amount before the test becomes available. Because each examination-sitting will involve the same costs, a user fee will be charged each time an applicant takes the examination.

Further, these regulations are part of Treasury’s and the IRS’s effort to increase oversight of the tax return preparer industry based upon findings and recommendations made by the IRS in Publication 4832, “Return Preparer Review” (the Report), which was published on January 4, 2010. All individuals who wish to become a registered tax return preparer must pass the competency examination because, during the implementation process, Treasury and the IRS concluded that all registered tax return preparers should be subject to uniform standards of qualification and practice, which includes demonstrating a minimum level of competency. When obtaining tax return preparation services, taxpayers should know that all registered tax return preparers are subject to the same federal regulations and standards, regardless of where the registered tax return preparer is employed or in what state the individual resides. Requiring all registered tax return preparers to fulfill the same competency examination requirements ensures that all registered tax return preparers have met the same minimum competency standards. Additionally, requiring all registered tax return preparers to pass the IRS approved competency examination addresses concerns raised by several commentators during the IRS’s study of the tax return preparation industry about the potential for unfairness if certain tax return preparers are exempt from these requirements. Accordingly, Treasury and the IRS do not believe that a process to review and certify employer testing is appropriate.

The comments on the user fee to be fingerprinted in conjunction with the preparer tax identification number, acceptance

January 9, 2012 253 2012–2 I.R.B.

petency testing in the proposed regulations that preceded these final regulations. Treasury and the IRS did receive comments from the public on the proposed regulations in general. A summary of these comments along with Treasury’s and the IRS’s assessment of the issues raised in the comments and descriptions of any revisions resulting from the comments is set forth elsewhere in this preamble under the Summary of Comments and Explanation of Revisions heading.

A description and an estimate of the number of small entities to which the rule will apply or an explanation of why an estimate is not available .

These final regulations affect all individuals who want to become a registered tax return preparer under the new oversight rules in Circular 230. Only individuals, not businesses, can practice before the IRS or become a registered tax return preparer. Thus, the economic impact of these regulations on any small entity generally will be a result of applicants owning a small business or a small entity employing applicants. The NAICS code that relates to tax preparation services (NAICS code 541213) is the appropriate code for the registered tax return preparer program. Entities identified as tax preparation services are considered small under the Small Business Administration size standards (13 CFR 121.201) if their annual revenue is less than $7 million. The IRS estimates that approximately 350,000 individuals will become registered tax return preparers. The IRS estimates that approximately 70 to 80 percent of the individuals who apply to become registered tax return preparers are operating as or employed by small entities.

A description of the projected report- ing, recordkeeping, and other compliance requirements of the rule, including an esti- mate of the classes of small entities subject to the requirements and the type of profes- sional skills necessary for preparation of a report or record.

The final regulations do not directly impose any reporting or recordkeeping requirements on any small entities. The final regulations, however, require certain tax return preparers to pay a user fee to take the registered tax return preparer competency examination. Small entities may be affected by these costs if the entities

may be effective prior to thirty days after publication if the publishing agency finds that there is good cause for an earlier effective date.

This regulation is part of the IRS’s continued efforts to implement the recommendations in the Report. The recently published amendments to Circular 230 established registered tax return preparers as practitioners under Circular 230 and required that individuals must pass a competency examination, among other requirements, to become a registered tax return preparer. Before the competency examination can be offered, the competency examination user fee must be in place. Further, to enable the IRS to begin designating individuals as registered tax return preparers in time for the 2012 filing season, the competency examination user fee must be finalized significantly before the 2012 filing season.

Thus, the Treasury and the IRS find that there is good cause for these regulations to be effective upon the publication of these final regulations in the Federal Register .

Special Analyses

It has been determined that these final regulations are not a significant regulatory action as defined in Executive Order 12866, as supplemented by Executive Order 13563.

It has been determined that a final regulatory flexibility analysis under 5 U.S.C. 603 is required for this final rule. The analysis is set forth under the heading, “Final Regulatory Flexibility Analysis.”

Pursuant to 26 U.S.C. 7805(f), the notice of proposed rulemaking preceding these final regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business. The Chief Counsel for Advocacy did not submit comments on the notice of proposed rulemaking.

