DEFERRED PAYMENTS MADE TO INDEPENDENT CONTRACTOR FROM ACCRUAL METHOD ENTITY MAY NOT BE DEDUCTED UNTIL PAYEE INCLUDES PAYMENT IN INCOME.

Rev. Rul. 88-68

ISSUE

If a taxpayer that uses the accrual method of accounting pays fees for services rendered by an independent contractor who uses the cash receipts and disbursements method of accounting and the payment is made pursuant to an arrangement that defers the contractor's receipt of the fees more than a brief period of time beyond the taxpayer's taxable year in which the services are rendered, when may the taxpayer deduct the fees?

FACTS

A, an independent contractor who uses the cash receipts and disbursements method of accounting, performed services for TP, the taxpayer, in 1987. The amounts to be paid by TP for the services are ordinary and necessary business expenses under section 162 of the Code. TP uses the accrual method of accounting. Prior to the performance of any services, TP agreed to pay A 25 percent of A's fee in 1987 and 25 percent in each of the three succeeding years, to be paid on June 1 of each year. TP paid A the agreed amount in 1987, and A included this amount in gross income. Both A and TP file returns on the basis of a calendar year.

LAW AND ANALYSIS

Section 461(a) of the Internal Revenue Code provides that the amount of any deduction shall be taken for the taxable year which is the proper taxable year under the method of accounting used in computing taxable income.

Section 1.446-1(c)(1)(ii) of the Income Tax Regulations provides that under an accrual method of accounting, deductions are allowable for the taxable year in which all events have occurred that establish the fact of the liability giving rise to such deduction and the amount thereof can be determined with reasonable accuracy. This standard is known as the "all events test."

Section 461(h)(1) of the Code provides that in determining whether an amount has been incurred with respect to any item during any taxable year, the all events test shall not be treated as met any earlier than when economic performance with respect to such item occurs.

Section 461(h)(2) of the Code provides that except as provided in regulations prescribed by the Secretary, the time when economic performance occurs shall be determined under certain listed principles. Under section 461(h)(2)(A)(i), if the liability of a taxpayer arises out of the providing of services to the taxpayer by another person, economic performance occurs as such person provides such services.

Section 1.461(h)-4T of the Temporary Income Tax Regulations provides that in the case of a contribution or compensation subject to section 404, pursuant to the authority under section 461(h)(2), economic performance occurs, if section 404(a)(5) is applicable, as an amount attributable to such contribution is includible in the gross income of an employee (or, if section 404(d) applies, a nonemployee).

Section 404(a) of the Code provides that if compensation is paid or accrued on account of any employee under a plan deferring the receipt of the compensation, the compensation is not deductible under chapter 1 of subtitle A of the Code (sections 1 through 1399); if the compensation would otherwise be deductible under chapter 1 of subtitle A of the Code, however, the compensation is deductible under section 404, subject to the limitations imposed by section 404 as to the amounts deductible in any year.

Section 404(a)(5) of the Code provides the general rule that compensation paid under a nonqualified plan (that is, a plan to which contributions are not deductible under section 404(a)(1), (2), or (3)) of deferred compensation is deductible in the taxable year in which an amount attributable to the contribution is includible in the gross income of employees participating in the plan.

Section 404(b) of the Code provides, in part, that if there is no plan, but there is a method or arrangement of compensation which has the effect of a plan deferring the receipt of compensation, section 404(a) shall apply as if there were such a plan.

Section 404(d) of the Code extends the general deduction-timing rule of section 404(a) to benefits or compensation paid to nonemployees by providing that if a plan would be covered by section 404(a) (as modified by section 404(b)) but for the fact that there is no employer-employee relationship, the contributions or compensation if otherwise deductible by the payor under chapter 1 of subtitle A, shall be deductible for the taxable year in which an amount attributable to the compensation is includible in the gross income of the persons participating in the plan.

Section 1.404(b)-1T, Q&A-1, of the temporary regulations provides in part that section 404(a) and (d) applies to all compensation and benefit plans, or methods or arrangements, however denominated, which defer the receipt of any amount of compensation or benefit, including fees or other payments. Under section 404(a)(5) and (b), if otherwise deductible, a contribution paid or incurred with respect to a nonqualified plan, or method or arrangement, providing for deferred benefits is deductible in the taxable year of the employer in which or with which ends the taxable year of the employee in which the amount attributable to the contribution is includible in the gross income of the employee (without regard to any applicable exclusion under chapter 1, subtitle A, of the Code). Section 1.404(d)-1T of the temporary regulations explains in more detail the application of section 404(a), (b), and (d) to deferred benefits or compensation for service providers with respect to which there is no employer-employee relationship. It provides, in part, that section 404(d) governs the deduction of compensation paid or incurred by a payor under a plan, or method or arrangement, deferring the receipt of compensation for service providers with respect to which there is no employer-employee relationship. In such a case, section 404(a) and (b) and the regulations thereunder apply as if the person providing the services were the employee and the person to whom the services are provided were the employer.

Section 1.404(b)-1T, Q&A-1, of the temporary regulations further provides that, for example, a limited partnership (using the accrual method of accounting) may not accrue deductions for a fee owed to an unrelated person (using the cash receipts and disbursements method of accounting) who performs services for the partnership until the partnership taxable year in which or with which ends the taxable year of the service provider in which the fee is included in income. However, as provided in Q&A-2, if the fee is paid within a brief period of time after the end of the partnership's taxable year in which the services were rendered, the fee is deductible in the year in which the services were rendered.

