The Accrual Method
Learn about the complex and technically demanding accrual method of taxpayer accounting.
In this lesson, we'll touch on the accrual method of tax accounting. As we learned in our lesson on the cash method, a taxpayer using the cash method of tax accounting generally reports income for the year it's received and claims deductions for the year the corresponding expenses are paid. See 26 C.F.R. § 1.446–1(c)(1)(ii). Very often, that's not true of the accrual method, though it sometimes is.
Reporting Income Generally
An accrual-method taxpayer must report income for the year in which two requirements are satisfied. This two-pronged test is often called the all-events test. First, each event necessary to fix the taxpayer's right to receive the income has occurred. Second, it's possible to determine the income's amount with reasonable accuracy. Id.
Typically, the first requirement is deemed satisfied on the earliest of three events, which are when the necessary performance takes place, when the payment becomes due, or when payment is made. Rev. Rul. 83-106, 1983-2 C.B. 77 (1983).
For a very simple example, suppose a taxpayer, a professional consultant, enters a consulting agreement with a client. In December of year one, the taxpayer performs the services. In January of year two, the taxpayer sends the client a bill for $2,000, indicating that payment is due in February. The client fully pays the bill in March of year two.
Under the accrual method, the taxpayer reports the $2,000 of income in her tax return for year one. That's because she rendered performance in year one, and the amount due is ascertainable.
The all-events test doesn't require a legally enforceable obligation, but only a fixed right to receive payment. For instance, a casino using the accrual method generally must report income for the year when the all-events test is satisfied concerning a customer's gambling debts to the test, even if gambling debt is unenforceable under state law. See id.; Flamingo Resort, Inc. v. United States, 664 F.2d 1387 (9th Cir. 1982).
Special Rule for Bad Debt
There's a special rule for bad, or uncollectible, debt. If there arises substantial uncertainty about whether the taxpayer will ever receive the income, and the uncertainty exists when the all-events test is satisfied, the taxpayer need not report the income. But if the uncertainty arises only after the all-events test is satisfied, then the taxpayer must report the income and may be entitled to a bad-debt deduction. Rev. Rul. 80-361, 1980-52 I.R.B. 13 (1980). Substantial uncertainty usually requires strong evidence that the taxpayer's debtor has become financially unstable or insolvent. Rev. Rul. 83-106, 1983-2 C.B. 77 (1983).
Sometimes, an accrual-method taxpayer will receive payment in one year for services or property to be provided in later years. For instance, a taxpayer might receive the full premium for a five-year insurance policy in year one. Under the general rules, the taxpayer would report the entire prepayment as income for, at the latest, the year of receipt.
But the nuances here are hard to nail down. Still, we can glean two somewhat oversimplified observations from the cases.
First, if an accrual-method taxpayer receives prepayment for services to be provided at fixed, predetermined times, some courts have been open to allowing the taxpayer to defer reporting the income until the corresponding services are performed. See Artnell Co. v. Comm'r of Internal Revenue, 400 F.2d 981 (7th Cir. 1968); Tampa Bay Devil Rays, Ltd. v. Comm'r of Internal Revenue, T.C. Memo. 2002-248, 2002 WL 31163108 (Sept. 30, 2002). But see I.R.S. Action on Decision, In Re: Artnell Co., 1971 WL 29312 (Jul. 27, 1971).
Second, if the services are to be performed on the customer's demand, not at fixed times, courts have required the taxpayer to report the entire prepayment as income for the year of receipt, absent specific exception in the tax laws. See Schlude v. Comm'r of Internal Revenue, 372 U.S. 128 (1963).
Suppose a baseball team sells prepaid season tickets. Each ticket costs $1,000 and covers ten games, for an average cost of $100 per game. In year one, a spectator buys a season ticket for two home games to occur in year one, three to occur in year two, and five in year three. The games are scheduled for fixed dates and times. The taxpayer may report $200 of income in year one, $300 in year two, and $500 in year three. See Artnell Co., 400 F.2d 981; Tampa Bay Devil Rays, Ltd., 2002 WL 31163108.
But suppose an accrual-method taxpayer provides roadside assistance to its members on demand. Membership dues are $500 per year. In year one, a member prepays $1,500 for three years of membership. The taxpayer must report the entire prepayment as income for year one, absent specific statutory exception. See Schlude, 372 U.S. 128.
Incidentally, there is a limited, elective exception for prepaid dues to some membership organizations, and another for prepaid subscriptions. See 26 U.S.C. §§ 455-56.
Now, let's cover deductions in the accrual method. Generally, deductions are reported for the year in which three requirements are satisfied. Somewhat confusingly, this test is also called the all-events test. First, each event establishing the taxpayer's liability for the deductible expense has transpired. Second, the liability's amount is determinable with reasonable accuracy. And third, economic performance on the liability has occurred. 26 C.F.R. § 1.446–1(c)(1)(ii).
Let's elaborate on the first and third requirements. The first is generally satisfied on the earlier of two events. First, each event needed to establish and fix the taxpayer's liability has occurred, which may include contractual performance. Second, payment comes due. Rev. Rul. 2007-3, 2007-1 C.B. 350 (2006).
If the taxpayer contests the liability, the first requirement generally isn't satisfied until the contest is resolved. See Dixie Pine Prods. Co., 320 U.S. 516 (1944). A contest is any act by which the taxpayer affirmatively raises a bona fide dispute over the liability's accuracy or validity to someone asserting it. Examples include filing suit or even sending written protest with payment. See 26 C.F.R. § 1.461–2(b)(2).
A taxpayer may pay a liability though she contests it, for instance, to stop interest from accruing while litigation is pending. Federal tax law generally allows an accrual-method taxpayer to claim the corresponding deduction in the year of payment. 26 U.S.C. § 461(f). If the taxpayer later recovers any part of the payment, she may have to report that as income. See 26 C.F.R. § 1.461–2, Example 1.
The particulars of determining when economic performance occurs are beyond the scope of this course. Generally, though, economic performance occurs if the taxpayer either receives the services, property, or use of property for which she incurred the liability, or incurs costs to provide services or property she's liable to provide. See id. at § 1.461–4(d)(4); 26 U.S.C. § 461(h)(2)(A)-(B).
We could say much more about the accrual method, as federal tax law creates all sorts of exceptions and nuances to the rules we've discussed. But for this course, it's enough to have a basic sense of the accrual method.