FINAL REGULATORY FLEXIBILITY ANALYSIS

When an agency either promulgates a final rule that follows a required notice of proposed rulemaking or promulgates a final interpretative rule involving the internal revenue laws that imposes a collection of information requirement on small entities as described in 5 U.S.C.

603(a), the Regulatory Flexibility Act (5 U.S.C. chapter 6) requires the agency to “prepare a final regulatory flexibility analysis.” A final regulatory flexibility analysis must, pursuant to 5 U.S.C. 604(a), contain the five elements listed in this final regulatory flexibility analysis. For purposes of this final regulatory flexibility analysis, a small entity is defined as a small business, small nonprofit organization, or small governmental jurisdiction. See 5 U.S.C. 601(3)-(6). The Treasury and the IRS conclude that the final regulations (together with other contemplated guidance provided for in these regulations) will impact a substantial number of small entities and the economic impact may be significant.

A statement of the need for, and the ob- jectives of, the final rule .

The Treasury and the IRS are implementing regulatory changes that increase the oversight of the tax return preparer industry based upon findings and recommendations in the Report. These regulatory changes include establishing registered tax return preparers as Circular 230 practitioners. Individuals who wish to become a registered tax return preparer must pass a competency examination. Individuals who pass the competency examination and become a registered tax return preparer will receive a special benefit that the general public does not receive because a registered tax return preparer is allowed to prepare and sign Form 1040 series returns (and accompanying schedules) for compensation. The regulations under section 6109 (75 FR 60309) in conjunction with Notice 2011–6, 2011–3 I.R.B. 315 (January 17, 2011), provide that only attorneys, certified public accountants, enrolled agents, and registered tax return preparers can prepare and sign all or substantially all of a Form 1040 series return (and accompanying schedules) for compensation. This final rule recovers the full costs to the IRS to oversee the registered tax return preparer competency examination.

Summaries of the significant issues raised in the public comments responding to the initial regulatory flexibility analysis and of the agency’s assessment of the is- sues, and a statement of any changes made to the rule as a result of the comments .

Treasury and the IRS received no public comments responding to the initial regulatory flexibility analysis related to com

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cost for overseeing the examination and does not include any fees charged by the administrator of the examination.

(c) Person liable for the fee . The person liable for the competency examination fee is the applicant taking the examination.

(d) Effective/applicability date . This section is applicable beginning November 25, 2011.

Steven T. Miller, Deputy Commissioner for Services and Enforcement.

Approved November 21, 2011.

Emily S. McMahon, Acting Assistant Secretary of the Treasury (Tax Policy).

(Filed by the Office of the Federal Register on November 22, 2011, 11:15 a.m., and published in the issue of the Federal Register for November 25, 2011, 76 F.R. 72619)

Section 461.—General Rule for Taxable Year of Deduction

26 CFR 1.461–4: Economic performance.

Recurring item exception to the all events test. This ruling clarifies the treatment of certain liabilities under the recurring item exception to the economic performance requirement under section 461(h)(3) of the Code. It also addresses the application of the “not material” and “better matching” requirement of the recurring item exception in the context of a lease and a service contract each having a term of one year. The ruling distinguishes contracts for the provision of services from insurance and warranty contracts and applies the recurring item exception differently. Rev. Proc. 2011–14 modified and amplified.

Rev. Rul. 2012–1

ISSUES

Under the situations described below: (1) Is the amount of X’s liability material for purposes of the recurring item exception in §461(h)(3) of the Internal Revenue Code if the liability accrues over more than one taxable year for financial accounting purposes?

(2) For purposes of the recurring item exception, does the accrual of X’s liability

choose to pay some or all of these fees for their employees.

Under the amendments to Circular 230, tax return preparers may also incur costs for exam preparation courses, plus incidental costs, such as for travel and accommodations, in order to obtain the designation of registered tax return preparer under Circular 230. Course prices can vary greatly, from free to hundreds of dollars. Many small tax return preparation firms may choose, as with the user fee, to bear these costs for their employees. In some cases, small entities may lose sales and profits while their employed tax return preparers attend exam preparation classes or are studying and sitting for the examination. Some small entities that employ tax return preparers may even need to alter their business operations if a significant number of their employees cannot satisfy the necessary registration and competency requirements. Treasury and the IRS conclude, however, that only a small percentage of small entities, if any, may need to cease doing business or radically change their business model due to these final regulations.

