Taxpayers primarily focus on the ability to take a deduction. Another consideration, however, is the timing of the deduction. Section 461 provides the rules for when a deduction can be taken based on both the timing regime the taxpayer has elected and the facts and circumstances surrounding the deduction.

Most taxpayers use the cash method. For cash method taxpayers, pursuant to Treas. Reg. Sec. 1.461-1(a)(1), “amounts representing allowable deductions shall, as a general rule, be taken into account for the taxable year in which paid.” That means cash method taxpayers can generally take a deduction in the year in which the expense is paid.

In contrast, some taxpayers elect or must use the accrual method. Under this method, pursuant to Treas. Reg. Sec. 1.461-1(a)(2), “a liability . . . is incurred, and generally is taken into account for Federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and the economic performance has occurred with respect to the liability.” The first portion of this requirement is referred to as the “all events test.”

Section 461(h) provides more guidance on when “the economic performance has occurred with respect to the liability.” Where the liability arises out of providing services or providing property, or the use of property by the taxpayer, economic performance occurs at the time of the provision of the services or property or the use of the property. Section 461(h)(2)(A). However, if the liability requires the taxpayer to provide property or services, economic performance occurs “as the taxpayer provides such property or services.” Section 461(h)(2)(B). Finally, in the case of a liability of the taxpayer that requires a payment to another person and arises out of any workers compensation act or tort, economic performance occurs as the payments are made. Section 461(h)(2)(C).

Section 461(h)(4) provides guidance on the all events test, stating “the all events test is met with respect to any item if all events have occurred which determine the fact of liability and the amount of such liability can be determined with reasonable accuracy.” Treas. Reg. §. 1.461-1(a)(2)(ii) explains the exact amount of the liability not being determined does not prevent a taxpayer from deducting the portion of the liability that can be computed with reasonable accuracy within the taxable year. The example provided involves a $10,000 liability, of which the taxpayer admits liability for $6,000 but contests the remainder. In that case, $6,000 can be taken as a current year deduction, while the remainder contested portion cannot.

John G. Hodnette is an attorney with Fox Rothschild in Charlotte.

August 14, 2023/by TAX