Section 1.404(b)-1T, Q&A-2, of the temporary regulations provides that, for purposes of section 404(a), (b), and (d), a plan, or method or arrangement, defers the receipt of compensation or benefits to the extent it is one under which an employee receives compensation or benefits more than a brief period of time after the end of the employer's taxable year in which the services creating the right to such compensation or benefits are performed. The determination of whether a plan, or method or arrangement, defers the receipt of compensation or benefits is made separately with respect to each employee and each amount of compensation or benefit.

Section 1.404(b)-1T, Q&A-2(b)(1), of the temporary regulations provides that a plan, or method or arrangement, is presumed to be one that defers the receipt of compensation for more than a brief period of time after the end of an employer's taxable year to the extent that compensation is received after the 15th day of the 3rd calendar month after the end of the employer's taxable year in which the services are rendered ("the 2-1/2 month period").

Under section 1.404(b)-1T, Q&A-2(b), of the temporary regulations, this presumption may be rebutted only by demonstrating that it was impracticable to avoid the deferral of the receipt by an employee of the amount of compensation or benefits beyond the applicable 2-1/2 month period and that, as of the end of the employer's taxable year, such impracticability was unforeseeable. A plan, or method or arrangement, is not considered to defer the receipt of compensation or benefits for more than a brief period of time after the end of the employer's taxable year to the extent that compensation or benefits are received by the employee on or before the end of the applicable 2-1/2 month period. See section 1.404(b)- 1T, Q&A-2(c), of the temporary regulations.

Section 1.404(b)-1T, Q&A-2(d), of the temporary regulations provides that, solely for purposes of the rules of section 1.404-1T, Q&A-2(b) and (c), compensation or benefits that relate to services rendered during an employer's taxable year ending on or after July 18, 1984, and on or before March 21, 1986, are deemed to have been received within the applicable 2-1/2 month period if such receipt actually occurred on or before March 21, 1986.

Section 451(a) of the Code provides that the amount of any item of gross income shall be included in gross income for the taxable year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, the amount is to be properly accounted for as of a different period.

Section 1.446-1(c)(1)(i) of the regulations provides that under the cash receipts and disbursements method in the computation of taxable income, all items which constitute gross income are to be included for the taxable year in which actually or constructively received.

TP's agreement with A is a method or arrangement of compensation that has the effect of a plan deferring the receipt of compensation, because under the agreement A is to receive some of the compensation more than a brief period of time after the end of TP's taxable year in which the services creating the right to the compensation were performed. See section 1.404(b)-1T, Q&A-2, of the temporary regulations. However, TP's 1987 payment for services that A performs in 1987 is not deferred compensation, since TP's 1987 payment is not more than a brief period of time after the end of TP's taxable year in which A performed the services. Under section 1.404(b)-1T, Q&A- 2(a), "The determination of whether a plan, or method or arrangement, defers the receipts [sic] of compensation or benefits is made separately with respect to . . . each amount of compensation or benefit." Therefore, TP may deduct its 1987 payment in 1987 under sections 162 and 461(h) of the Code, because TP's liability has arisen out of A providing services to TP in 1987. Section 461(h)(2)(A).

As for the other three payments, although TP's liability is otherwise deductible under section 162 of the Code, section 404(d) prevents TP from accruing deductions for the fee owed to A until the taxable year of TP in which or with which ends the taxable year of A in which A includes the fee in income. Sections 1.404(b)-1T and 1.461(h)-4T of the temporary regulations. Because A uses the cash receipts and disbursements method of accounting, A includes as income for 1988 only the amount actually received in 1988. Section 451(a) and section 1.446-1(c)(1)(i) of the regulations. Accordingly, under section 404(d), for tax year 1988 TP may deduct only the amount A actually receives from TP in 1988. See also H.R. Rep. No. 432, Part 2, 98th Cong., 2d Sess. 1283 (1984); S. Rep. No. 498, 96th Cong., 1st Sess. 16-17 (1979), 1980-1 C.B. 517, 524; S. Rep. No. 1263, 95th Cong., 2nd Sess. 73 (1978), 1978-3 (Vol. 1) C.B. 315, 371; H.R. Rep. No. 1445, 95th Cong., 2nd Sess. 61 (1978), 1978-3 (Vol. 1) C.B. 181, 235.

HOLDING

TP's 1987 payment for services rendered in 1987 by A, an independent contractor, is not deferred compensation, because that payment is not received by A more than 2-1/2 months after the end of TP's taxable year in which the services were performed. Therefore, section 404(d) does not apply. TP may deduct its 1987 payment in 1987.

TP's 1988, 1989, and 1990 payments are made under an arrangement to defer the receipt of compensation more than 2-1/2 months after the end of the taxable year of TP in which the services were performed. Therefore, section 404(d) applies. TP may deduct such payments only in the year that contains the last day of the taxable year of A in which the amount is included in income. Because TP and A both use the calendar year as their taxable year, TP may deduct the 1988 payment in 1988, the 1989 payment in 1989, and the 1990 payment in 1990.

DRAFTING INFORMATION

The principal author of this revenue ruling is Scott D. Feldstein of the Interpretative Division. For further information regarding this revenue ruling contact Mr. Feldstein on (202) 566-4324 (not a toll-free call).