A description of the steps the agency has taken to minimize the significant eco- nomic impact on small entities consistent with the stated objectives of applicable statutes, including a statement of the fac- tual, policy, and legal reasons for select- ing any alternative adopted in the final rule and why other significant alternatives af- fecting the impact on small entities that the agency considered were rejected .

Treasury and the IRS are not aware of any steps that could be taken to minimize the economic impact on small entities that would also be consistent with the objectives of these final regulations and have determined that there is no viable alternative to these final regulations. These regulations do not impose any more requirements on small entities than are necessary to effectively administer the internal revenue laws. Further, the regulations do not subject small entities to any requirements that are not also applicable to larger entities covered by the regulations.

The IOAA authorizes the charging of user fees for agency services, subject to policies designated by the President. The OMB Circular implements presidential policies regarding user fees and encourages user fees when a government agency

provides a special benefit to a member of the public. As Congress has not appropriated funds to the registered tax return preparer program, there are no viable alternatives to the imposition of user fees, which fees recover the costs to the IRS for providing the special benefits associated with the registered tax return preparer program.

Drafting Information

The principal author of these regulations is Emily M. Lesniak, Office of the Associate Chief Counsel (Procedure and Administration).

- - - -

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 300 is amended as follows:

Part 300—USER FEES

Paragraph 1. The authority citation for part 300 continues to read in part as follows:

Authority: 31 U.S.C. 9701. Par. 2. Section 300.0 is amended by redesignating paragraph (b)(12) as paragraph (b)(13) and adding new paragraph (b)(12) to read as follows:

§300.0 User fees; in general .

- - - (b) - - (12) Taking the registered tax return preparer competency examination.

§300.12 [Redesignated as §300.13]

Par. 3. Redesignate §300.12 as §300.13.

Par. 4. Adding new §300.12 to read as follows:

§300.12 Registered tax return preparer competency examination fee .

(a) Applicability . This section applies to the competency examination to become a registered tax return preparer pursuant to 31 CFR 10.4(c). (b) Fee . The fee for taking the registered tax return preparer competency examination is $27, which is the government

January 9, 2012 255 2012–2 I.R.B.

formance occurs as the services or property is provided.

Section 1.461–4(d)(3)(i) provides that if the liability of a taxpayer arises out of the use of property by the taxpayer, economic performance occurs ratably over the period of time the taxpayer is entitled to the use of the property.

Section 1.461–4(g)(5) provides that if the liability of a taxpayer arises out of the provision to the taxpayer of insurance, or a warranty or service contract, economic performance occurs as payment is made to the person to which the liability is owed. A warranty or service contract is a contract that a taxpayer enters into in connection with property bought or leased by the taxpayer, pursuant to which the other party to the contract promises to replace or repair the property under specified circumstances. Section 1.461–4(g)(5)(i).

Section 461(h)(3)(A) and § 1.461–5(b) provide 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 timely 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 (A) the amount of the liability is not material or (B) the accrual of the liability in the taxable year results in a better matching of the liability with the income to which it relates than would result from accruing the liability for the taxable year in which economic performance occurs. Section 461(h)(3)(B) provides that in making a determination under the materiality and matching requirements, the treatment of the liability on financial statements shall be taken into account.

Section 1.461–5(b)(4)(i) provides that in determining whether a liability is material, consideration is given to the amount of the liability in absolute terms and in relation to the amount of other items of income and expense attributable to the same activity. Section 1.461–5(b)(4)(ii) provides that a liability is material if it is material for financial statement purposes under gener

over more than one taxable year result in better matching of the liability with related income if X generates the related income in its trade or business over more than one taxable year and the liability accrues over more than one taxable year for financial accounting purposes?

(3) Is X’s liability that arises under a service contract properly characterized as a “liability arising out of the provision of services” under § 1.461–4(d)(2), rather than a “liability arising out of the provision of a warranty or service contract” under § 1.461–4(g)(5)?

(4) Does the recurring item exception apply to X’s liability to provide services pursuant to a service contract that is characterized as a “liability arising out of the provision of services” under § 1.461–4(d)(2)?

