The rules for the deductibility of prepaid expenses are riddled with exceptions to the basic premise that neither cash nor accrual-basis taxpayers ought to deduct any prepayment except to the extent that the purchase - whether it is in the form of an asset or a service - is used in the same tax year. Grace periods, exceptions and additional restrictions can all change a result. The latest variation on the theme of "things are not always what they appear," comes in the form of a chief counsel's advice memorandum.

AM 2007-009 holds that the exceptions to the economic performance rule in determining when a prepayment is deductible must be applied "all-or-nothing." The chief counsel's office believes that neither the three-and-a-half-month rule in Reg. §1.461-4(d)(6) nor the recurring item exception in Reg. §1.461-5 authorize a taxpayer to apportion a deduction so that part of the total deduction may be taken in an earlier tax year.

According to the Internal Revenue Service, this latest misuse of the prepayment rules has been uncovered in "various industries" and from a transaction that has been promoted by several accounting firms. While the chief counsel's boilerplate advisory within the AM warns that it "may not be used or cited as precedent," it is unrealistic to conclude that IRS personnel would not seek to use it against those other industries and accounting firms.

Litigation or reconsideration by the service may provide the only permanent solution. In the meantime, however, several tax strategies may help lessen the AM's immediate impact, at least in connection with new transactions.


The AM was issued in response to a situation involving an accrual-basis taxpayer who had entered into a 12-month service contract starting in Year Two but executed in Year One. At the time the contract was signed, the taxpayer made a partial prepayment to cover a portion of the services to be rendered. The taxpayer deducted the prepayment in Year One, under the theory that it involved the first three-and-a-half months or was a recurring item over the first eight-and-a-half months.


Under the all-events test of Code Sec. 461, a liability can be deducted only when all events have occurred to establish the liability; the amount of the liability can be determined with reasonable accuracy; and economic performance has occurred regarding the liability. Generally, the all-events test cannot be met any earlier than the occurrence of economic performance.

If the liability arises from the providing of services, economic performance occurs as the services are provided. Generally, economic performance for prepaid services would not occur until the services are performed in Year Two. However, Reg. 1.461-4(d)(6)(ii) and (iv) allow two exceptions, called the three-and-a-half-month rule and the recurring item exception. The latter is also called the eight-and-a-half-month exception, after the maximum time allotted to the exception under Code 461(h)(3).

* Under the three-and-a-half-month rule, a taxpayer can treat services as provided to the taxpayer (and therefore as economic performance) as payments are made, if the taxpayer can reasonably expect the services to be provided within three-and-a-half months after the date of payment.

* Under the recurring item exception, a liability is treated as incurred for a tax year if it is fixed and recurring in nature and economic performance occurs by the time the taxpayer files a return for the year, but no later than eight-and-a-half months into the year.

The IRS is taking the position that meeting either the three-and-a-half-month or the eight-and-a-half-month rule is "all or nothing;" a partial deduction relating to the portion of the prepayment attributable to either period is not allowed.

It points to language in the regulations referring to the liability, not to the extent of the liability to which a deduction for prepayment would be allowed.

In doing so, it has also concluded that the ability to reasonably estimate the amount of services that will be provided within the three-and-a-half-month or eight-and-half-month period is irrelevant.

In making its point, the IRS also cited two other time periods mentioned in regulations, such as the two-and-a-half-month deferred-compensation rule under Reg 1.404(b)-1T(b)(1) that considers compensation to be deferred to the extent that it is received after two-and-a-half months after the close of the employer's tax year. It concluded that, by inference, all the services under the contract must be provided within the applicable three-and-a-half or eight-and-a-half months, even though it admitted that neither regulation subsection specifically states that all the service must be provided within those periods.

Whether the chief counsel's office is correct in its analysis remains to be tested. The language of the regulations is arguably ambiguous. And while the three-and-a-half-month exception may be a matter of administrative convenience over which the IRS has more say, the eight-and-a-half-month exception is specifically found in Code Sec. 461(h), which language describes "such services," rather than "the services" as used in the reg.


While the validity of the chief counsel's latest position is being sorted out within the IRS and through litigation, taxpayers do have several strategy options. Each seems to fit within the IRS's reasoning, yet with a probability of success not enjoyed by the taxpayer addressed in the AM.

Both solutions involve a divide-and-conquer approach. First, if the entire length of the contract doesn't fit within the three-and-a-half-month or eight-and-a-half-month period, consider writing two separate contracts, one to cover the allowable period and one further out. As long as the contracts are not considered as one (different payment schedules, work descriptions, liquidated damages or similar variations might prove that they are not), a deduction for prepayment would appear to fit within the rules.

Second, if more than one type of service is involved, try to bunch one of them into the three-and-half-month or eight-and-a-half-month period. The IRS's conclusion under both subsections of the reg was that if a single contract provides for different services, authority exists to use the three-and-a-half-month or eight-and-a-half-month exceptions for a portion of a liability. Splitting hairs on what constitutes "different" services, of course, may be the IRS's next focal point.

Stay tuned.

George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.

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