FACTS

X is a corporation that uses an accrual method of accounting, including the recurring item exception provided in § 461(h)(3) and § 1.461–5, for federal income tax purposes. X files its federal income tax returns on a calendar year basis and prepares annual financial statements in accordance with generally accepted accounting principles.

On July 1, 2011, X enters into a one-year lease agreement for property it will use in its trade or business to generate income over the period of the lease. The lease of the property begins on July 1, 2011, and continues through June 30, 2012. The terms of the lease agreement require X to pay $50,000, the entire balance of the lease liability, on July 1, 2011, and X pays the $50,000 on that date. X ’s financial statements account for the lease agreement by recognizing the $50,000 expense ratably over the one-year period of the lease.

In conjunction with entering into the lease agreement, X also enters into a one-year service contract with a maintenance company unrelated to the lessor of the property. The service contract begins on July 1, 2011, and continues through June 30, 2012. Under the terms of the service contract, the maintenance company will inspect and clean the leased property monthly and provide any necessary repair and maintenance services relating to the normal wear and tear or routine mainte

nance of the property. The services to be provided to X under the service contract are general services to be provided on an ongoing and recurring basis. The terms of the service contract require X to pay $2,400, the entire balance of the liability, on July 1, 2011, and X pays the $2,400 on that date. X ’s financial statements account for the service contract by recognizing the $2,400 expense as the services are provided over the one-year period of the contract.

X reasonably expects that it will enter into similar leases and service contracts on a recurring basis in the future.

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 in computing taxable income.

Section 1.461–1(a)(2)(i) provides that, under an accrual method of accounting, a liability is incurred, and 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 (requirements (1) and (2) are collectively referred to as the “all events test”), and (3) economic performance has occurred with respect to the liability. See also § 1.446–1(c)(1)(ii)(A). 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 is due, whichever happens earliest. Rev. Rul. 2007–3, 2007–1 C.B. 350; 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.

Section 461(h)(1) and § 1.461–4(a)(1) 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)(i) provides that if the liability of a taxpayer arises out of the providing of services or property to the taxpayer by another person, economic per

2012–2 I.R.B. 256 January 9, 2012

X has determined that under generally accepted accounting principles, its lease liability should be recognized ratably over the period of the lease, and thus accrues the liability on its financial statements over the period of the lease. Furthermore, X uses the leased property in its trade or business to generate income over the period of the lease. In addition, absent overriding facts or circumstances that indicate that accrual in the earlier year would result in better matching, the accrual of the lease liability in a year prior to the satisfaction of economic performance will not result in a better matching of the liability with the related income as compared to accruing the liability for the taxable year in which economic performance occurs. Because X ’s lease liability is material under § 1.461–5(b)(1)(iv)(A), and because it does not satisfy the matching requirement of § 1.461–5(b)(1)(iv)(B), X cannot use the recurring item exception to treat its lease liability as incurred in 2011.

Service Contract Liability

On July 1, 2011, all the events have occurred that establish the fact of X ’s service contract liability (because X ’s payment is due under the service contract on that date) and the amount of the service contract liability can be determined with reasonable accuracy. The applicable economic performance rule depends on whether the service contract liability arises out of the provision of services to X under § 1.461–4(d)(2)(i) (a “service liability”), or whether the liability arises out of the provision to X of a warranty or service contract under § 1.461–4(g)(5) (a “payment liability”). Further, the matching requirement of the recurring item exception applies differently depending on whether the service contract liability is a service liability under § 1.461–4(d)(2)(i) or a payment liability under § 1.461–4(g)(5).

Section 1.461–4(g)(5)(i) defines a warranty or service contract as a contract that a taxpayer enters into in connection with property bought or leased by the taxpayer, pursuant to which the other party to the contract promises to replace or repair the property under specified circumstances. The term “specified circumstances” implies the occurrence of a unique or irregular circumstance necessitating the repair or replacement of property. Thus, the war

ally accepted accounting principles. Section 1.461–5(b)(4)(iii) provides that a liability that is immaterial for financial statement purposes under generally accepted accounting principles may be material for purposes of the materiality requirement of the recurring item exception.

Section 1.461–5(b)(5)(i) provides that in determining whether the matching requirement of the recurring item exception is satisfied, generally accepted accounting principles are an important factor, but are not dispositive. Section 1.461–5(b)(5)(ii) provides that in the case of a liability described in § 1.461–4(g)(5) (insurance, warranty or service contract), the matching requirement of the recurring item exception is deemed satisfied.

ANALYSIS

Lease liability

On July 1, 2011, all the events have occurred that establish the fact of X ’s lease liability (because X ’s payment is due under the lease agreement on that date) and the amount of the lease liability can be determined with reasonable accuracy. Because the lease liability arises out of the use of property provided to X, economic performance occurs ratably over the period of time that X is entitled to use the property. Section 1.461–4(d)(3)(i). Therefore, unless the recurring item exception applies, X ’s lease liability is incurred ratably over the one-year lease period beginning July 1, 2011 and ending June 30, 2012. To apply the recurring item exception to its lease liability, X must, in part, demonstrate either that the lease liability is immaterial or that recognizing the liability in a year prior to the ratable use of the property results in a better matching of the expense to the related income. In determining whether a liability is immaterial, the legislative history of the recurring item exception provides:

If an item is considered material for financial statement purposes, it will also be considered material for tax purposes. For example, assume that a calendar-year taxpayer enters into a one-year maintenance contract on July 1, 1985. If the amount of the expense is prorated between 1985 and 1986 for financial statement purposes, it should be prorated for tax purposes. If, however,

the full amount is deducted in 1985 for financial statement purposes because it is not material under generally accepted accounting principles, it may (or may not) be considered an immaterial item for purposes of [the recurring item] exception. H.R. Conf. Rep. 98–861, at 874 (1984) (original formatting omitted). The example in the legislative history makes clear that a liability is material under the recurring item exception if it is deemed sufficiently material for financial statement purposes so that it accrues over more than one taxable year.

Consistent with the legislative history, and with the directive in § 461(h)(3)(B) that the treatment of a liability on financial statements be taken into account, § 1.461–5(b)(4)(ii) provides that a liability is material if it is material for financial statement purposes under generally accepted accounting principles. Because X ’s lease liability accrues over more than one taxable year for financial statement purposes under generally accepted accounting principles, the lease liability is material for purposes of applying the recurring item exception. Therefore, to apply the recurring item exception to its lease liability, X must demonstrate that recognizing the liability in a year prior to the ratable use of the property results in a better matching of the liability to the income to which it relates than would result from accrual of the liability in the taxable year in which economic performance occurs.

In determining whether the matching requirement of the recurring item exception is satisfied, the treatment of a liability on financial statements must be taken into account. Section 461(h)(3)(B). Generally accepted accounting principles are an important factor, but are not dispositive. Section 1.461–5(b)(5)(i). Accruing a liability over more than one taxable year results in better matching than accrual in a single, earlier year if: (1) the liability accrues over more than one taxable year for financial accounting purposes under generally accepted accounting principles; (2) the liability relates to income that a taxpayer generates in its trade or business over more than one taxable year; and (3) there are no overriding facts or circumstances that indicate accrual of the full liability in the earlier year results in a better match with the income.

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in “specified circumstances.” This revenue ruling does not address the tax treatment for a mixed service and warranty contract.

HOLDINGS

(1) For purposes of the recurring item exception in § 461(h)(3), the amount of X ’s lease liability is material.

(2) For purposes of the recurring item exception, the accrual of X ’s lease liability over more than one taxable year results in better matching of the liability with related income.

(3) X ’s service contract liability is properly characterized as a liability arising out of the provision of services to the taxpayer under § 1.461–4(d)(2), rather than as a liability arising out of the provision to the taxpayer of a warranty or service contract under § 1.461–4(g)(5).

(4) The recurring item exception does not apply to X ’s service contract liability.

APPLICATION

Any change in a taxpayer’s method of accounting to conform to any of the holdings in this revenue ruling is a change in method of accounting to which the provisions of §§ 446 and 481 and the regulations thereunder apply. A taxpayer that wants to change its method of accounting to conform to any of the holdings in this ruling must follow the automatic change in accounting method provisions of Rev. Proc. 2011–14, 2011–4 C.B. 330, with the following modifications:

(1) The scope limitations in section 4.02 of Rev. Proc. 2011–14 do not apply to a taxpayer that wants to make the change for its first taxable year ending on or after December 13, 2011, provided an issue is not under consideration, as defined in section 3.09 of Rev. Proc. 2011–14, regarding whether all the events have occurred that establish the fact of the liability; and

(2) For purposes of section 6.02(4) of Rev. Proc. 2011–14, the taxpayer must include on line 1a of the Form 3115 the designated automatic accounting method change number “161.”

EFFECT ON OTHER DOCUMENTS

Rev. Proc. 2011–14 is modified and amplified to include this automatic change in section 19 of the APPENDIX.

ranty and service contracts contemplated in § 1.461–4(g)(5) are similar to insurance contracts, which also are characterized by the occurrence of a unique or irregular circumstance necessitating the repair or replacement of property. The regulations recognize this similarity by treating insurance, warranty contracts, and service contracts collectively as a single category of payment liability under § 1.461–4(g)(5).

The service contracts addressed in § 1.461–4(g)(5)(i) are distinguishable from contracts for general services that are provided on an ongoing and recurring basis. This distinction is reinforced in the deemed matching rule of § 1.461–5(b)(5)(ii), which provides that the matching requirement is deemed satisfied only for certain payment liabilities, including service contract liabilities addressed in § 1.461–4(g)(5). Deemed matching for these types of liabilities is appropriate because a liability is triggered only by the occurrence of a unique or irregular circumstance. In contrast, a deemed matching rule would be inappropriate for services that are performed on an ongoing and recurring basis and contribute to the taxpayer’s income-generating activities over a certain period.

The services to be provided to X under the terms of the service contract are general services to be provided on an ongoing and recurring basis rather than services to be provided only in “specified circumstances.” Therefore, X ’s service contract liability is a service liability under §1.461–4(d)(2)(i), rather than a payment liability under §1.461–4(g)(5), for purposes of applying the economic performance rules. Accordingly, under § 1.461–4(d)(2), economic performance of X ’s service contract liability occurs as the services are provided to X over the term of the contract.

To apply the recurring item exception to its service contract liability, X must, in part, demonstrate either that its liability is not material or that recognizing the liability in a year prior to the performance of the services results in a better matching of the expense to the related income. In determining whether a liability is not material, § 461(h)(3)(B) provides that financial statement treatment is considered, and both the legislative history of § 461(h)(3) and § 1.461–5(b)(4)(ii) provide that a li

ability is material if it is material for financial statement purposes under generally accepted accounting principles. Because X’s service contract liability accrues 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. Therefore, to apply the recurring item exception to its service contract liability, X must demonstrate that recognizing the liability in a year prior to the performance of the services results in a better matching of the liability to the income to which it relates than would result from accruing the liability in the taxable year in which economic performance occurs. The deemed matching rule for certain payment liabilities in §1.461–5(b)(5)(ii) does not apply to X ’s service contract liability because X ’s liability does not arise out of the provision of a warranty or service contract under §1.461–4(g)(5).

In determining whether the matching requirement of the recurring item exception is satisfied, generally accepted accounting principles are an important factor, but not dispositive. Section 1.461–5(b)(5)(i). Under generally accepted accounting principles, X has determined that its service contract liability should be recognized as services are provided over the period of the contract. Furthermore, the services provided to X are used in the ongoing operation of X’s trade or business to generate income over the period of the contract. Absent any other overriding facts or circumstances that would indicate better matching, the accrual of the service contract liability in a year prior to the satisfaction of economic performance will not result in a better matching of the liability with the related income as compared to accruing the liability for the taxable year in which economic performance occurs. Because X ’s service contract liability is material under § 1.461–5(b)(1)(iv)(A), and because it does not satisfy the matching requirement of § 1.461–5(b)(1)(iv)(B), X cannot use the recurring item exception to treat its service contract liability as incurred in 2011. Some contracts call for services to be performed on a recurring basis and for additional performance to be provided only

2012–2 I.R.B. 258 January 9, 2012

DRAFTING INFORMATION

The principal author of this revenue ruling is Charles H. Kim of the Office of

the Associate Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact

Charles H. Kim at (202) 622–5020 (not a toll-free call).

January 9, 2012 259 2012–2 I.R.B.